Principles and Factors Influencing Value

Introduction: Principles and Factors Influencing Value

The concept of value forms the bedrock of real estate economics and investment. This chapter delves into the fundamental principles governing value creation, maintenance, and diminution in the context of real estate, thereby providing a crucial framework for understanding appraisal practices. While value is often intuitively understood, a rigorous scientific approach is necessary to disentangle its complex determinants and enable accurate, reliable, and defensible valuations. This chapter aims to provide that scientific basis.

The scientific importance of understanding value lies in its direct relevance to efficient resource allocation, informed investment decisions, and equitable taxation policies. Real estate represents a significant component of global wealth, and accurate valuation is essential for its efficient utilization and management. Misunderstandings about the principles of value can lead to market inefficiencies, misallocation of capital, and ultimately, economic instability. This chapter bridges theoretical economic concepts with practical real estate applications, fostering a deeper understanding of market dynamics.

This chapter will systematically explore the core characteristics of value, distinguishing it from related concepts such as price and cost. We will then examine key appraisal principles rooted in economic theory, including supply and demand, substitution, competition, anticipation, and contribution. Furthermore, we will analyze how these principles interact and influence each other in shaping real estate value. Finally, we will discuss the various factors – social, economic, political, and environmental – that exert significant influence on property values. By providing a comprehensive overview of these principles and factors, this chapter aims to equip the reader with the theoretical and practical knowledge necessary to critically analyze real estate markets and conduct sound valuation analyses. Specifically, upon completion of this chapter, you will be able to:

1. Define value and delineate its essential characteristics, relating them to core economic concepts such as utility and scarcity.
2. Differentiate between value, price, and cost, recognizing the limitations of using price as a sole indicator of value.
3. Understand and apply the key appraisal principles, including highest and best use, consistent use, and agents of production, to real-world valuation scenarios.
4. Define various types of value, such as market value, investment value, and liquidation value, and understand their respective applications in different valuation contexts.
5. Analyze the impact of social, economic, governmental, and environmental factors on real estate values, considering both direct and indirect influences.

Chapter 2: Principles and Factors Influencing Value

I. WHAT IS VALUE?

Value, in its broadest sense, represents the relative worth of an object, good, or service expressed in terms of another. In real estate valuation, value is typically quantified in monetary terms. A fundamental definition of value is the “monetary worth of property, goods, or services to buyers and sellers.” Crucially, value isn’t inherent; it’s assigned based on benefits. Thus, a more refined definition considers value as the “present worth of future benefits” expressed in monetary units.

The concept of value is deeply rooted in economic theory and has evolved over time. Modern real estate valuation principles are built upon years of research and practical application. Importantly, these principles are interdependent, forming a unified theory of value.

This chapter delves into the characteristics of value, differentiates between value, price, and cost, explores economic principles driving value creation, and examines factors that influence value within the real estate market.

II. FOUR CHARACTERISTICS OF VALUE

Economic theory postulates that value isn’t intrinsic to an object but rather arises from external forces. These forces are encapsulated in the “Four Characteristics of Value”:

1. Utility
2. Scarcity
3. transferability❓❓
4. Effective Demand

A. UTILITY

Utility signifies the capacity of a good or service to satisfy a want or need. Real estate exhibits utility through various applications:

• Site for structures (residential, commercial, industrial)
• Production of agricultural or mineral resources
• Recreational purposes

Example: A vacant parcel in a developed area has utility because it can be used to build a house or a commercial structure.

B. SCARCITY

Scarcity dictates that a good or service must be limited in availability to possess value. Abundance diminishes value, regardless of utility.

Example: Waterfront properties typically command higher prices due to their limited availability (scarcity) compared to inland properties. If all properties were waterfront, the premium would disappear.

C. TRANSFERABILITY

Transferability refers to the ability to transfer ownership rights from one party to another through sale, lease, gift, or inheritance. Without transferability, economic value cannot be established.

Example: Public parks, while beneficial, are generally not considered to have “value” in the economic sense as they cannot be bought or sold.

D. EFFECTIVE DEMAND

Effective demand is the combination of desire and purchasing power. Simply wanting something isn’t enough; prospective buyers must have the financial capacity to acquire it.

• Desire: Purchasers must want to own the property, perceiving it as advantageous.
• Purchasing Power: The ability to pay for the property, influenced by economic factors.

Example: Real estate in an area with high employment rates and wages exhibits effective demand due to the desirability of proximity to jobs and the financial capacity of residents to purchase properties.

III. VALUE DISTINGUISHED FROM PRICE AND COST

While often used interchangeably, value, price, and cost have distinct meanings in appraisal:

• Value: A theoretical estimate of what a property is worth under specific conditions.
• Price: The actual amount paid for a property in a specific transaction. Price is a factual historical event.
• Cost: The expense incurred to create, produce, or obtain a property.

Example: A home sells for $300,000, including seller financing at a below-market interest rate. The $300,000 is the price. However, the home’s Market Value❓❓ is likely less than $300,000 because the buyer is also paying for the favorable financing terms.

IV. PRINCIPLES OF APPRAISAL (ECONOMIC VALUE)

Several economic principles underpin real estate appraisal:

A. PRINCIPLE OF SUPPLY AND DEMAND

This fundamental principle dictates that value is determined by the interaction of supply (the amount of a good or service available) and demand (the desire and ability to purchase that good or service).

