Principles and Factors Influencing Real Estate Value

Chapter 2 Principles and Factors Influencing Real Estate Value

I. WHAT IS VALUE?

In its essence, value represents the relative worth of an asset, typically expressed in monetary terms. More formally, value is the present worth of future benefits derived from the ownership of real estate. This definition incorporates both the tangible aspects of the property and the intangible benefits such as location, prestige, and potential income.

Value is not an intrinsic property❓❓ of an asset but rather a reflection of market perceptions and expectations. This implies that value is subjective and can fluctuate based on various economic, social, political, and environmental factors.

II. FOUR CHARACTERISTICS OF VALUE

Modern economic theory posits that value is not inherent in a thing itself but arises from external forces. The four key characteristics that contribute to value are:

A. Utility

Utility refers to the ability of a property to satisfy a want or need. Real estate offers utility in various forms, including:

1.  Residential: Providing shelter, security, and a sense of community.
2.  Commercial: Generating income through business operations.
3.  Industrial: Facilitating production and distribution of goods.
4.  Agricultural: Supporting farming and livestock activities.

The greater the utility of a property, the higher its potential value.

B. Scarcity

Scarcity implies limited availability relative to demand. The less abundant a property type or location is, the more valuable it tends to be. For example:

1.  Waterfront properties command premium prices due to their limited supply.
2.  Properties in prime urban locations are more valuable than those in remote areas.

Scarcity interacts with demand to determine market prices.

C. Transferability

Transferability refers to the ability to convey ownership rights from one party to another. Without clear title and the legal right to sell, lease, or bequeath a property, its value is significantly diminished. Factors affecting transferability include:

1.  Legal restrictions (e.g., zoning regulations).
2.  Encumbrances (e.g., liens, easements).
3.  Marketability of title.

D. Effective Demand

Effective demand represents the combination of desire and purchasing power. Potential buyers must not only want a property but also have the financial capacity to acquire it. Economic indicators such as:

1.  Income levels
2.  Employment rates
3.  Credit availability

significantly impact effective demand and, consequently, property values.

III. VALUE DISTINGUISHED FROM PRICE AND COST

It is crucial to differentiate between value, price, and cost:

1.  Value: An estimate of worth based on market analysis and appraisal principles.
2.  Price: The actual amount paid for a property in a transaction. Price is a historical fact.
3.  Cost: The expenses incurred to create or obtain a property, including materials, labor, and overhead.

While these terms are related, they are not interchangeable. Price may deviate from value due to market inefficiencies or unique circumstances. Cost influences value but does not dictate it.

IV. PRINCIPLES OF APPRAISAL (ECONOMIC VALUE)

Several economic principles underpin real estate appraisal:

A. Principle of Supply and Demand

This fundamental principle states that value is influenced by the relationship between the availability of properties (supply) and the desire and ability of buyers to acquire them (demand).

1.  High demand and limited supply typically lead to increased values.
2.  Low demand and excess supply result in decreased values.

Market equilibrium occurs when supply and demand are balanced.

B. Principle of Substitution

The principle of substitution asserts that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle is central to the sales comparison approach to appraisal.

C. Principle of Competition

Competition among sellers tends to lower prices, while competition among buyers tends to increase them.

1.  Excessive profits in real estate development can attract new competitors, increasing supply and potentially lowering values.
2.  Limited availability of desirable properties can intensify competition among buyers, driving up prices.

D. Principle of Change

Real estate markets are dynamic and constantly evolving. Changes in:

1.  Economic conditions
2.  Demographics
3.  Government regulations
4.  Technological advancements

can significantly impact property values. Appraisers must consider these trends in their analyses.

E. Principle of Anticipation

Value is influenced by expectations of future benefits. For example:

1.  A property located near a planned transportation hub may increase in value due to anticipated accessibility improvements.
2.  Developers often purchase <a data-bs-toggle="modal" data-bs-target="#questionModal-325575" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">land</span><span class="flag-trigger">❓</span></a> in anticipation of future demand, impacting current land values.

