Determinants of Real Estate Value

Chapter 2: Determinants of Real Estate Value

I. WHAT IS VALUE?

Value in real estate represents the present worth of future benefits derived from ownership. It is a complex concept influenced by various factors and is often expressed in monetary terms. It’s crucial to differentiate value from price and cost, which are related but distinct concepts. Value is not intrinsic but is created by external market forces.

II. FOUR CHARACTERISTICS OF VALUE

For real estate to possess value, it must exhibit four fundamental characteristics, often remembered by the acronym DUST:

A. Utility

Utility refers to the ability of a property to satisfy a want or need. It signifies usefulness and functionality. This can be derived from various factors, including:

• Shelter: Providing protection from the elements.
• Income Generation: Potential for rental income or business operations.
• Recreation: Access to amenities or natural resources.
• Investment: Anticipation of future appreciation.

Example: A vacant lot suitable for building a residential home possesses utility because it addresses the need for housing. The value of a commercial property depends largely on the potential for business profitability.

B. Scarcity

Scarcity dictates that a limited supply of a particular property type relative to demand contributes to its value. If a property type is abundant, its value diminishes.

Example: Waterfront properties command higher prices due to their limited availability compared to inland properties. This scarcity drives up demand and, consequently, value.

C. Transferability❓❓

Transferability refers to the ease with which ownership rights can be conveyed from one party to another. Clear title, absence of legal encumbrances, and marketability are essential for transferability.

Example: A property with a clouded title (unclear ownership history) is less valuable because the transfer of ownership is uncertain and potentially problematic. Properties with restrictions that limit future use will be less valuable than a similar property without restrictions.

D. Effective Demand

Effective demand represents the desire and financial capacity of potential buyers to acquire a property. It is not merely wishful thinking but a willingness and ability to pay. This requires:

• Desire: A genuine❓ interest in owning the property.
• Purchasing Power: Sufficient financial resources to complete the transaction.

Example: A luxury home in an area with high unemployment will likely have lower effective demand compared to a similar home in a prosperous area.

III. VALUE DISTINGUISHED FROM PRICE AND COST

It is essential to differentiate between Value, Price and Cost.

• Value: An opinion or estimate of worth, representing the theoretical worth of a property. It is the anticipated exchange value.
• Price: The actual amount paid for a property in a transaction. It is a historical fact representing the agreement between a specific buyer and seller.
• Cost: The total expenditure required to create or reproduce a property, including labor, materials, and overhead.

A. Direct and Indirect Costs

Direct Costs: These are costs directly attributable to a project or item such as materials and labor.

Indirect Costs: These are costs that are not directly attributable to a project but necessary to perform business operations such as marketing expenses.

B. Development Cost and Construction Cost

Development Cost: This encompasses all the costs associated with bringing a project from concept to completion including construction costs, financing costs, legal fees, and marketing expenses.

Construction Cost: The hard costs associated with erecting a building including materials, labor, and equipment.

C. Replacement Cost and Reproduction Cost

Replacement Cost: The cost of constructing a building of equivalent utility using current materials, design standards, and construction methods.

Reproduction Cost: The cost of creating an exact replica of a building using the same materials and construction techniques as the original.

IV. PRINCIPLES OF APPRAISAL (ECONOMIC VALUE)

Several economic principles govern how value is created and influenced in the real estate market.

A. Principle of Supply and Demand

This fundamental principle states that value is directly related to the interaction of supply and demand.

• High Demand, Limited Supply: Value increases.
• Low Demand, Abundant Supply: Value decreases.

This can be represented mathematically (though not precisely) as:

Value ∝ Demand / Supply

Example: During a housing boom, demand increases, and supply struggles to keep pace, leading to rising home prices. Conversely, during an economic downturn, demand decreases, and a glut of available properties leads to price declines.

B. Principle of Substitution

This principle suggests that a prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. It forms the basis for the sales comparison approach to appraisal.

Example: If two similar houses are available in the same neighborhood, a buyer will likely choose the one with the lower price, assuming all other factors are equal.

C. Principle of Competition

Competition among sellers or buyers can influence property values.

• Excess Profits Attract Competition: This can lead to increased supply and potentially lower prices.
• Lack of Competition May Lead to Stagnation: This can lead to decreased value due to fewer investments in the area.

Example: The presence of several new home builders in a specific area can intensify competition, potentially leading to lower prices and incentives for buyers.

D. Principle of Change

Real estate values are not static but are constantly influenced by various economic, social, political, and environmental forces.

Example: Changes in zoning regulations, economic conditions, or demographic trends can significant❓ly impact property values in a particular area.

E. Principle of Anticipation

Value is based on the expectation of future benefits. Investors purchase real estate based on the anticipated cash flows and appreciation.

Example: Land located near a planned infrastructure project (e.g., a new highway or transit station) may increase in value due to the anticipation of increased accessibility and development potential.

F. Principle of Balance

Value is maximized when the various agents of production (land, labor, capital, and entrepreneurship) are in proper balance.

