Market Dynamics: Competition, Change, and Value Principles

Chapter: Market Dynamics: Competition, Change, and Value Principles

Introduction:

This chapter delves into the fundamental principles that govern market dynamics, particularly focusing on competition, change, and their impact on value creation within the real estate market. Understanding these principles is crucial for anyone seeking to navigate the complexities of real estate cycles and make informed decisions regarding investment, development, and valuation. We will explore the scientific underpinnings of these concepts, incorporating theoretical frameworks, mathematical formulations, and practical examples.

C. PRINCIPLE OF COMPETITION

The bedrock of market equilibrium lies in the interplay of supply and demand. Competition acts as the engine that drives this equilibrium.

1. Competition and Supply-Demand Imbalance:

   • Competition arises when supply and demand are not in balance.
   • Excess Supply: When supply exceeds demand, sellers compete for a limited pool of buyers.
   • Excess Demand: Conversely, when demand surpasses supply, buyers compete for scarce properties.

2. The Balancing Act of Competition:

   • Competition is a self-correcting mechanism, nudging supply and demand towards equilibrium.
   • Buyer Competition: Increased buyer competition leads to price increases, incentivizing supply and curbing demand.
   • Seller Competition: Increased seller competition leads to price decreases, stimulating demand and dampening supply.

3. Mathematical Representation:
   Let’s consider a simplified model where:

   • D represents demand
   • S represents supply
   • P represents price

   The effect of competition can be seen as an adjustment mechanism. If S > D, then the price will decrease by a factor k to increase demand until equilibrium. Similarly if D > S, then the price will increase by a factor k to decrease demand until equilibrium. We can express the changes to price as:

   • P(t+1) = P(t) - k(S(t) - D(t)) when S > D
   • P(t+1) = P(t) + k(D(t) - S(t)) when D > S

   Where:

   • P(t) is the price at time t.
   • P(t+1) is the price at time t+1.
   • k is a constant representing the market’s sensitivity to imbalances.

4. Principle of Substitution and Competitive Pricing:

   • The principle of substitution states that a rational buyer will not pay more for a property than the cost of acquiring an equally desirable substitute.
   • Sellers often lower prices on properties when there is an oversupply of houses to attract buyers through the principle of substitution.

5. Case Example: Oversupply of Housing

   • In an oversupplied housing market, sellers may lower prices to attract buyers.
   • Price reductions improve marketability using the principle of substitution.
   • Continued price reductions will either stimulate demand, as buyers find more purchasing power, or reduce supply, as sellers withdraw properties until better times.

6. Competition Can Correct Excess Demand Too.

   • When buyers compete, prices increase, which has the effect of reducing demand by decreasing the purchasing power of buyers.
   • Increased prices also increases the supply as more sellers enter the market to take advantage of higher selling prices.

7. The Danger of Excess Competition (Oversupply):

   • Appraisers must be aware of the competitive state of the real estate market.
   • Excess competition can negatively impact value because of overreaction or overcorrection by the market, motivated by excess profits.
   • Sellers/builders add so much new property to the market that supply vastly outstrips demand, causing values to decline❓❓.

D. PRINCIPLE OF CHANGE

real estate markets❓❓ are dynamic, not static. Understanding the principle of change is essential for accurate valuation and investment analysis.

1. The Constant Flux of Supply and Demand:

   • The principle of change acknowledges that supply and demand are in constant flux, influenced by social, economic, and other factors.
   • This principle necessitates valuing properties as of a specific date, as market conditions are constantly shifting.
   • The law of change states that changes are always taking place, even if they are imperceptible.

2. Impact on the Sales Comparison Approach:

   • The sales comparison approach estimates the value of a property by examining the sale price of equivalent properties, called comparable properties.
   • Yesterday’s sale prices do not necessarily indicate today’s value.
   • Appraisers must account for market changes between the sale dates of comparables and the appraisal date. More recent comparables provide a more reliable indication of value.

3. Case Example: Impact of External Factors:

   • Comparable property sold three months ago for $185,000.
   • Announcement of prison construction negatively impacts neighborhood desirability.
   • Subsequent comparable sales reflect the change, selling for $172,000 and $174,000.
   • The appraiser must adjust the value of the first comparable to reflect the market changes resulting from the prison construction.

4. The Real Estate Cycle:

   • Change in real estate is often described in terms of the real estate cycle.
   • The real property life cycle is a pattern in changing values.