F. Principle of Balance

The principle of balance suggests that maximum value is achieved when the various factors of production (land, labor, capital, and entrepreneurship) are in equilibrium.

1.  Over-improvement of a property may not yield a commensurate increase in value if it is not in balance with the surrounding neighborhood.

Point of Diminishing Returns: As more of one factor of production is added, while others are held constant, marginal productivity increases at first, then decreases.

G. Principle of Surplus Productivity

Surplus productivity is the net income remaining after the costs of labor, capital, and coordination have been paid. This remaining income is attributed to The land❓.

H. Principle of Contribution

The principle of contribution states that the value of a component of a property is measured by its contribution to the overall value, not by its individual cost.
A swimming pool may add significant value in a warm climate but have little impact in a colder region.

I. Principle of Increasing and Decreasing Returns

Increasing returns occur when additional investment yields a proportionally greater increase in value. Decreasing returns occur when additional investment yields a proportionally smaller increase in value.

V. EFFECT OF USE ON REAL ESTATE VALUE

A. Highest and Best Use Principle

The highest and best use is the most probable use of a property that is:

1.  Legally permissible.
2.  Physically possible.
3.  Financially feasible.
4.  Maximally productive.

The highest and best use determines the potential value of a property.

B. Consistent Use Principle❓❓

This principle dictates that a property should be valued based on a single, consistent use. It avoids valuing the land under one use and the improvements under another.

C. Conformity, Progression, and Regression Principles

1.  Conformity: Properties tend to achieve maximum value when they are similar to and compatible with surrounding properties.
2.  Progression: The value of a less expensive property tends to increase if it is located near more expensive properties.
3.  Regression: The value of a more expensive property tends to decrease if it is located near less expensive properties.

VI. PRODUCTION AS A MEASURE OF VALUE

A. Agents of Production Principle

Land, labor, capital, and entrepreneurship are the four agents of production that contribute to real estate value. The principle dictates that the value of real estate is directly influenced by the cost of, and returns to, each of these agents.

VII. TYPES OF VALUE

A. Market Value❓❓

Market value is the most probable price a property should bring in a competitive and open market, assuming:

1.  A willing buyer and a willing seller.
2.  Reasonable exposure to the market.
3.  Informed parties acting prudently.
4.  Payment in cash or its equivalent.

Market value is the primary focus of most real estate appraisals.

B. Price

The amount paid for something in the past.

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 value of a property if it were sold quickly, often under duress.

F. Assessed Value

The value assigned to a property for tax purposes.

G. Insurable Value

The value of a property for insurance purposes, typically based on the cost to replace the improvements.

H. Going Concern Value

The value of a business enterprise, including both real estate and intangible assets like goodwill.

VIII. FORCES AFFECTING VALUE

Numerous factors influence real estate value:

A. Social Factors

1.  Demographic trends (population growth, age distribution).
2.  Lifestyle preferences.
3.  Educational attainment.
4.  Crime rates.
5.  Prestige
6.  Recreation
7.  Culture
8.  Family Orientation
9.  Homeowner Restrictions

B. Economic Factors

1.  Employment rates.
2.  Income levels.
3.  Interest rates.
4.  Inflation.
5.  Availability of credit.
6.  Local economy
7.  Rents
8.  Vacancy Factors
9.  Plottage
10. Parking
11. Corner Influence

C. Political Factors

1.  Zoning regulations.
2.  Building codes.
3.  Property taxes.
4.  Government subsidies.
5.  Rent control
6.  Growth Limitations
7.  Environmental Restrictions
8.  Building and Health Codes

D. Environmental (Physical) Factors

1.  Location
2.  Climate
3.  Water
4.  Transportation
5.  View
6.  Soil
7.  Size and Shape
8.  Exposure
9.  Environmental Hazards
10. Topography

These factors interact in complex ways to shape real estate values.