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Concept of Value and its Impact on Real Estate
The concept of value is a cornerstone in real estate appraisal, multifaceted and transcending price or cost. This chapter, “The Concept of Value and its Impact on Real Estate,” explores this concept, analyzes its aspects, understands influencing factors, and examines its scientific and practical importance in real estate appraisal.
Understanding value is an analytical process based on economic foundations and market principles. Real estate appraisal relies on economic theory, where real estate is a commodity subject to supply and demand, influenced by social, economic, governmental, and environmental factors. Understanding these factors and their interactions is the essence of the scientific practice of real estate appraisal.
The chapter will define value, distinguishing it from price and cost. It will review economic theories underlying the understanding of value, including supply and demand, utility, scarcity, transferability, and effective demand. It will explore types of value such as market value, use value, investment value, and liquidation value, and how these differ based on circumstances and objectives. It will analyze the social, economic, governmental, and environmental factors that directly and indirectly affect real estate value, and how appraisers can evaluate these factors when estimating value.
The chapter aims to provide the knowledge and understanding necessary to define value, distinguishing it from price and cost, and understand its characteristics; apply supply and demand and utility theories; identify different types of value (market, use, investment, liquidation) and understand their uses; identify and analyze social, economic, governmental, and environmental factors influencing real estate value; understand how to estimate the quantitative and qualitative impact of different factors on real estate value; develop critical thinking and logical analysis when dealing with real estate appraisal issues; define optimal use, and its impact on value.
Definition of Value:
Value is an economic concept reflecting the expected benefit of acquiring an asset, representing the monetary worth of properties, goods, or services. In real estate, value is an estimate of the highest price a potential buyer is willing to pay for a property under specific market conditions.
- Basic Characteristics of Value: Utility (ability to satisfy a need), Scarcity (limited supply vs. demand), Transferability (ease of ownership transfer), Effective Demand (desire supported by purchasing power), Demand (desire to own).
- Value vs. Price vs. cost❓: Value is an estimate of asset worth in the market; Price is the actual amount paid in a transaction; Cost is the expense to build or create a property.
- Replacement Cost: Cost to create a substitute with similar utility.
- Reproduction Cost: Cost to create an exact replica.
Economic Theory of Value:
Property value depends on the interaction of supply and demand in the market.
- Market: The interaction between buyers and sellers regarding property exchange.
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Law of Supply and Demand: If demand exceeds supply, values rise; if supply exceeds demand, values fall. A property’s value cannot exceed the price of a substitute property with similar utility (Principle of Substitution). A rational investor will not buy a property if its income is less than the opportunity cost. Competition increases when supply and demand are unbalanced, tending to restore equilibrium.
- Simplified Supply and Demand Formula: If D = Demand, S = Supply, and V = Value, then if D > S, V increases; if D < S, V decreases.
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Market Changes: Appraisers must estimate value at a specific date. Value depends on the expected future benefits of property ownership and fluctuates with the real estate cycle (development, maturity, decline, and renewal).
Production as a Measure of Value:
Wealth creation relies on four factors of production: capital, Land❓❓, labor, and coordination.
- Factors of Production: Capital (financial resources), Land (location, area, natural characteristics), Labor (human effort), Coordination (management and organization).
- Balance Among Factors of Production: Property value improves when these factors are balanced, up to the point of diminishing returns.
- Surplus Productivity: Attributed to land; the remaining net income after deducting costs of capital, labor, and coordination.
- Marginal Productivity: The value of a property component is its marginal productivity; the amount its presence increases the overall property value.
- Diminishing Returns: Incremental increases in investment in a factor of production will initially increase the rate of return, but eventually reach a point where the return begins to decrease.
Impact of Use on Property Value:
- Highest and Best Use: Property should be valued based on its highest and best use, which is any reasonable and legal use that achieves maximum profit. This depends on the nature and value of property improvements.
- Consistent Use: Land and improvements should be valued for the same use.
- Conformity: Property value increases when surrounding property uses are compatible.
Types of Value:
Value types differ based on the purpose of the assessment and surrounding circumstances.
- Market Value: Determined by the market in a transaction between independent parties, with informed and rational buyers and sellers acting without coercion and with reasonable market exposure. It may vary based on the specific definition and requires adjustments for non-cash financing terms and unusual market concessions.
- Value in Use: Value of the property for a specific purpose, not its highest and best use.
- Investment Value: Value to a specific investor, not the market.
- Liquidation Value: What the property would bring with limited market exposure.
- Assessed Value: Market value multiplied by the applicable assessment ratio.
- Insurable Value: Value for reimbursement purposes under an insurance policy.
