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Understanding Real Estate Value: Principles and Influences
Chapter 2 Understanding Real estateโ Value: Principles and Influences
I. WHAT IS VALUE?
Value, in its essence, represents the relative worth of an asset, service, or good, typically expressed in monetary terms. Itโs the quantification of the benefits one expects to derive from possessing or using something. A common definition is โthe monetary worth of property, goods or services to buyers and sellers.โ Value is inherently linked to anticipated benefits, so we can define value as โthe present worth of future benefitsโ expressed in monetary terms. Understanding value requires a comprehensive approach, considering various interdependent principles.
II. FOUR CHARACTERISTICS OF VALUE
Value isn’t intrinsic. It is created by external market forces, specifically:
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Utility: The ability of a good or service to satisfy a need or want. Real estate offers utility for residential, commercial, agricultural, and recreational purposes.
Example: A vacant lot suitable for building a house possesses utility. -
Scarcity: Limited availability relative to demand. A surplus diminishes value.
Example: Waterfront properties are typically more valuable due to their limited availability compared to non-waterfront properties. -
Transferability: The ability to convey ownership rights from one party to another. Without transferability, no exchange can occur, and therefore value is non existent. This includes the ability to will, lease, give or sell a property.
Example: National parks, held for public enjoyment, lack economic value in the sense of market exchange, reflecting their โpricelessโ nature. -
Effective Demand: The combination of desire and purchasing power. Desire without the ability to pay does not create value.
Example: Strong employment rates and high wages in an area correlate with higher real estate values due to increased effective demand.
III. VALUE DISTINGUISHED FROM PRICE AND COST
Value, price, and cost are related but distinct concepts:
- Value: A theoretical estimate of worth under specific conditions.
- Price: The actual amount asked, offered, or paid in a transaction, a historical fact.
- Cost: The expense incurred to create, produce, or obtain a property.
A. Direct and Indirect Costs
Direct Costs: Expenses directly attributed to the creation of an asset.
Indirect Costs: Overhead and administrative expenses.
B. Development Cost and Construction Cost
Development Cost: The total cost, including land acquisition and construction.
Construction Cost: Expenses solely related to building.
C. Replacement Cost and Reproduction Cost
Replacement Cost: The cost of building a property of equal utility using modern materials and design.
Reproduction Cost: The cost of creating an exact replica of the property using the same materials and design.
IV. PRINCIPLES OF APPRAISAL (ECONOMIC VALUE)
Several economic principles govern how value is determined in the real estate market:
A. Principle of Supply and Demand
Value is determined by the interaction of supply (the amount of a good or service available) and demand (the desire and ability to purchase that good or service).
- When demand exceeds supply, prices tend to rise.
- When supply exceeds demand, prices tend to fall.
Equilibrium occurs where supply equals demand. A shift in either supply or demand results in a new equilibrium.
Example: High demand and limited housing supply in a city drive up housing prices.
B. Principle of Substitution
A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle underpins all three approaches to value: cost, sales comparison, and income capitalization.
Example: If two similar houses are available, a buyer will choose the one with the lower price, assuming all other factors are equal.
C. Principle of Competition
Profits tend to attract competition. Excess profits in real estate development encourage new projects, which can eventually lead to oversupply and reduced profitability.
Example: A successful shopping center attracts other developers to build nearby, potentially diluting the market and lowering the value of existing centers.
D. Principle of Change
Real estate values are constantly changing due to various forces, including:
- Economic conditions
- Social trends
- Government regulations
- Environmental factors
Understanding these dynamic forces is crucial for accurate valuation.
Example: New infrastructure developments, like a new highway, can significantly impact property values in the surrounding area.
E. Principle of Anticipation
Value is based on the expectation of future benefits. Investors buy properties based on their anticipated future income or appreciation.
Example: Land in the path of future development is often valued higher than land in less promising areas.
F. Principle of Balance
Value is maximized when the four agents of production (land, labor, capital, and entrepreneurship) are in equilibrium. Imbalances can lead to inefficiencies and reduced value.
