Principles and Factors Affecting Real Estate Value

Chapter 2: Principles and Factors Affecting Real Estate Value

I. WHAT IS VALUE?

Value, in its essence, represents the relative worth of a property. This worth is typically expressed in monetary terms, reflecting the perceived benefits a property offers to potential buyers and sellers. It is crucial to understand that value is not an intrinsic property inherent to the real estate itself, but rather a reflection of external factors and market conditions. We can define VALUE as “the monetary worth of property, goods or services to buyers and sellers.” Furthermore, Value represents “the present worth of future benefits” expressed in monetary terms.

II. FOUR CHARACTERISTICS OF VALUE

Modern economic theory emphasizes that value is not intrinsic. Instead, it arises from the interplay of specific characteristics. These four characteristics must be present for a property to possess value:

A. Utility❓❓

Utility refers to the ability of a property to satisfy a want or need. Real estate demonstrates utility through its potential for various uses, including residential, commercial, agricultural, and recreational purposes.

• Example: A vacant lot suitable for constructing a residential home has utility because it fulfills the need for shelter and housing.

B. SCARCITY

Scarcity denotes the limited availability of a particular type of property. A property with high utility but abundant availability will have diminished value. Scarcity is directly tied to the principle of supply and demand.

• Example: Waterfront properties command higher prices than non-waterfront properties due to their limited supply. If all properties were waterfront, the scarcity factor would be eliminated, and waterfront properties would not hold a premium value.

C. TRANSFERABILITY

Transferability refers to the ability to transfer ownership rights from one party to another. This includes the legal right to sell, lease, gift, or bequeath the property. Without transferability, no exchange can occur, and the property has no value in the economic sense.

• Example: Public lands designated as national parks cannot be bought or sold, so they don’t have “value” in the economic sense.

D. EFFECTIVE DEMAND

Effective demand represents the combination of desire for a property and the financial capacity (purchasing power) to acquire it. Desire alone is insufficient; potential buyers must possess the means to pay for the property.

• Example: A town with robust employment and high wages will see increased real estate value because residents have the financial capacity to purchase property, resulting in effective demand.

III. VALUE DISTINGUISHED FROM PRICE AND COST

While the terms value, price, and cost are often used interchangeably, they have distinct meanings in real estate valuation.

• Value: The theoretical worth of a property under specific market conditions.
• Price: The actual amount paid or offered for a property in a specific transaction. Price is a historical fact, while value is an estimate.

• Cost: The expense incurred in creating or acquiring a property, including materials, labor, and services.

  • Example: A purchaser buys a house for $100,000 with seller financing at below market rates. The price is $100,000. The value is lower because it includes the benefits of the favorable interest rates.

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 the value of a property is influenced by the relationship between the availability of similar properties (supply) and the desire and ability of buyers to purchase them (demand).

• When demand exceeds supply, prices and values tend to increase.
• When supply exceeds demand, prices and values tend to decrease.

Mathematically, this can be conceptualized as:

• Value ∝ Demand / Supply

B. PRINCIPLE OF SUBSTITUTION

This principle asserts that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute property. The principle of substitution is fundamental to all three approaches to value.

• Example: A buyer considering two similar houses in the same neighborhood will generally choose the one with the lower price, assuming all other factors are equal.

C. PRINCIPLE OF COMPETITION

Competition arises when profits are generated in a market. This leads to an increase in supply, which can ultimately drive down prices and values.

• Example: If a new residential development is highly successful, other developers will likely enter the market with similar projects, increasing supply and potentially moderating prices.

D. PRINCIPLE OF CHANGE

The real estate market is dynamic and constantly evolving due to economic, social, political, and environmental factors. Appraisers must account for these changes when estimating value.

• Example: An area undergoing gentrification may experience rapid increases in property values due to demographic shifts, infrastructure improvements, and new business development.

E. PRINCIPLE OF ANTICIPATION

Value is based on the anticipated future benefits of owning a property, not just its current use or condition. These benefits can include income, appreciation, and personal enjoyment.

