Principles of Real Estate Value

Chapter 3: Principles of Real Estate Value
Introduction
Value is a multifaceted concept central to real estate appraisal. Understanding its underlying principles is crucial for accurately estimating property worth. This chapter delves into the scientific theories and principles that shape real estate value, exploring the interplay of economic forces, market dynamics, and property characteristics.
3.1 Historical Context of Value Theory
The understanding of value has evolved over centuries, shaped by various schools of economic thought.
- 3.1.1 Classical School: Adam Smith and his contemporaries identified land, labor, and capital as primary agents of production. They believed value stemmed from the cost of production, influencing the cost approach to valuation. This school also considered utility❓❓ and scarcity.
- 3.1.2 Challenges to Classical Theory: The labor theory of value (Karl Marx) argued that all value originated from labor, while the austrian school❓❓ emphasized marginal utility, linking value to demand. Marginal utility later influenced the concept of contribution.
- 3.1.3 Neoclassical Synthesis: Alfred Marshall❓❓ merged classical supply-cost considerations with the demand-price theory of marginal utility, laying the foundation for modern appraisal theory. Marshall identified the three approaches to value, while Irving Fisher developed the income theory of value, a precursor to the income capitalization approach.
3.2 Agents of Production
A marketable property is a result of four agents of production.
- Land: The underlying earth and its natural resources.
- Labor: Physical and intellectual work required for construction and improvement.
- Capital: Machinery, equipment, buildings, and infrastructure used in production.
- Entrepreneurial Coordination: The management and risk-taking involved in developing and marketing the property, reflecting the required return expected by a property buyer. Entrepreneurial incentive refers to the amount of money a developer expects to make, while entrepreneurial profit refers to the amount of money the developer actually receives.
3.3 Factors of Value: The Acronym STUD
Four key characteristics interact to determine a commodity’s value: Utility, Scarcity, Transferability (implied in market context, relates to clear title and legal ownership), and Demand (often linked to Effective Purchasing Power).
- Utility: The ability of a property to satisfy a need or desire.
- Example: Agricultural land’s utility lies in its ability to produce crops or provide grazing.
- Scarcity: Limited availability relative to demand.
- Example: Waterfront property is generally more valuable due to its limited supply.
- Desire: The want or need for a property in the minds of potential purchasers.
- Example: A swimming pool adds value only if buyers desire it.
- Effective Purchasing Power: The financial capacity of potential buyers to acquire the property.
- Example: A luxury home in a low-income area may not achieve its anticipated price due to a lack of buyers with sufficient purchasing power.
- Let D represent Demand, P represent Price, and I represent Income. The relationship can be simplified as:
- D = f(P, I), where D increases as P decreases or I increases (all other factors being equal).
3.4 Supply and Demand Dynamics
The interplay of supply and demand is fundamental to value determination.
- 3.4.1 Basic Principles: As demand increases, prices rise in the short run, incentivizing increased supply in the long run.
- 3.4.2 Mathematical Representation: A simplified model of supply and demand can be represented as follows:
- Qd = a - bP (Demand equation, where Qd is quantity demanded, P is price, and a and b are constants).
- Qs = c + dP (Supply equation, where Qs is quantity supplied, P is price, and c and d are constants).
- Equilibrium occurs where Qd = Qs.
- 3.4.3 Market Disequilibrium:
- Oversupply: Occurs when supply exceeds demand, leading to price decreases. Developers cannot sell them or can only sell them at a discount.
- Declining Markets: Characterized by falling listing prices, extended marketing periods, and potential drops in transaction volume. Rising interest rates or tightening credit markets may also signal a declining market.
- Experiment: An experiment can be conducted using a simulated market with varying supply and demand scenarios to observe the effect on property prices. Participants act as buyers and sellers, adjusting their offers based on market conditions.
3.5 Distinctions Among Price, Cost, and Value
Appraisers must clearly differentiate between these terms.
- Price: The agreed-upon amount for a real estate transfer, a factual historical datum.
- Cost: The dollar amount required to reproduce, build, or assemble an improvement.
