Value Drivers: Land Use, Economics, and Ownership

Value Drivers: Land Use, Economics, and Ownership

Introduction

Real estate appraisal is fundamentally rooted in an understanding of value, which is, in turn, influenced by a complex interplay of factors. This chapter delves into three critical value drivers: land use, economics, and ownership. These factors are intertwined and exert significant influence on property values, necessitating a thorough understanding for accurate and reliable appraisal practices.

1. Land Use: Shaping Value through Regulation and Function

Land, a finite resource, is the foundational element of real estate. How land is utilized directly impacts its value. Land use is governed by a complex system of regulations, market forces, and societal preferences.

1.1. Land Use Regulations and their Impact

• Zoning Ordinances: These regulations dictate permissible land uses within specific geographic areas. They control density, building heights, setbacks, and types of activities allowed (e.g., residential, commercial, industrial). Zoning influences value by restricting or promoting certain development opportunities.

  • Example: Land zoned for high-density residential development in a desirable location will typically command a higher value than land zoned for single-family residences in the same area.

• Building Codes: These codes ensure structural integrity, safety, and accessibility of buildings. More stringent building codes can increase construction costs but also contribute to higher quality properties with enhanced market appeal, impacting value both positively and negatively.

  • Experiment: Compare the costs associated with building a structure to meet different levels of building code requirements. Analyze how these costs affect the market value of comparable properties.

• Environmental Regulations: Regulations pertaining to wetlands, endangered species habitats, and pollution control can significantly restrict land use and development potential. Compliance costs, mitigation requirements, and potential use limitations all affect property value.

  • Example: Land containing protected wetlands might have limited development potential, resulting in a lower appraised value compared to a similar parcel without such environmental constraints.
  • Subdivision Regulations: Dictate how land can be divided into smaller parcels for development. These regulations influence the density and pattern of development, thereby impacting land value.

1.2. Highest and Best Use Analysis
The concept of highest and best use is the cornerstone of land valuation. It refers to the most probable and legal use of a property that is physically possible, appropriately supported, financially❓ feasible, and results in the highest value. This analysis considers all possible uses and selects the one that maximizes the land’s potential.

• Four Criteria of Highest and Best Use:

  1. Legally Permissible: The use must comply with all applicable zoning ordinances, building codes, and environmental regulations.
  2. Physically Possible: The site must be suitable for the proposed use, considering factors like size, shape, topography, and soil conditions.
  3. Financially Feasible: The use must generate sufficient revenue or benefits to justify the costs of development and operation.
  4. Maximally Productive: Among all financially feasible uses, the one that generates the highest net return or utility is the highest and best use.

• Example: A vacant lot located in a commercial district could have several potential uses (e.g., retail store, office building, parking lot). A highest and best use analysis would evaluate each option based on its legality, feasibility, and profitability, ultimately determining which use would result in the highest land value.

1.3. Public vs. Private Land Use

• Public Land Use: Land owned and used by governmental entities for the benefit of the public (e.g., parks, schools, roads). Valuation of public land often prioritizes social benefits over pure economic return.
• Private Land Use: Land owned and used by individuals or private entities for personal or commercial gain. Valuation of private land focuses on maximizing economic return within the bounds of applicable regulations.
  The application of police power is a key difference between public and private ownership. For example, a municipal park may be an ideal location for industrial development from a purely financial standpoint, but zoning ensures that the park continues to be used for recreational purposes.

2. Economic Principles: The Foundation of Value

Economic principles underpin the concept of value in real estate. Understanding these principles is crucial for appraising properties accurately.

2.1. Supply and Demand

The interaction of supply and demand is a fundamental determinant of real estate values.

• Demand: Represents the quantity of real estate that buyers are willing and able to purchase at various price levels. Factors influencing demand include population growth, employment rates, income levels, interest rates, and consumer confidence.

• Supply: Represents the quantity of real estate available for sale or lease at various price levels. Factors influencing supply include construction costs, availability of land, zoning regulations, and developer sentiment.

• Equilibrium: The point where supply and demand are balanced, resulting in a stable market price.

• Mathematical Representation:

  • Let Qd represent quantity demanded.
  • Let Qs represent quantity supplied.
  • Let P represent price.
  • Qd = a - bP (Demand curve, where a and b are constants)
  • Qs = c + dP (Supply curve, where c and d are constants)
  • Equilibrium occurs where Qd = Qs
  • Therefore, a - bP = c + dP
  • Solving for P gives the equilibrium price: P = (a - c) / (b + d)
  • Experiment: Track housing prices, inventory levels (supply), and sales volume (demand) in a local market over time. Analyze how changes in supply and demand affect market values.