• Example: A developer may pay a premium for a property located near a planned transportation hub, anticipating that the improved accessibility will significantly increase the property’s value in the future.

F. PRINCIPLE OF BALANCE

This principle emphasizes that value is maximized when there is a balanced relationship between the agents of production (land, labor, capital, and entrepreneurship). An imbalance can lead to diminishing returns.

1. Point of Diminishing Returns:

   • The point where adding more of a specific factor of production (e.g., capital improvements) yields progressively smaller increases in value.

G. PRINCIPLE OF SURPLUS PRODUCTIVITY

Surplus productivity refers to the net income remaining after the costs of labor, capital, and management have been paid. This surplus represents the return attributable to the land.

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, rather than its individual cost.

• Example: A swimming pool may add value to a residential property, but its contribution to the overall value may be less than the cost of construction if the local market does not highly value swimming pools.

I. PRINCIPLE OF INCREASING AND DECREASING RETURNS

This principle states that investing additional resources into a property will initially yield increasing returns, but beyond a certain point, the returns will begin to diminish.

V. EFFECT OF USE ON REAL ESTATE VALUE

A. HIGHEST AND BEST USE PRINCIPLE

This principle is fundamental to real estate appraisal. It states that the value of a property is based on its most probable use that is:

1. Legally permissible
2. Physically possible
3. Financially feasible
4. Maximally productive

• The highest and best use must be determined independently of the current use.

B. CONSISTENT USE PRINCIPLE

This principle requires that when valuing land with improvements, the land and improvements must be valued based on the same use. It would be inconsistent to value the land based on its potential for a high-density development while valuing the improvements based on their current use as a single-family home.

C. CONFORMITY, PROGRESSION, AND Regression❓❓ PRINCIPLES

• Conformity: Value is maximized when a property conforms to the surrounding properties in terms of style, size, and quality.
• Progression: A lower-valued property benefits from being located near higher-valued properties.
• Regression: A higher-valued property suffers a decrease in value by being located near lower-valued properties.

VI. PRODUCTION AS A MEASURE OF VALUE

A. AGENTS OF PRODUCTION PRINCIPLE

The agents of production are the resources used to create goods or services. In real estate, these are typically categorized as:

1. Land: The site itself, including its natural resources.
2. Labor: The human effort required for construction, maintenance, and operation.
3. Capital: The financial resources invested in the property.
4. Entrepreneurship: The coordination and management of the other three agents to develop and operate the property.

Value is directly related to the efficient use of these four agents of production.

VII. TYPES OF VALUE

A. MARKET VALUE

Market value is 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. 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:

1. Buyer and seller are typically motivated;
2. Both parties are well informed or well advised, and acting in what they consider their own best interests;
3. A reasonable time is allowed for exposure in the open market;
4. Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
5. 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.

B. PRICE

The actual amount paid for a property in a specific transaction. Price is a historical fact.

C. VALUE IN USE

The value of a property for a specific use, which may not be its highest and best use.

D. INVESTMENT VALUE

The value of a property to a specific investor, based on their individual investment criteria and risk tolerance.

E. LIQUIDATION VALUE

The value of a property when it is sold quickly, often under duress, such as in a foreclosure or bankruptcy sale.

F. ASSESSED VALUE

The value assigned to a property by a taxing authority for property tax purposes.

G. INSURABLE VALUE

The value of a property for insurance purposes, typically representing the cost of replacing the improvements in the event of a loss.

H. GOING CONCERN VALUE

The value of a business enterprise, including both the real estate and the intangible assets such as goodwill, reputation, and customer relationships.

VIII. FORCES AFFECTING VALUE

Numerous external forces can influence real estate values:

A. SOCIAL FACTORS

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

B. ECONOMIC FACTORS

1. The Local Economy
2. Interest Rates
3. Rents
4. Vacancy Factors (The ratio of unoccupied space to total available space in a building or market area)
5. Plottage (The increased value resulting from combining two or more adjacent parcels of land into one larger parcel)
6. Parking
7. Corner Influence

C. POLITICAL FACTORS

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

D. ENVIRONMENTAL (PHYSICAL) FACTORS

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