   • Stages:

     1. Development/Growth: Raw land is improved; values increase.
     2. Maturity/Stability: Values remain relatively stable.
     3. Decline: Progressive value decline due to physical decay and loss of market appeal.
     4. Revitalization: Physical decay and loss of market appeal causes lower and lower prices, thus attracting investors to invest in the area and restart the life cycle process again.

5. The Real Property Life Cycle (Age Cycle):

   • Figure 2-2: Real Property Life Cycle (Age Cycle)
   • 2. Maturity (Values Stable)
   • 1. Development (Values Increase)
   • 3. Decline (Values Decrease)
   • 4. Revitalization (Life Cycle Begins Again)

6. The Revitalization Stage:

   • The cycle may be repeated with revitalization substituting the initial development stage, known as renewal, modernization, and increasing demand.

7. Case Example: Property Lifecycle in a Subdivision:

   • Development/Growth: Property values increase as raw land is developed into homesites and homes.
   • Maturity/Stability: Once the subdivision is completed, values remain stable.
   • Decline: Homes deteriorate, and values decline due to competition from newer developments.
   • Revitalization: Homes are renovated or replaced, restarting the cycle.

8. Gentrification and Revitalization:

   • Gentrification: A lower-class neighborhood is purchased and renovated by more affluent buyers.
   • Results in increased value and desirability.
   • Common in major city areas, close to city centers, where structures have desirable architectural features.
   • Example: The Georgetown area of Washington, D.C., was once regarded with disdain but is now a sought-after and prestigious area.

E. PRINCIPLE OF ANTICIPATION

Value is not solely based on current conditions but also on anticipated future benefits.

1. Expectations and Value:

   • The principle of anticipation states that value is affected by buyers’ expectations regarding future benefits from property ownership.
   • Specifically, the utility of owning the property and the anticipated gain or loss on resale.

2. Case Example: Economic Slumps and Employer Relocations:

   • Expectations of a slump in economic activity depress property values.
   • Anticipation of a large employer relocating into town boosts property values.

F. PRINCIPLE OF BALANCE

Efficient resource allocation leads to maximum returns.

1. The Agents of Production:

   • The principle of balance states that production (rate of return) is maximized when the four agents of production (land, labor, capital, and coordination/entrepreneurship) are in equilibrium.

2. Over-Improvement and Under-Improvement:

   • Over- or under-improved properties suffer because the agents of production are not balanced. Too much or too little capital, labor, and coordination have been invested in relation to the land.

3. Case Example: Home Improvement Scenario:

   • $20,000 lot.
   • 1,000 sq ft home costs $50/sq ft to build, sells for $77,000. Profit: $7,000, 10% return on investment.
   • 2,000 sq ft home costs $50/sq ft to build, sells for $130,000. Profit: $10,000, 8.3% return.
   • The larger home is an over-improvement - an imbalance among the agents of production.
   • Though the profit is larger in dollar amount, the percentage return is lower.

4. Application to Neighborhoods and Districts:

   • Overdevelopment of office space decreases the value of all office space.
   • Prices and rents are depressed until the market absorbs the oversupply.
   • Too much labor, capital, and coordination have been invested in office space relative to demand.

5. The Point of Diminishing Returns:

   • The point of diminishing returns occurs when the agents of production are in balance.
   • Additional expenditures for capital, labor, or management fail to increase productivity or value enough to offset their costs.

G. PRINCIPLE OF SURPLUS PRODUCTIVITY

This principle provides a way to estimate the value of land based on its productivity.

1. Defining Surplus Productivity:

   • Surplus productivity is a measure of the value of improved land.
   • It assumes that the productivity (net income) of capital, labor, and coordination equals their costs.
   • When the cost of capital, labor, and coordination is deducted from the total net income, the remaining income (surplus productivity) is attributed to the land.

2. Case Example: Calculating Land Value:

   • Property has a net income of $10,000 per year.
   • The cost of labor, capital, and management is $8,000 per year.
   • The remaining net income❓❓ of $2,000 is attributed to the value of the land.

H. PRINCIPLE OF CONTRIBUTION

Focuses on how individual components contribute to the overall property value.

1. Component Value:

   • The value of an individual component of a property is measured according to the principle of contribution.
   • The value of a component, regardless of its cost, equals the amount of value it adds to the property as a whole or the amount by which its absence decreases the value of the property as a whole.

2. Marginal Productivity and Marginal Cost:

   • The amount of value a component adds is its marginal productivity.
   • The actual cost of the component is its marginal cost.

3. Case Example: New Siding

   • By installing new siding on a house, the owner increased the value of the house by $5,000. $5,000 represents the marginal productivity of the new siding.