Principles of Value: Production and Types

Chapter: Principles of Value: Production and Types

Introduction

This chapter delves into the economic principles underlying real estate value, focusing on production as a fundamental driver and exploring various types of value relevant to appraisal. Understanding these concepts is crucial for accurately estimating and interpreting property value in diverse contexts.

I. Production as a Measure of Value

A. Definition of Production

In economic theory, production refers to the creation of wealth, not merely the physical construction of improvements. This wealth creation capacity is a key determinant of land and property value. Production is the ability to generate income or utility from real estate.

B. Agents of Production Principle

The economic concept of production involves four key agents:
1. Land (Natural Resources): This encompasses the site, its location, and any inherent❓❓ natural resources (e.g., minerals, timber, water). Land provides the foundation for development and economic activity.
2. Labor (Employment): This includes the physical and intellectual effort applied to land to create improvements and generate income. It represents the human capital involved in real estate development and operation.
3. Capital (Financial Resources): Capital includes the financial investment required to acquire land, construct improvements, and operate a real estate venture. This can take the form of equity, debt, or a combination thereof.
4. Coordination (Management or Entrepreneurship): This involves the organizational and managerial skills necessary to combine land, labor, and capital effectively. Entrepreneurship entails risk-taking and innovation in real estate development and operation.
These agents can work individually or in concert with each other, to generate a return in the form of income or profit. It is the rate of return (or profit), in relationship to the amount of resources invested, that is the measure of production and value.

C. Return on Investment as a Measure of Production

The return on investment (ROI) serves as a quantitative measure of production efficiency. A higher ROI indicates a more productive use of the agents of production.

ROI = (Net Operating Income / Total Investment) * 100

Where:
* Net Operating Income (NOI) = Revenue - Operating Expenses
* Total Investment = Land Cost + Construction Cost + Soft Costs (permits, fees, etc.)

Example: A developer invests $1,000,000 in a rental property that generates $100,000 in annual net operating income. The ROI is 10%.

D. The Capitalistic Economic Model and Production

Adam Smith, in “The Wealth of Nations,” argued that value is fundamentally derived from the interaction of the four agents of production. In a capitalistic system, each agent is entitled to a return:

• Land: Rent
• Labor: Wages
• Capital: Interest
• Coordination (Management/Entrepreneurship): Profit

The allocation of returns to each agent reflects their contribution to the overall production process.

E. Practical Application: Example Scenario

Consider a real estate developer undertaking a residential project:

Project Details:
* Land Cost: $500,000
* Construction Cost: $1,500,000
* Development Time: 12 months
* Anticipated Sale Price: $2,500,000
* Loan Interest Rate: 8%
* Developer’s Required Profit Margin: 15%

Calculations:
1. Total Project Cost (excluding profit): $500,000 (Land) + $1,500,000 (Construction) = $2,000,000
2. Interest Expense (assuming full loan for construction): $1,500,000 * 0.08 * 1 = $120,000
3. Total Cost (including interest): $2,000,000 + $120,000 = $2,120,000
4. Required Profit: $2,120,000 * 0.15 = $318,000
5. Minimum Acceptable Sale Price: $2,120,000 + $318,000 = $2,438,000

Analysis:

The developer needs to sell the property for at least $2,438,000 to achieve the desired profit margin. Market conditions will determine the actual selling price, which may be higher or lower than the minimum acceptable price. This exercise demonstrates how the costs associated with each agent of production influence the perceived value and required sale price.

II. Types of Value

The concept of “value” is multifaceted in real estate. Different types of value exist, each relevant in specific contexts and for distinct purposes. An appraiser must identify the specific “Standard of Value” that is being estimated.

A. Market Value

1. Definition: The most probable price that a property should bring in a competitive and open market, under all conditions requisite to a fair sale, with the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

2. Key Assumptions:

   • Willing and knowledgeable buyer and seller
   • Reasonable exposure time in the market
   • Payment in cash or equivalent terms
   • No undue influence or special concessions

3. Definition according to The Federal Register, V55, No. 251, December 31, 1990, Washington, D.C.:
   “The most probable price which 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. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

   • the buyer and seller are typically motivated;
   • both parties are well informed or well advised, and acting in what they consider their best interests;
   • a reasonable time is allowed for exposure in the open market;
   • payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and
   • the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.”

4. Importance: Market value is the most common type of value sought in real estate appraisals, particularly for lending purposes.

5. Arm’s Length Transaction: When all the conditions for the market value are met, it is said that the transaction is an “arm’s length transaction.”

B. Price

1. Definition: The actual amount paid for a property in a specific transaction.
2. Relationship to Market Value: Price may or may not equal market value. Various factors can cause a divergence between price and market value, including:
   • Lack of information by either buyer or seller
   • Time constraints or duress
   • Unique motivations or needs
   • Non-market financing terms
3. Note: As a nationally known investment guru once said, “If the terms are right, the price is immaterial.” What he was saying is if the terms allow a reasonable cash flow from the investment, it doesn’t matter what the price is.

C. Value in Use (Use Value)

1. Definition: The value of a property for a specific use or purpose, regardless of its potential value for other uses.
2. Focus: Value in use emphasizes the property’s contribution to an ongoing business or operation.
3. Dependence on Business Climate: Use value is highly sensitive to the economic conditions and profitability of the specific business or operation.
4. Example: A manufacturing plant may have a high value in use to its owner due to its strategic location and specialized equipment. However, its market value as a general industrial building may be lower if there is limited demand for manufacturing facilities.

D. Other Types of Value (Brief Overview)

1. Investment Value: The value of a property to a specific investor, based on their individual investment criteria and financial goals.
2. Liquidation Value: The estimated price that a property could be sold for quickly in a forced sale or liquidation scenario.
3. Insurance Value: The cost to replace or rebuild a property in the event of damage or destruction.
4. Assessment Value: The value assigned to a property for property tax purposes.
5. Going Concern Value: The total value of a business, including its real estate, tangible assets, and intangible assets (e.g., goodwill, brand reputation).

III. Additional Considerations

A. Conformity, Progression, and Regression

These principles explain how a property’s value is affected by its relationship to surrounding properties:
* Conformity: Properties tend to achieve maximum value when they are similar to surrounding properties in terms of style, size, and quality.
* Progression: A lower-valued property in an area of higher-valued properties may experience an increase in value due to its location.
* Regression: A higher-valued property in an area of lower-valued properties may experience a decrease in value due to its location.

B. Ethical Considerations

Appraisers must avoid biases and discriminatory practices in their valuations. Factors such as race, ethnicity, or religion should never be considered in determining value.

Conclusion

Understanding the principles of production and the various types of value is essential for accurate and reliable real estate appraisal. By applying these concepts, appraisers can provide credible opinions of value that are grounded in economic theory and market realities.