Principles of Production and Types of Value

Chapter 2: Principles of Production and Types of Value
VI. Production as a Measure of Value
We have established that value is influenced by supply and demand, operating within the principles of substitution, competition, change, and anticipation. Now, we’ll explore production, a critical concept in understanding value, particularly in real estate❓.
In economic theory, PRODUCTION is defined as the creation of wealth. It’s the capacity to generate wealth that serves as a measure for the value of land and any improvements made upon it. The concept of production finds numerous applications throughout the appraisal process.
A. AGENTS OF PRODUCTION PRINCIPLE
The FOUR AGENTS OF PRODUCTION are:
- CAPITAL (Financial Resources)
- LAND (Natural Resources)
- LABOR (Employment)
- Coordination❓❓ (Management or Entrepreneurship)
These agents can act independently or collectively to yield a return, whether in the form of income or profit. The RATE OF RETURN (OR PROFIT) relative to the resources invested is the indicator of production and value.
Case/Example: In a real estate development project:
* Investors provide capital.
* The developer supplies management (coordination).
* Construction crews provide labor.
These three agents, combined with land, create value in the form of a housing development.
The economic system of CAPITALISM, based on private property ownership and personal rights, was elaborated by Adam Smith in his 1776 book, Wealth of Nations. Smith argued that value is derived from the combination of these four agents of production. For land, an owner receives rent; for labor, wages; for capital, interest; and for management, profit proportional to the risk undertaken.
As an illustration of this capitalistic theory, consider a property purchasable for
Total Costs:
Land:
Interest:
Price: $387,960
Therefore, the builder may conclude that $387,960 would be a fair price for the home to be built. However, market forces could push the price higher or lower, potentially leading to a loss.
Mathematical representation:
Total Cost = Land Cost + Improvement Cost + Interest Cost + Profit
Where:
Profit = (Desired Rate of Return) * (Land Cost + Improvement Cost + Interest Cost)
Example Computation
Let’s analyze a simplified scenario. A developer buys land for
Total Cost = L + I + r + π
Profit = (π)*(L + I + r)
π = 0.15 * (200,000 + 300,000 + 30,000) = 0.15 * 530,000 = $79,500
Total Cost = 200,000 + 300,000 + 30,000 + 79,500 = $609,500
VII. Types of Value
Various types of value exist. Distinguishing among them and identifying the STANDARD OF VALUE to be estimated is crucial in the appraisal process. The appraisal must define the Standard of Value being estimated. Common types of value in real estate appraisals include investment value, value in use, liquidation value, insurance value, assessed value, going concern value, and market value (see Figure 2-4 in the provided PDF).
A. MARKET VALUE
The most frequently estimated type of value in real estate appraisals is MARKET VALUE, also known as exchange value or value in exchange. It represents the value of property as determined by the open market. The Federal Register, V55, No. 251, December 31, 1990, Washington, D.C., defines it as:
“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.”
This definition of market value is a standard component of any form report used by lenders.
In essence, MARKET VALUE is the most probable cash (or cash equivalent) amount paid for a property on a specific date in a fair and reasonable open market transaction. Several conditions must be met for a market transaction to be fair and reasonable:
- Both buyer and seller must be typically well-informed about market conditions and the property itself.
- Both buyer and seller must act reasonably, in their own self-interest, and without undue pressure.
- The property must be exposed to the market for a reasonable duration.
- No extraordinary circumstances, such as liberal financing or concessions, should be present.
When these four conditions are met, the transaction is considered an “arm’s length transaction.”
- Market Value in Non-Cash Equivalent Transactions
Few real estate transactions are “all cash” in today’s market. Financing comparable to typical market financing is considered cash equivalent. However, if financing includes non-typical concessions (e.g., below-market interest in a seller-financed deal), the appraiser must identify these terms and assess their impact on value.
- Other Definitions of Market Value
Market value has been subject to various interpretations by economists, judges, and legislatures. Consequently, it doesn’t always hold the same meaning in all situations. For example, state laws regarding condemnation (taking private property for public use) and tax assessment often contain their own definitions of market value. When performing appraisals governed by state law, the appraiser must adhere to the legal definition of market value.
B. PRICE
Market value is what a property should bring at sale, while PRICE is the actual amount paid. Price may equal market value, but can also be higher or lower due to factors such as:
- An uninformed seller unaware of market value.
- An uninformed buyer unaware of market value.
- A seller facing immediate sale requirements.
- A seller unmotivated to sell.
- A buyer lacking strong motivation to buy.
- A buyer requiring a specific property for a specific reason.
- Seller financing offering below-market interest rates.
Note: As a nationally known investment guru once stated, “If the terms are right, the price is immaterial.” This means that reasonable cash flow from the investment justifies the price paid.
C. VALUE IN USE
VALUE IN USE (or “use value”) refers to the value of a property specifically for a particular purpose. This contrasts with market value, which considers all possible uses. Use value is often viewed in terms of a property’s value to an ongoing business operation, making it sensitive to the business climate.
Case/Example:
Chapter Summary
This chapter, “Principles of Production and Types of Value,” from the training course “Foundations of Real Estate Value: Principles and Applications,” delves into the economic underpinnings of real estate value, moving beyond basic supply and demand to explore the role of production and different value perspectives.
The chapter introduces the concept of PRODUCTION as the creation of wealth, which serves as a measure of the value of land and its improvements. It emphasizes the “Agents of Production Principle,” identifying four key agents: CAPITAL (financial resources), LAND (natural resources), LABOR (employment), and coordination❓ (management/entrepreneurship). These agents, working individually or collectively, generate income or profit, and the rate of return relative to investment quantifies production and value. This section aligns with Adam Smith’s capitalistic theory that value is derived from the combination of these four agents, with each agent deserving appropriate compensation (rent for land, wages for labor, interest for capital, and profit for management). A numerical example illustrates how these agents contribute to determining the fair price of a home, although market forces may ultimately dictate the final price.
The chapter further discusses various TYPES OF VALUE, stressing the importance of identifying the specific Standard of Value being estimated in an appraisal. MARKET VALUE is presented as the most common type, defined as the most probable price a property would bring in a competitive and open market under fair sale conditions. The definition provided aligns with standard lending practices, emphasizing the requirements of a well-informed and typically motivated buyer and seller, reasonable market exposure, payment in cash or equivalent, and a price unaffected by special financing or concessions (an “arm’s length transaction”). The chapter acknowledges the prevalence of non-cash transactions and clarifies that financing comparable to typical market financing is considered equivalent to cash. However, atypical financing requires appraiser adjustment. It also acknowledges that market value definitions can vary by jurisdiction, particularly in cases of condemnation or tax assessment, necessitating appraisers to adhere to relevant state laws.
Finally, the chapter distinguishes between PRICE and VALUE. Price is the amount actually paid, which may deviate from market value due to factors like uninformed parties, urgency, lack of motivation, or specific buyer needs. It also introduces VALUE IN USE, which refers to the value of a property for a specific purpose, contrasting with market value’s broader perspective of potential uses. Value in use is also closely tied to the business climate in which the business is operating.
In conclusion, this chapter provides a foundation for understanding how value is created through the interaction of production agents and how different perspectives on value (market value, value in use, etc.) influence appraisal practices. The implications are that appraisers must not only understand market dynamics but also analyze the cost❓ of production, return on investment, and the specific context in which a property’s value is being assessed.