1. Point of Diminishing Returns: Adding more of one agent of production without a corresponding increase in others will eventually lead to diminishing returns.

Example: Adding excessive landscaping to a property will not necessarily result in a proportional increase in value. There is a point where the marginal cost of additional landscaping exceeds the marginal increase in value.

G. Principle of Surplus Productivity

This principle holds that the net income remaining❓❓ after the costs of labor, capital, and coordination have been paid is attributable to the land itself.

Example: A well-managed commercial property generates significant revenue. After deducting operating expenses, debt service, and management fees, the remaining net operating income (NOI) is attributable to the land’s productive capacity.

H. Principle of Contribution

The value of a component part of a property is measured by its contribution to the overall value of the whole. This can be either positive or negative.

Example: A swimming pool might add value to a residential property in a warm climate but might detract from value in a colder climate due to the additional maintenance costs.

I. Principle of Increasing and Decreasing Returns

This principle states that adding incremental improvements to a property can increase its value, but only up to a certain point. Beyond that point, additional improvements may not yield a proportional increase in value.

Example: Renovating a kitchen can significantly increase the value of a home. However, spending excessive amounts on ultra-high-end appliances and finishes may not result in a commensurate increase in the sale price.

V. EFFECT OF USE ON REAL ESTATE VALUE

The permitted and potential uses of a property play a crucial role in determining its value.

A. Highest and Best Use Principle

The highest and best use is defined as the most probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. It must meet four criteria:

1. Legally Permissible: The use must comply with all applicable zoning regulations, building codes, and environmental restrictions.
2. Physically Possible: The site must be suitable for the proposed use, considering factors like size, shape, topography, and soil conditions.
3. Financially Feasible: The proposed use must generate sufficient income or value to justify the costs of development and operation.
4. Maximally Productive: Among all financially feasible uses, the one that results in the highest value to the property owner is the highest and best use.

Example: A vacant lot in a commercially zoned area might have its highest and best use as a retail store, office building, or restaurant, depending on market conditions and demand.

B. Consistent Use Principle

The concept that land should not be valued based on one use while the improvements are valued based on another use.

Example: An appraiser must not value the land based on commercial use if valuing the improvements based on residential use.

C. Conformity, Progression, and Regression Principles

Conformity: Property values are maximized when they conform to the surrounding properties in terms of style, size, and quality.
Progression: The value of a less expensive property tends to increase when it is located near more expensive properties.
*Regression: The value of a more expensive property tends to decrease when it is located near less expensive properties.

Example: A modest home in a neighborhood of luxurious mansions will likely benefit from the progression effect. Conversely, a newly renovated home❓❓ surrounded by dilapidated properties may experience the regression effect.

VI. PRODUCTION AS A MEASURE OF VALUE

The value of real estate can also be viewed in terms of the agents of production: land, labor, capital, and entrepreneurship.

A. Agents of Production Principle

Real estate production requires the coordinated efforts of these four agents:

1. Land: The natural resource providing the site and raw materials.
2. Labor: Human effort and expertise required for construction and operation.
3. Capital: Financial resources used to fund the project.
4. Entrepreneurship: The skills and risk-taking ability needed to organize and manage the project.

VII. TYPES OF VALUE

Different types of value are used for various purposes in real estate.

A. Market Value

Market value is the most probable price 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. Key elements include:

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

4. An arm’s-length transaction

5. Market Value in Non-Cash Equivalent Transactions
   Adjustments must be made to the sales price in the transaction if the sale is non-cash equivalent.

6. Other Definitions of Market Value
   There are many ways to describe “Market Value” that may depend on a particular situation.

B. Price

The amount of money paid 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 specific investment criteria and risk tolerance.

E. Liquidation Value

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

F. Assessed Value

The value assigned to a property by a government entity for property tax purposes.

G. Insurable Value

The cost of replacing or reproducing a property for insurance purposes.

H. Going Concern Value

The value of an operating business, including its tangible and intangible assets.

VIII. FORCES AFFECTING VALUE

Numerous factors influence real estate values. These can be broadly categorized as:

A. Social Factors

Demographic trends, lifestyle preferences, population growth, and social attitudes can impact property values.

1. Prestige
2. Recreation
3. Culture
4. Family Orientation
5. Homeowner Restrictions

B. Economic Factors

Economic conditions, interest rates, employment levels, income growth, and inflation influence property values.

1. The Local Economy
2. Interest Rates
   Mathematical Formula for Mortgage Payments:
   M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1]
   Where:
   M = Monthly mortgage payment
   P = Principal loan amount
   i = Monthly interest rate (annual interest rate / 12)
   n = Number of payments (loan term in years * 12)
3. Rents
4. vacancy factors❓
5. Plottage
6. Parking
7. Corner Influence

C. Political Factors

Government regulations, zoning ordinances, building codes, taxes, and environmental regulations impact property values.

1. Taxes
2. Zoning
3. Rent Control
4. Growth Limitations
5. Environmental Restrictions
6. Building and Health Codes

D. Environmental (Physical) Factors

Location, climate, topography, soil conditions, natural hazards, and environmental quality affect property values.

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