- Land: Natural resources and location.
- Labor: Human effort applied to production.
- Capital: Money, equipment, and infrastructure.
- Entrepreneurship: The coordination and risk-taking involved in the production process.
- Point of Diminishing Returns
Value is maximized when the four agents of production (land, labor, capital, and entrepreneurship) are in equilibrium. Imbalances can lead to inefficiencies and reduced value. The Point of Diminishing Returns indicates that beyond a certain level of investment, the marginal increase in value decreases.
G. Principle of Surplus Productivity
Net income remaining after the costs of labor, capital, and coordination have been paid.
Surplus Productivity = net operating incomeโโ โ (Labor Costs + Capital Costs + Coordination Costs)
H. Principle of Contribution
The value of a component is measured by its contribution to the value of the whole, rather than its individual cost.
Example: Adding a swimming pool may increase property value, but not necessarily by the cost of the pool.
I. Principle of Increasing and Decreasing Returns
Increasing Returns: Investing in improvements will add value (initial phase).
Decreasing Returns: Investment in improvements will not add value or might detract (later phase).
V. EFFECT OF USE ON REAL ESTATE VALUE
A. Highest and Best Use Principle
The most probable and legalโ use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. It must be legally permissible, physically possible, financially feasible, and maximally productive.
Example: A vacant lot in a commercial zone may have a higher value if used for a retail store than for a single-family home.
B. Consistent Use Principle
Land should not be valued based on one use while improvements are valued based on another. The land and improvements should be valued on their most appropriate consistent use.
C. Conformity, Progression, and Regression Principles
- Conformity: Properties tend to achieve maximum value when they are similar to other properties in the neighborhood.
- Progression: The value of a lower-valued property increases when located near higher-valued properties.
- Regression: The value of a higher-valued property decreases when located near lower-valued properties.
VI. PRODUCTION AS A MEASURE OF VALUE
A. Agents of Production Principle
The value of a property is influenced by the interaction of the four agents of production: land, labor, capital, and entrepreneurship.
VII. TYPES OF VALUE
A. Market Value
The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.
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Market Value in Non-Cash Equivalent Transactions
Analysis and adjustments are needed to account for non-cash components. -
Other Definitions of Market Value
Vary slightly based on the specific context and purpose of the appraisal.
B. Price
The amount actually paid for a property in a specific transaction.
C. Value in Use
The value of a property to a specific user for a specific purpose.
D. Investment Value
The value of a property to a particular investor based on their investment criteria.
E. Liquidation Value
The estimated value of a property if sold quickly, often under duress.
F. Assessed Value
The value assigned to a property by a government agency for property tax purposes.
G. Insurable Value
The value of a property for insurance purposes, typically representing the cost of replacing the structure.
H. Going Concern Value
The value of a business enterprise, including both tangible and intangible assets.
VIII. FORCES AFFECTING VALUE
Real estate values are influenced by a variety of factors:
A. Social Factors
- Prestige
- Recreation
- Culture
- Family Orientation
- Homeowner Restrictions
B. Economic Factors
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The Local Economy
Job growth/decline
Wage levels
*Diversification -
Interest Rates
*Impact on affordability and investment returns -
Rents
*Indicator of market demand and property income -
Vacancy Factors
*Reflect market equilibrium between supply and demand -
Plottage
*Increased value from combining smaller parcels into a larger one -
Parking
*Important for commercial properties -
Corner Influence
*Enhanced visibility and accessibility for commercial properties
C. Political Factors
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Taxes
*Property taxes affect affordability and investment returns -
Zoning
*Regulations that control land use and development -
Rent Control
*Limits on rent increases can affect property values -
Growth Limitations
*Restrictions on development can impact property supply and demand -
Environmental Restrictions
*Regulations protecting natural resources can affect development potential -
Building and Health Codes
*Minimum standards for safety and construction
D. Environmental (Physical) Factors
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Location
*Proximity to amenities, schools, transportation, and employment centers -
Climate
*Desirability of the local climate -
Water
*Access to water resources -
Transportation
*Availability of transportation options -
View
*Scenic views increase property value -
Soil
*Soil quality affects construction costs and suitability for agriculture -
Size and Shape
*Impact on usability and development potential -
Exposure
*Sunlight and weather exposure -
Environmental Hazards
*Contamination, flooding, or other hazards can negatively impact value -
Topography
*Slope and elevation of the land
Chapter Summary
Understanding Real estateโ Value: Principles and Influences
This chapter provides a foundational understanding of real estate value, distinguishing it from related concepts and outlining the core principles that govern it. It examines the characteristics of value, differentiating it from price and cost, exploring key appraisal principles, assessing the impact of land use and production, classifying different types of value, and analyzing the various forces that affect real estate value.
