Identifying Types of Value Beyond Market Value

Chapter 7: Identifying Types of Value Beyond Market Value

This chapter delves into the multifaceted nature of real estate value, exploring various types of value beyond the commonly understood market value. Understanding these alternative value concepts is crucial for appraisers and real estate professionals to provide❓ accurate and relevant valuations in diverse scenarios. We will explore the scientific principles underlying each type of value, along with practical examples and relevant equations.

7.1 Use value❓❓

• Definition: Use value represents the value of a property to a specific❓ user for a specific use. This differs from market value, which assumes a hypothetical typical buyer and use.
• Scientific Principles: Use value aligns with the concept of utility in economics. Utility refers to the satisfaction or benefit derived from consuming a good or service. In the context of real estate, a specific user may derive unique utility from a property due to its suitability for their particular operations, strategic location relative to their business network, or the presence of specialized infrastructure. This utility is not necessarily reflected in the general market.
• Practical Application:
  • Consider a specialized manufacturing plant. Its use value to the current owner, who utilizes its unique layout and equipment for their specific production process, may be significantly higher than its market value to a typical buyer unfamiliar with the specialized manufacturing process. The market might view the building as simply a warehouse of obsolete machinery, while the current user recognizes its specialized function in their manufacturing process.

• Mathematical Representation: The present value of cash flow analysis can be used to model use value.

  • Use Value = Σ (CFt / (1 + r)t) + SV / (1 + r)n
    • Where:
      • CFt = Cash flow in period t (e.g., annual net operating income) for the specific user.
      • r = Discount rate reflecting the specific user’s required rate of return (often higher than the market rate if the use is specialized or risky).
      • t = Time period
      • n = Number of periods in the analysis
      • SV = Salvage value/terminal value at the end of the holding period, reflecting a typical user.
  • Example Experiment:
  • Scenario: A university owns a building adjacent to its campus that is used solely for faculty research. The building is older, requires costly upgrades, and would not be attractive to typical office tenants.
  • Experiment: Compare the building’s market value (based on comparable office buildings) to its use value. To determine use value, estimate the replacement cost of alternative research space (e.g., cost to build a new research building on campus) and the costs to relocate the current faculty. If the replacement and relocation costs exceed the building’s market value, the use value exceeds its market value.

7.2 Investment Value

• Definition: Investment value is the value of a property to a specific investor based on their individual investment criteria, including required rate of return, risk tolerance, and financing options.
• Scientific Principles: Investment value is based on individual financial modeling and risk assessment. Investors have different expectations, access to capital, and tax considerations. These factors influence their willingness to pay for a property.
• Practical Application:
  • A real estate investment trust (REIT) might be willing to pay a premium for a property that fits perfectly within its portfolio diversification strategy, even if other investors would not. Their superior management and synergies might justify a higher investment value for the REIT.

• Mathematical Representation:

  • The Discounted Cash Flow (DCF) analysis is commonly used to estimate investment value.
    • Investment Value = Σ (CFt / (1 + ri)t) + SV / (1 + ri)n
      • Where:
        • CFt = Projected cash flow in period t (e.g., net operating income)
        • ri = Discount rate reflecting the investor’s specific required rate of return, which incorporates their risk assessment, the expected rate of inflation, and the rate of return for comparable investments.
        • t = Time period
        • n = Number of periods in the analysis
        • SV = Salvage value/terminal value at the end of the holding period, estimated according to investor requirements.

  • Investors might also use the Capital Asset Pricing Model (CAPM) to determine ri

    • ri = rf + Beta * (rm - rf)
      • Where:
        • ri = required rate of return for the investment
        • rf = risk-free rate of return (e.g., US Treasury bond yield)
        • Beta = measure of the investment’s volatility relative to the market
        • rm = expected return on the market

• Example Experiment:

  • Scenario: Two investors are considering purchasing the same apartment building. Investor A is a conservative investor with a low required rate of return (e.g., 8%) and access to cheap debt financing. Investor B is a more aggressive investor with a higher required rate of return (e.g., 12%) and limited access to financing.
  • Experiment: Develop a DCF model for each investor, using their specific required rates of return and financing assumptions. The investment value will likely be higher for Investor A because they require a lower return and have access to cheaper financing, even though the cash flows from the property are the same for both.

7.3 Insurable Value

• Definition: Insurable value is the portion of a property’s value that is covered by casualty insurance. It typically represents the replacement cost of the physical structures, excluding land and any items not subject to damage (such as underground piping).
• Scientific Principles: Insurable value is directly tied to the principles of risk management and probability theory. Insurance companies assess the likelihood of specific perils (fire, flood, wind) and calculate premiums based on the cost to rebuild or repair the damaged property.
• Practical Application:
  • When calculating the insurable value of a building, the appraiser would need to deduct the land value because the land cannot be destroyed by insurable events (fire, wind).
• Mathematical Representation: Insurable value can be estimated using the cost approach method:
  • Insurable Value = Replacement Cost New (RCN) - Depreciation (accrued physical deterioration, functional obsolescence, external obsolescence)
    • Where:
      • RCN = Cost to construct a new building identical to the existing one, using current materials and labor costs.
      • Depreciation = The loss in value due to wear and tear, functional inadequacies, or external factors.
• Example Experiment:
  • Scenario: A commercial building is located in an area prone to flooding. The replacement cost new is \$1,000,000. Accrued depreciation is estimated at \$100,000.
  • Experiment: Research the flood risk factors for the property and the typical insurance coverage available for such risks. The insurable value would be calculated by subtracting the depreciation from the RCN: $1,000,000 - $100,000 = $900,000. However, given the location, the insurance company may require flood-proofing measures or reduce the coverage amount.