- Formulas: Total Cost = (Direct Costs) + (Indirect Costs) + (Entrepreneurial Profit)
- Value: An opinion of worth, always used with a modifier (e.g., market value, insurable value). Value is a function of the benefits that ownership is anticipated to provide in the future, discounted to its present worth.
3.6 Anticipation and Change
- 3.6.1 Anticipation: Value is based on the present worth of future benefits❓. Buyers are willing to spend capital in anticipation of future benefits of ownership.
- 3.6.2 Change: Real estate markets are dynamic, influenced by factors such as interest rates, employment, and demographics. Appraisers must recognize and analyze market changes. All appraisers must be able to recognize change in real estate markets because that is a basic requirement of market analysis.
3.7 Principles Related to Supply, Demand, and Market Equilibrium
- 3.7.1 Competition: Competition among buyers and sellers influences value.
- Example: Competition between sellers to find a buyer causes them to lower their prices to attract buyers away from equally desirable properties. Builders cannot charge any price they want for a new property because they have competition too. Competition keeps sellers from charging too much and buyers from paying too little.
- 3.7.2 Substitution: A buyer will pay no more for a property than the cost of acquiring a comparable substitute.
- Example: An owner of a one-year-old property can sell that property for no more than the cost of building a new structure that could serve as a substitute (assuming that used improvements are worth less than new ones). Therefore, a one-year-old building is limited by the cost of a new building.
- 3.7.3 Balance: Value is created and sustained when interacting elements are in equilibrium.
- Example: When a
100,000 in net income, investors will be attracted to it. If the property costs 10,000 in net income per year, which is a net return of 1% on the investment, the elements are out of balance and no new buildings will be brought to market until productivity returns.
- Example: When a
- 3.7.4 Law of Increasing and Decreasing Returns: A principle that states that at some point, adding more of one factor of production, while holding all others constant, will at first increase output (increasing returns) but eventually lead to a decrease in output (decreasing returns).
- 3.7.5 Externalities: Influences outside the property itself can impact value, either positively or negatively.
Conclusion
Understanding the principles of real estate value is fundamental to accurate appraisal. By considering the historical context, agents of production, factors of value, supply and demand dynamics, and related principles, appraisers can develop well-supported and credible value opinions.
Chapter Summary
This chapter, “Principles of Real Estate Value,” from the training course “Understanding Real Estate Value: Principles and Applications” provides a comprehensive overview of the fundamental concepts underlying real estate valuation. It traces the evolution of value theory from classical economics, which emphasized cost of production, to neoclassical economics, which integrates supply-cost considerations with demand-price theory. The chapter highlights the contributions of key economic thinkers like Adam Smith, Karl Marx, Alfred Marshall, and Irving Fisher, and their influence on modern appraisal theory.
The core principles discussed include the four agents of production (land, labor, capital, and entrepreneurial coordination) and the four factors of value (utility❓, scarcity, desire, and effective purchasing power❓). Utility refers to the usefulness of the property❓, while scarcity influences demand. Desire reflects the market’s want for a property, and effective purchasing power determines if potential buyers can afford it. The interaction of these factors determines demand, which interacts with supply to influence prices.
The chapter emphasizes the distinctions between price, cost, and value. Price is the agreed-upon amount in a transaction, cost is the expense to reproduce or build, and value represents worth, always used with a modifier (e.g., market value).
Anticipation of future benefits, such as appreciation or income, is a key driver of value. Real estate markets are dynamic, influenced by changes in interest rates, employment, and demographics. The chapter explores the interplay of supply and demand, highlighting how imbalances can lead to overbuilt or declining markets. Competition among buyers and sellers influences prices, preventing either from exerting undue control.
The principle of substitution❓ states that a buyer will not pay more than the cost of an equivalent substitute. Balance, or equilibrium, among interacting elements sustains property value. The law of diminishing returns suggests that at some point, additional investment in a property will yield decreasing returns.
The implications of these principles for real estate appraisal are significant. Appraisers must understand how these economic forces shape market dynamics and property values. The chapter implicitly suggests that a thorough understanding of these principles is essential for accurate and reliable appraisals, which in turn are crucial for informed decision-making in real estate investment, lending, and development.