Key Scientific Points and Principles:
Four Characteristics of Value: The chapter emphasizes that value is not intrinsic but created by external factors. These are:
Utility: The ability of a propertyโ to satisfy a need or want.
Scarcity: Limited availability relative to demand.
Transferability: The ability to transfer ownership rights.
Effective Demand: Desire for the property coupled with the purchasing power to acquire it.
Value vs. Price vs. Cost:
Value: An estimate of worth under specific conditions.
Price: The actual amount paid in a transaction, a historical fact.
Cost: The expenses incurred to create or obtain a property.
Principles of Appraisal (Economic Value): Several interconnected economic principles influence real estate value:
Supply and Demand: Value is affected by the balance between the availability of properties and the desire for them.
Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
Competition: Profits tend to attract competition, which can then reduce profitability.
Change: Real estate values are dynamic and influenced by ongoing economic, social, and environmental changes.
Anticipation: Value is based on the expectation of future benefits.
Balance: Value is maximized when there is equilibrium among the factors of production (land, labor, capital, and coordination). Diminishing returns occur when adding more of one factor yields less incremental value.
Surplus Productivity: Net income remaining after the costs of labor, capital and coordination have been paid.
Contribution: The value of a component part is measured by how much it adds to the overall value of the property.
Increasing and Decreasing Returns: Initially, investment yields increasing returns, but beyond a certain point, further investment leads to decreasing returns.
Effect of Use on Real Estate Value:
Highest and Best Use: The most profitable and legally permissible use of a property.
Consistent Use: Land cannot be valued for one use while improvements are valued for another.
Conformity, Progression, and Regression: Values are maximized when properties are similar and consistent with the neighborhood. Progression suggests lower-valued properties benefit from being near higher-valued ones, while regression implies the opposite.
Production as a Measure of Value:
Agents of Production: Value is generated by the interaction of land, labor, capital, and coordination.
Types of Value: The chapter defines various types of value:
Market Value: The most probable price a property should bring in a competitive and open market.
Price: The actual transaction amount.
Value in Use: The value of a property for a specific use.
Investment Value: The value to a particular investor.
Liquidation Value: The value in a forced sale scenario.
Assessed Value: The value assigned for taxation purposes.
Insurable Value: The value for insurance coverage.
Going Concern Value: The value of an operating business.
Forces Affecting Value: Several external factors can influence real estate values:
Social Factors: Demographics, lifestyle preferences, cultural trends, family orientation, homeowner restrictions.
Economic Factors: localโ economy, interest rates, rents, vacancy rates, plottage (increased value from combining adjacent parcels), parking availability, corner influence.
Political Factors: Taxes, zoning regulations, rent control, growth limitations, environmental restrictions, building codes.
Environmental (Physical) Factors: Location, climate, water availability, transportation, view, soil conditions, size and shape of the parcel, exposure, environmental hazards, topography.
Conclusions and Implications:
The chapter emphasizes that understanding real estate value requires a holistic view, considering various interconnected factors. Appraisers must consider the unique characteristics of each property, the prevailing market conditions, and the potential impact of future changes. Furthermore, a keen awareness of the social, economic, political, and environmental forces influencing value is critical for accurate valuation. This knowledge empowers stakeholders to make informed decisions in real estate investment, development, and management.
