Foundations of Value: Land Use and Economic Principles

Foundations of Value: land use❓ and Economic Principles

Introduction

This chapter delves into the fundamental principles underpinning real estate value, focusing on land use and its economic context. We will explore how land’s unique characteristics, coupled with broader economic forces, shape property values. Understanding these foundations is crucial for accurate and reliable real estate appraisal.

The Unique Nature of Land

Land, unlike many other economic goods, possesses distinctive characteristics that significantly influence its value and use:

1. fixed supply❓: The total amount of land on Earth is finite. While land can be improved or altered, the overall supply remains constant. This fixed supply makes land a scarce resource, a key driver of value.
2. Immobility: Land is geographically fixed. It cannot be moved from one location to another. This immobility ties its value to the specific characteristics of its location, including accessibility, neighborhood quality, and environmental factors.
3. Durability: Land is inherently durable; it does not depreciate like buildings or machinery. While land can be damaged or contaminated, its basic existence is perpetual.
4. Heterogeneity: Every parcel of land is unique. Differences in topography, soil composition, access, and surrounding environment ensure that no two pieces of land are exactly alike. This heterogeneity leads to variations in value.
5. Locational Value: The value of land is greatly influenced by its location, based on the principle of “site value”. The principle indicates the importance of a specific location with attributes that make it important and thus more valuable than surrounding location options.

Land Use and Economic Principles

Economic principles provide a framework for understanding how land is allocated and valued. Here are some key concepts:

1. Supply and Demand:
   • The basic economic principle of supply and demand dictates that prices are determined by the interaction of these two forces. In the context of land, the fixed supply means that changes in demand have a more pronounced effect on price.
   • Formula: Price = f(Demand, Supply)
   • Where:
     • Price is the market price of land.
     • Demand represents the quantity of land buyers are willing to purchase at various prices.
     • Supply is the quantity of land available for sale at various prices.
   • Example: Increased demand for residential housing in a city will drive up land prices, especially in desirable neighborhoods where supply is limited.

2. Highest and Best Use:

   • This principle states that the value of a property is determined by its most profitable and likely use. The “highest and best use” must be:
     • Legally permissible: Compliant with zoning and other regulations.
     • Physically possible: Suitable given the land’s size, shape, and topography.
     • Financially feasible: Capable of generating sufficient income to justify development costs.
     • Maximally productive: Yielding the greatest return to the owner.
   • The highest and best use can change over time due to changes in market conditions, regulations, or technology.
   • Example: A vacant lot might have its highest and best use as a parking lot in the short term, but as a high-rise apartment building in the long term as the city’s population density increases.

3. Substitution:

   • The principle of substitution states that a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
   • This principle underlies the sales comparison approach to appraisal, where the value of a property is estimated by comparing it to similar properties that have recently sold.
   • Example: If two similar houses are for sale in the same neighborhood, a buyer will likely choose the one with the lower price, unless the more expensive one offers some unique advantage.
4. Anticipation:
   • The value of a property is based on the anticipation of future benefits, such as income, appreciation, or personal enjoyment.
   • This principle is central to the income capitalization approach to appraisal, where the value of a property is estimated based on the present value of its expected future income stream.
   • Formula: Value = Σ [CFt / (1 + r)^t]
   • Where:
     • Value is the present value of the property.
     • CFt is the expected cash flow in year t.
     • r is the discount rate, reflecting the required rate of return.
     • t is the time period (year).
   • Example: A developer might pay a premium for a piece of land if they anticipate that it will be rezoned for a more profitable use in the future.
5. Contribution:
   • The principle of contribution states that the value of any component of a property is measured by its contribution to the overall value of the property.
   • This principle is particularly relevant in considering improvements to land.
   • Example: Adding a swimming pool to a house will only increase its value if the pool is desired by potential buyers and its value exceeds the cost of installation.
6. Increasing and Decreasing Returns:
   • This principle suggests that adding increments of one agent of production while other agents of production are held constant will increase income production up to a point (increasing returns), after which income production will decrease (decreasing returns).
7. Externalities:
   • Externalities are effects on property value caused by factors external to the property itself. These can be positive (e.g., proximity to a park) or negative (e.g., proximity to a noisy highway).
   • Externalities highlight the interconnectedness of land values and the importance of considering the surrounding environment in appraisal.
   • Example: The construction of a new school near a residential neighborhood can increase property values due to improved access to education.