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

Formula:
Value ∝ Demand / Supply

Example: A surge in population in an area with limited housing stock leads to increased demand and rising property values.

B. PRINCIPLE OF SUBSTITUTION

This principle states that a rational buyer will pay no more for a property than they would for a comparable, equally desirable substitute. This principle forms the basis for the sales comparison approach to valuation.

Example: If two similar houses are for sale in the same neighborhood, a buyer will likely choose the one with the lower price.

C. PRINCIPLE OF COMPETITION

Competition among sellers drives prices down, while competition among buyers drives prices up. Excessive profits in a market will attract competitors, potentially reducing profitability and, consequently, property values.

Example: A highly profitable shopping center may attract new development of competing centers, potentially diluting the market share and profitability of the original center.

D. PRINCIPLE OF CHANGE

Real estate values are dynamic and constantly influenced by changing economic, social, political, and environmental conditions.

Example: A new highway construction can dramatically increase the value of previously isolated properties.

E. PRINCIPLE OF ANTICIPATION

Value is influenced by the anticipation of future benefits or detriments associated with a property.

Example: The expectation of a new transit line being built near a property can drive up its value in anticipation of increased accessibility.

F. PRINCIPLE OF BALANCE

This principle states that maximum value is achieved when the agents of production (land, labor, capital, and entrepreneurship) are in equilibrium. Over- or under-investment in any one agent can reduce overall value.

1. Point of Diminishing Returns

This refers to the point where adding more of one agent of production yields progressively smaller increases in output or value.

Example: Adding more workers to a construction site may initially increase productivity, but at some point, overcrowding will lead to inefficiencies and reduced output.

G. PRINCIPLE OF SURPLUS PRODUCTIVITY

This principle refers to the net income remaining after the costs of labor, capital, and management❓❓ have been paid. This surplus is attributable to the land.

Formula:

Surplus Productivity = Net Operating Income (NOI) - (Labor Costs + Capital Costs + Management Costs)

Example: A highly productive farm generates significant income after covering expenses, resulting in a high land value.

H. PRINCIPLE OF CONTRIBUTION

The value of a particular component of a property is measured by its contribution to the overall value of the property, not its individual cost.

Example: Adding a swimming pool to a house may cost $50,000, but it may only increase the property’s value by $30,000. The pool’s contribution to value is $30,000.

I. PRINCIPLE OF INCREASING AND DECREASING RETURNS

This principle is related to the principle of balance. It states that increasing investment in a property will yield increasing returns up to a certain point. Beyond that point, further investment will result in decreasing returns and potentially lower value.

Example: Renovating a kitchen can significantly increase a home’s value, but over-improving it with luxury appliances may not yield a commensurate return on investment in a specific market.

V. EFFECT OF USE ON REAL ESTATE VALUE

A. HIGHEST AND BEST USE PRINCIPLE

This principle dictates that a property’s value is determined by its most profitable, legally permissible, physically possible, and financially feasible use. This use should be identified before any valuation can be done.

Example: A vacant lot in a downtown area might have a higher value if developed as a high-rise apartment building rather than a single-family home.

B. CONSISTENT USE PRINCIPLE

This principle states that land should not be valued based on one use while improvements are valued based on another use. The land and improvements must be valued using the same consistent use.

Example: A property with a commercial building on it should not be valued by assuming the land is being used for a new high-rise, and the building is being used as a fast-food restaurant.

C. CONFORMITY, PROGRESSION, AND REGRESSION PRINCIPLES

• Conformity: Properties tend to achieve maximum value when they conform to the surrounding properties in terms of style, size, and quality.
• 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.

Example: A small, older house in a neighborhood of larger, newer houses will likely experience an increase in value due to progression, while a large, luxurious home in a neighborhood of smaller, older homes may experience a decrease in value due to regression.

VI. PRODUCTION AS A MEASURE OF VALUE

A. AGENTS OF PRODUCTION PRINCIPLE

Value is created by the combination of four agents of production:

1. Land: The site itself.
2. Labor: Human effort required for development and maintenance.
3. Capital: Financial resources invested in the property.
4. Entrepreneurship: The organizational and risk-taking skills to combine the other factors.

VII. TYPES OF VALUE

Different types of value are used in specific situations:

A. MARKET VALUE

Market value is the most common type of value sought in real estate appraisal. It is typically defined as 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.

1. Market Value in Non-Cash Equivalent Transactions
2. Other Definitions of Market Value

B. PRICE
The amount asked, offered or paid for a property.

C. VALUE IN USE

The value of a property for a specific use, regardless of its highest and best use.

D. INVESTMENT VALUE

The value of a property to a particular investor based on their specific investment criteria.

E. LIQUIDATION VALUE

The value of a property in a forced sale situation, typically lower than market value.

F. Assessed Value❓❓

The value assigned to a property by a government agency for taxation purposes.

G. INSURABLE VALUE

The value of a property for insurance purposes, typically based on replacement cost.

H. GOING CONCERN VALUE

The value of a business, including its real estate, goodwill, and other intangible assets.

VIII. FORCES AFFECTING VALUE

Several external forces influence real estate values:

A. SOCIAL FACTORS

• Prestige
• Recreation
• Culture
• Family Orientation
• Homeowner Restrictions

B. ECONOMIC FACTORS

• The Local Economy
• Interest Rates
• Rents
• Vacancy Factors
• Plottage: The increase in value resulting from the assemblage of two or more parcels of land.
• 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