Foundations of Value: Principles and Influences

Chapter 2 Understanding Value: Foundations of Value: Principles and Influences

I. WHAT IS VALUE?

Value, in its essence, represents the relative worth of an object or service, typically expressed in terms of a medium of exchange, such as money. A common definition of value is “the monetary worth of property, goods, or services to buyers and sellers.” More specifically, value can be thought of as the “present worth of future benefits,” expressed in monetary terms. This implies that the perceived value of something is directly related to the benefits it is expected to provide over time.

II. FOUR CHARACTERISTICS OF VALUE

Modern economic theory suggests that value is not intrinsic to an object but is created by external forces and circumstances. These circumstances are defined by the “Four Characteristics of Value”:

1. Utility:
   - Definition: The ability of a good or service to satisfy a want or need.
   - Application to Real Estate: Real estate provides utility as a site for various activities, including residential, commercial, agricultural, and recreational purposes.
   - Example: A residential building lot has utility because it can be used for the construction of a home.
   - Scientific Principle: Utility is related to the concept of “satisfaction” or “welfare” in economics. A property with higher utility offers more potential satisfaction, thus commanding a higher value.

2. Scarcity:
   - Definition: Limited availability of a good or service relative to demand.
   - Application to Real Estate: Scarce resources, like waterfront property, are generally more valuable due to their limited supply.
   - Example: Waterfront properties typically have higher values than non-waterfront properties due to their scarcity.
   - Scientific Principle: Scarcity drives value through the principle of supply and demand. As supply decreases relative to demand, the price (and hence value) increases.
   - Equation: Value ∝ 1 / Supply (assuming constant demand)

3. transferability❓❓:
   - Definition: The ability to transfer ownership of a good or service from one party to another.
   - Application to Real Estate: Transferability is essential for establishing value because value presupposes an exchange, real or theoretical.
   - Example: Land❓❓ dedicated as a national park, which cannot be bought or sold, does not have economic value in the traditional sense.
   - Scientific Principle: The concept of “property rights” in economics emphasizes the importance of transferability. Clear and enforceable property rights facilitate transactions, thereby enabling value creation.

4. Effective Demand:
   - Definition: The combination of desire for a good or service and the purchasing power to acquire it.
   - Application to Real Estate: Effective demand arises when potential buyers not only want to own property but also have the financial means to purchase it.
   - Example: Real estate in areas with strong employment and high wages has value because there is both desire for housing and the purchasing power to afford it.
   - Scientific Principle: Effective demand is rooted in microeconomic principles. It reflects the intersection of consumer preferences (desire) and budget constraints (purchasing power).
   - Equation: Effective Demand = Desire * Purchasing Power

III. VALUE DISTINGUISHED FROM PRICE AND COST

While the terms “value,” “price,” and “cost” are often used interchangeably, they have distinct meanings in the context of real estate appraisal:

• Value: An estimate of what a property is theoretically worth under specific circumstances, based on market conditions and property characteristics.
• Price: The actual amount asked, offered, or paid in a particular transaction. Price is a historical fact.
• Cost: The total expenditure required to create, produce, or obtain a property, including labor, materials, and other inputs.

IV. PRINCIPLES OF APPRAISAL (ECONOMIC VALUE)

Several core economic principles underpin the process of real estate appraisal:

A. Principle of Supply and Demand:
- Definition: The relationship between the availability of a good or service and the desire for it.
- Application to Real Estate: Real estate values are directly influenced by the balance between the supply of available properties and the demand from potential buyers or renters.
- Scientific Principle: This principle is a cornerstone of economics. When demand exceeds supply, prices (and values) tend to rise; when supply exceeds demand, prices tend to fall.
- Graph: A graph could illustrate how the equilibrium price shifts based on changes in supply and demand curves.

B. Principle of Substitution:
- Definition: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
- Application to Real Estate: Appraisers often use comparable sales to estimate the value of a subject property, based on the principle that buyers will choose the least expensive option that meets their needs.
- Example: If two similar houses are for sale, a buyer will generally choose the one with the lower price.
- Scientific Principle: This principle is based on the concept of “opportunity cost.” A rational buyer will always choose the option that maximizes their utility for a given cost.

C. Principle of Competition:
- Definition: Competition among sellers drives prices down, while competition among buyers drives prices up.
- Application to Real Estate: The level of competition in a market affects property values. A market with many competing properties may experience lower values than a market with limited competition.
- Example: In a neighborhood with many similar houses for sale, sellers may have to lower their prices to attract buyers.
- Scientific Principle: Competition is a fundamental force in markets, ensuring that resources are allocated efficiently. It tends to drive prices towards the equilibrium point where supply equals demand.

D. Principle of Change:
- Definition: Real estate values are dynamic and subject to change over time due to various factors, including economic conditions, demographics, and government policies.
- Application to Real Estate: Appraisers must consider the potential for future changes when estimating the value of a property.
- Example: A neighborhood undergoing gentrification may experience rapid increases in property values.
- Scientific Principle: The principle of change highlights the dynamic nature of markets. Time series analysis can be used to study how real estate values change over time and to identify the factors that contribute to these changes.

E. Principle of Anticipation:
- Definition: The value of a property is based on the expected future benefits it will provide.
- Application to Real Estate: Investors often purchase properties based on their anticipation of future income or appreciation.
- Example: A developer may purchase land in anticipation of future growth in the area.
- Scientific Principle: This principle aligns with the concept of “present value” in finance. The present value of an asset is the sum of its expected future cash flows, discounted back to the present.
- Equation: PV = CF1 / (1+r) + CF2 / (1+r)^2 + … + CFn / (1+r)^n, where PV = Present Value, CF = Cash Flow, r = Discount Rate, n = Number of periods.