- Going Concern Value: Value of an ongoing business enterprise that includes real estate as an integral part of its operations.
Factors Influencing Value:
Value is affected by social, economic, governmental, and environmental factors.
- Social Influences: Demographics and social norms.
- Economic Influences: Affect property values by influencing the cost of capital and purchasing power.
- Governmental Influences: Laws and regulations such as zoning, taxes, environmental laws, financial regulations, and building codes.
- Environmental Influences: Land characteristics, climate, infrastructure, and location, including land shape, sun exposure, environmental hazards, and topography.
- Land Shape: Regular plots are generally more valuable per square foot than irregular plots.
- Exposure: Residential properties with morning sun in kitchens and dining areas and sunset views are more valuable.
- Environmental Hazards: Issues like contaminated soil or asbestos negatively affect value.
- Topography: Flat or gently rolling land with good drainage is more valuable.
Chapter Summary
The chapter addresses the concept of value in real estate appraisal, clarifying that value is not an inherent property but a monetary estimate based on multiple factors.
Key Points:
- Definition of Value:
- Value is the “monetary value of properties, goods, services, etc.”
- Value depends on four elements: utility, scarcity, transferability, and effective demand (desire supported by purchasing power).
- Distinction between Value, Price, and cost❓:
- Price: actual amount paid in a transaction.
- Cost: expenses needed to create or build the property.
- Value: estimate of a property’s potential price.
- Replacement cost is the cost of creating a substitute with equal utility, while replication cost is the cost of creating an exact copy.
- Economic Theory of Value:
- Market: interaction between buyers and sellers.
- Supply and Demand: determine property value in a competitive market. values❓ increase when demand exceeds supply and decrease vice versa.
- Principle of Substitution: Property value cannot exceed the price of a substitute with similar utility.
- Opportunity Cost: Property income less than the opportunity cost will deter a rational investor.
- Competition: Imbalance in supply and demand increases competition, which tends to restore balance.
- Production as a Measure of Value:
- Four factors of production create wealth: capital, land❓, labor, and coordination.
- Value of a property or market is optimized when production factors are balanced. The point of balanced production factors is the point of diminishing returns.
- Surplus productivity is attributed to land and is what remains of the net income after deducting capital, labor and coordination cost.
- The value of a component of a property is its marginal productivity, which is the amount its presence increases the value of the whole property.
- Additional investment in a factor of production will initially increase the rate of return but will eventually reach a point (point of diminishing return) where the return starts to decrease.
- Impact of Use on Property Value:
- Property must be valued based on its highest and best use, which is any reasonable and legal use that yields the greatest profit.
- Highest and best use depends on the nature and value of property improvements. The highest and best use for a vacant property is not necessarily its highest and best use as currently improved.
- Both land and improvements must be valued for the same (consistent) use.
- Property value improves when the uses of surrounding properties align with the subject property’s use.
- Types of Value:
- Appraisal reports must specify the standard of value being assessed.
- Market Value: determined by the market in a commercial transaction.
- Buyer and seller must be reasonably informed about market conditions and the property.
- Buyer and seller must act reasonably, in self-interest, and without coercion.
- The property must be offered on the market for a reasonable period.
- Market value may vary depending on its specific definition and its applicability to the appraisal circumstances.
- Market value must be adjusted to account for financing terms not equivalent to cash and any other unusual market concessions.
- Use Value: property value for a specific purpose only, as opposed to its highest and best use.
- Investment Value: value to a specific investor, as opposed to the market.
- Liquidation Value: what the property will bring with limited market exposure.
- Assessed Value: market value multiplied by the applicable assessment ratio.
- Insurable Value: value for reimbursement purposes under an insurance policy.
- Going-Concern Value: the value of a continuing business enterprise that includes property as an integral part of its operations.
- Factors Influencing Value:
- Value is affected by social, economic, governmental, and environmental influences.
- Social influences are factors like demographics and social norms.
- Economic influences affect property values by impacting the cost of capital and the purchasing power of buyers and investors.
- Governmental influences include laws and regulations affecting value, such as zoning, taxes, environmental laws, financial regulations, and building codes.
- Environmental influences include land characteristics, climate, infrastructure, and location.
Conclusions:
A comprehensive understanding of value is essential for real estate appraisal, helping appraisers identify influencing factors, choose appropriate methods, and provide accurate market value estimates.
Implications:
- Real estate appraisers: must be aware of economic, social, governmental, and environmental factors affecting property value.
- Investors: must understand different types of value and their impact on investment decisions.
- Lenders: must rely on accurate appraisals for the safety of real estate loans.
- Policymakers: must consider the impact of government policies on property value.