Land Use Controls and Regulations

Governmental regulations play a significant role in shaping land use and property values:

1. Zoning:
   • Zoning ordinances regulate the types of activities that can occur on specific parcels of land.
   • Zoning can affect land values by restricting certain uses, increasing scarcity for permitted uses, and ensuring compatibility between neighboring properties.
   • Example: Zoning might restrict residential development in an industrial area, preventing potential conflicts and protecting industrial land values.
2. Building Codes:
   • Building codes set minimum standards for construction, ensuring safety and quality.
   • Building codes can affect development costs and the type of structures that can be built.
   • Example: Energy-efficient building codes can increase construction costs but also lead to lower operating expenses for building owners.
3. Environmental Regulations:
   • Environmental regulations protect natural resources and prevent pollution.
   • These regulations can restrict development in sensitive areas like wetlands or floodplains, affecting land values.
   • Example: Regulations protecting endangered species can limit development in their habitats.
4. Eminent Domain:
   • Eminent domain is the power of the government to take private property for public use, even if the owner does not want to sell it.
   • The government must provide “just compensation” to the owner for the property.
   • Eminent domain can affect land values by creating uncertainty and potentially displacing existing uses.

Agents of Production and Land Value

The four agents of production—land, labor, capital, and entrepreneurial coordination—interact to create real estate value. Their roles are as follows:

1. Land: The foundation upon which all development occurs. Its location and physical characteristics are fundamental.
2. Labor: The human effort involved in constructing and maintaining improvements to the land. This includes physical labor and intellectual contributions (architects, engineers).
3. Capital: The financial resources needed to acquire land, construct improvements, and fund operations.
4. Entrepreneurial Coordination: The skills and vision of the developer or investor who organizes and manages the entire process, taking risks and coordinating the other agents of production.

The interplay❓ of these four agents directly influences the value of real estate. A deficiency in any one area can negatively impact a property’s potential.

Practical Applications and Related Experiments

1. Zoning Impact Study:
   • Objective: To determine the effect of zoning changes on land values.
   • Method: Compare land prices in areas rezoned for higher-density development with prices in similar areas that remain under the original zoning. Analyze sales data before and after the rezoning to isolate the impact of the zoning change.
   • Experiment: Collect sales data of vacant lots in two areas, one area rezoned for commercial use and the other remaining residential. Compare the change in average sales prices over a period of 3 years after the rezoning.
2. Highest and Best Use Analysis Exercise:
   • Objective: To apply the concept of highest and best use to a specific property.
   • Method: Students or appraisers are presented with a case study describing a parcel of land. They must analyze the legal, physical, financial, and maximally productive considerations to determine the highest and best use of the property.
   • Experiment: Provide the size and location of a vacant lot with certain zoning restrictions. Ask participants to determine, with justification, whether the highest and best use is a parking lot, retail space, or a multi-family building.
3. Externality Impact Assessment:
   • Objective: To quantify the effect of a negative externality (e.g., noise pollution from an airport) on residential property values.
   • Method: Conduct a regression analysis of sales data, controlling for property characteristics (size, age, features) and proximity to the airport. The coefficient on the distance variable will indicate the magnitude of the externality’s impact.
   • Experiment: Gather data on home sales near an airport. Plot sales prices against distance from the airport. Observe and explain the correlation.

Conclusion

Land use and economic principles are the bedrock of real estate valuation. Understanding these principles is essential for appraisers to accurately assess property values and provide reliable advice to clients. The interaction of supply and demand, highest and best use considerations, government regulations, and the role of the agents of production all contribute to the complex dynamics of land valuation. By carefully analyzing these factors, appraisers can provide well-supported opinions of value that reflect the unique characteristics of each property.