F. Principle of Balance:
- Definition: Value is maximized when there is a proper balance between the agents of production: land, labor, capital, and entrepreneurship.
- Application to Real Estate: A well-balanced property with appropriate improvements and amenities will typically have a higher value than a property that is lacking in one or more areas.
- Example: A property with a beautifully designed house but poor landscaping may not achieve its full potential value.
- Scientific Principle: This principle reflects the concept of “optimal allocation” in economics. Resources should be allocated in a way that maximizes overall productivity and value.

1. Point of Diminishing Returns:
   - Definition:  As more of one agent of production is added while holding others constant, there will be a point where additional inputs yield smaller increases in output.
   - Application to Real Estate:  Adding more amenities to a property may not proportionally increase its value if the market already considers the property well-equipped.

G. Principle of Surplus Productivity:
- Definition: The net income remaining after the costs of labor, capital, and coordination have been paid. This surplus is attributed to the land.
- Application to Real Estate: Properties with high surplus productivity tend to be more valuable because they generate higher returns.
- Scientific Principle: This principle is closely related to the concept of “economic rent,” which is the payment to a factor of production (in this case, land) that is in excess of what is necessary to keep it in its current use.

H. Principle of Contribution:
- Definition: The value of a particular component of a property is measured by the amount it contributes to the overall value of the property, not by its cost.
- Application to Real Estate: Appraisers must consider the contribution of each feature of a property when estimating its value.
- Example: Adding a swimming pool may not increase the value of a property by the full cost of the pool if buyers do not value it highly.
- Scientific Principle: This principle is based on the concept of “marginal utility.” The contribution of an additional unit of a good or service is determined by the marginal utility it provides.

I. Principle of Increasing and Decreasing Returns:
- Definition: Investing in improvements to a property will yield increasing returns up to a certain point, after which further investments will yield decreasing returns.
- Application to Real Estate: Property owners should invest in improvements that provide the greatest return on investment.
- Example: Renovating a kitchen may significantly increase the value of a house, but adding a second kitchen may not provide a similar return.
- Scientific Principle: This principle is related to the concept of “economies of scale.” Initially, increasing the scale of production (by investing in improvements) can lead to lower costs and higher returns. However, beyond a certain point, diseconomies of scale may set in, leading to diminishing returns.

V. EFFECT OF USE ON REAL ESTATE VALUE

A. Highest and Best Use Principle:
- Definition: The highest and best use of a property is the most probable and legal use that is physically possible, appropriately supported, financially feasible, and that results in the highest value.
- Application to Real Estate: Appraisers must determine the highest and best use of a property when estimating its value.
- Example: A vacant lot in a commercial area may have a higher value if it is developed into a retail store than if it is used for residential purposes.
- Scientific Principle: This principle is based on the concept of “opportunity cost.” The highest and best use of a property is the use that generates the greatest economic benefit.

B. Consistent Use Principle:
- Definition: A property must be valued based on a single, consistent use.
- Application to Real Estate: Appraisers must avoid valuing a property based on a combination of different uses.

C. Conformity, Progression, and regression❓❓ Principles:
- Definition:
- Conformity: Values are greatest when there is reasonable similarity among properties in an area.
- Progression: The value of a lower-quality property is increased by its proximity to higher-quality properties.
- Regression: The value of a higher-quality property is decreased by its proximity to lower-quality properties.
- Application to Real Estate: Appraisers must consider the characteristics of surrounding properties when estimating the value of a subject property.

VI. PRODUCTION AS A MEASURE OF VALUE

A. Agents of Production Principle:
- Definition: The value of a property is created through the combined efforts of the agents of production: land, labor, capital, and entrepreneurship.
- Application to Real Estate: Appraisers must consider the contributions of each agent of production when estimating the value of a property.

VII. TYPES OF VALUE

A. Market Value:
- Definition: 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.
- Application to Real Estate: Market value is the most commonly used type of value in real estate appraisal.

B. Price:
- Definition: The amount asked, offered, or paid for a property.

C. Value in Use:
- Definition: The value of a property to a specific user for a specific use.

D. Investment Value:
- Definition: The value of a property to a particular investor based on their specific investment criteria.

E. Liquidation Value:
- Definition: The value of a property that is sold quickly, often under duress.

F. Assessed Value:
- Definition: The value of a property as determined by a taxing authority for the purpose of levying property taxes.

G. Insurable Value:
- Definition: The value of a property that is covered by an insurance policy.

H. Going Concern Value:
- Definition: The value of a business, including its tangible and intangible assets.

VIII. FORCES AFFECTING VALUE

Real estate values are influenced by a variety of factors, which can be broadly categorized as:

A. Social Factors:
- Prestige
- Recreation
- Culture
- Family Orientation
- Homeowner Restrictions

B. Economic Factors:
- The Local Economy
- Interest Rates
- Rents
- Vacancy Factors
- Plottage
- Parking
- Corner Influence

C. Political Factors:
- Taxes
- Zoning
- Rent Control
- Growth Limitations
- Environmental Restrictions
- Building and Health Codes

D. Environmental (Physical) Factors:
- Location
- Climate
- Water
- Transportation
- View
- Soil
- Size and Shape
- Exposure
- Environmental Hazards
- Topography

Each of these factors can have a significant impact on real estate values, and appraisers must carefully consider them when estimating the value of a property.