7.4 assessed value❓❓

• Definition: Assessed value is the value assigned to a property by a local government for property tax purposes.
• Scientific Principles: Assessed value is influenced by principles of public finance and tax policy. Local governments use assessed values to generate revenue to fund public services. The assessment process typically involves mass appraisal techniques, which rely on statistical modeling and comparable sales data to value a large number of properties efficiently.
• Practical Application:
  • In many jurisdictions, assessed value is not necessarily equivalent to market value. It might be a percentage of market value or determined based on a different valuation standard.
• Mathematical Representation:
  • Effective Tax Rate = (Property Tax / Market Value) * 100
  • Assessed Value = Market Value * Assessment Ratio
• Example Experiment:
  • Scenario: Review the assessment records of comparable properties in a neighborhood.
  • Experiment: Calculate the effective tax rates for each property and compare them to the stated assessment ratio. This will help determine whether the assessed values are consistent with market values. If discrepancies exist, further investigation is needed to understand the assessment methodology used.

7.5 Liquidation Value and Disposition Value

• Definition: Liquidation value and disposition value represent the estimated price a property would fetch if sold under duress, typically within a shortened marketing period. Liquidation value assumes a forced sale, while disposition value allows for a slightly longer, but still accelerated, marketing period.
• Scientific Principles: Liquidation and disposition values are related to market efficiency and time value of money. In an efficient market, prices reflect all available information. However, when time is limited, potential buyers may not have adequate information or time to conduct due diligence, resulting in a lower sale price.
• Practical Application:
  • Banks may use liquidation value in foreclosure proceedings to determine the minimum acceptable bid for a property.
• Mathematical Representation: Liquidation/Disposition Value is often estimated by applying a discount to the estimated market value.
  • Liquidation/Disposition Value = Market Value * (1 - <a data-bs-toggle="modal" data-bs-target="#questionModal-83577" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container"><a data-bs-toggle="modal" data-bs-target="#questionModal-317694" role="button" aria-label="Open Question" class="keyword-wrapper question-trigger"><span class="keyword-container">discount factor</span><span class="flag-trigger">❓</span></a></span><span class="flag-trigger">❓</span></a>)
  • The discount factor reflects the reduction in price due to the shorter marketing period and the increased risk associated with the forced sale.
• Example Experiment:
  • Scenario: A lender needs to quickly sell a foreclosed property.
  • Experiment: Research comparable sales of similar foreclosed properties sold within short marketing periods. Compare these sale prices to the estimated market value of the subject property, based on comparable sales with normal marketing times. The difference represents the discount factor that could be applied to estimate the liquidation/disposition value.

7.6 Value of the Going Concern

• Definition: The value of the going concern includes the total value of a business operation, encompassing the real estate, tangible personal property (e.g., equipment, inventory), and intangible assets (e.g., brand name, customer relationships, operating licenses).
• Scientific Principles: Going concern valuation relies heavily on the principles of business valuation and financial analysis. It assesses the profitability and sustainability of the business operation.
• Practical Application:
  • Valuing a hotel, restaurant, or manufacturing plant requires consideration of the entire business operation, not just the real estate. The operating profits of the business directly affect the returns to the business and are closely related to market trends.
• Mathematical Representation: Various business valuation methods can be used:
  • Asset Approach: Value of net assets (assets - liabilities).
  • Income Approach: Discounted cash flow analysis of the entire business.
    • Business Value = Σ (FCFIt / (1 + k)t) + Terminal Value / (1 + k)n
      • Where:
        • FCFIt = Free Cash Flow of the business for period t.
        • k = Weighted Average Cost of Capital (WACC) for the business.
        • Terminal Value = Estimated value of the business beyond the explicit forecast period.
  • Market Approach: Comparison to similar businesses that have been sold.
• Example Experiment:
  • Scenario: An investor is considering purchasing a restaurant.
  • Experiment: Conduct a thorough financial analysis of the restaurant, including a review of its income statements, balance sheets, and cash flow statements. Project future cash flows based on market trends, competition, and management capabilities. Discount these cash flows using a discount rate that reflects the risk of the restaurant business. Compare the resulting value to the price derived from comparable sales of similar restaurants.

By understanding these diverse types of value and their underlying scientific principles, real estate professionals can provide more comprehensive and accurate valuations for a wider range of situations.