2.2. Agents of Production

The value of real estate is also determined by the four agents of production: land, labor, capital, and entrepreneurial coordination.

1. Land: The site itself, including its location, physical characteristics, and legal attributes.
2. Labor: The human effort involved in constructing, maintaining, and managing the property.
3. Capital: The financial resources used to fund the development and operation of the property.
4. Entrepreneurial Coordination: The management and organizational skills required to bring the other three factors together and create a successful real estate project.

The sum of the costs associated with these agents is one basic measure of real property value.

2.3. Principles of Value
Several economic principles influence real estate value:

• Substitution: A buyer will pay no more for a property than the cost of acquiring a similar substitute. This principle underpins the sales comparison approach to valuation.
• Anticipation: Value is based on the expected future benefits of owning a property. This principle is fundamental to the income capitalization approach.
• Change: Real estate markets are constantly changing, and values are affected by economic, social, and political trends.
• Competition: Competition among buyers and sellers influences market prices.
• Contribution: The value of a component part of a property is measured by its contribution to the value of the whole.
• Increasing and Decreasing Returns: Adding more of a particular input (e.g., labor, capital) will initially increase returns, but eventually, the returns will diminish.
• Externalities: Factors external to a property (e.g., neighborhood amenities, traffic congestion) can affect its value.
• Balance: Maximum value is achieved when the four agents of production are in proper proportion.
  2.4. History of Value Theory
  Modern value theory began in the 18th and 19th centuries with the classical school of economic thought. Classical theory was based on contributions of the physiocrats. Physiocratic thinkers objected to the commercial emphasis of mercantilism. Agricultural productivity was the source of wealth. The classical school expanded and refined the tenets of physiocratic thought and attributed value to the cost of production. Adam Smith suggested capital in addition to land and labor. Smith believed value was created when the agents of production were brought together to produce a useful item.

3. Ownership: Rights and Restrictions

The type of ownership interest held in a property significantly impacts its value. Understanding the different forms of ownership and the rights and restrictions associated with them is essential.

3.1. Fee Simple Ownership

• Represents the most complete form of ownership, granting the owner unrestricted rights to use, sell, lease, or transfer the property.
• Subject only to government powers (e.g., taxation, eminent domain, police power, escheat) and private restrictions (e.g., easements, covenants).

3.2. Leasehold Ownership

• Grants the tenant the right to use and occupy the property for a specified period, subject to the terms of the lease agreement.
• The value of a leasehold interest depends on the difference between the market rent and the contract rent, as well as the remaining lease term.

• Mathematical Representation:

  • Let Vl represent the value of the leasehold interest.
  • Let MR represent the market rent.
  • Let CR represent the contract rent.
  • Let n represent the number of periods remaining in the lease.
  • Let r represent the discount rate.
  • Vl = Σ [(MR - CR) / (1 + r)^t], for t = 1 to n (Present value of the rental difference over the lease term)

3.3. Other Forms of Ownership

• Joint Tenancy: Ownership by two or more persons with right of survivorship (the deceased owner’s interest automatically transfers to the surviving owner(s)).
• Tenancy in Common: Ownership by two or more persons with no right of survivorship (each owner can dispose of their interest independently).
• Life Estate: Ownership for the duration of a person’s life (the “life tenant”). Upon the life tenant’s death, the property reverts to the remainderman.
• Condominium Ownership: Individual ownership of a unit within a multi-unit building, along with shared ownership of common areas.
• Cooperative Ownership: Ownership of shares in a corporation that owns the building. The shareholder receives a proprietary lease to occupy a specific unit.
• Land Trusts: Title may be held as a beneficial interest in a land trust.
• Limited Liability Corporations (LLC): Title may be held in an LLC.

3.4. Impact of Ownership Restrictions

• Easements: Grant a third party the right to use a portion of the property for a specific purpose (e.g., right-of-way for utilities).
• Covenants, Conditions, and Restrictions (CC&Rs): Private agreements that restrict land use and development within a subdivision or community.
• Liens: Claims against the property for unpaid debts.
• Encroachments: Physical intrusions onto the property by adjacent structures or improvements.

These restrictions can limit the owner’s rights and affect the property’s value. Appraisers must identify and analyze any such restrictions to determine their impact.

3.5. Public and Private Ownership Forms
One major distinction in real property ownership is the difference between private ownership and public ownership. Public ownership of real property takes many forms. Streets and roads, municipal utility systems, and other public facilities such as city halls, prisons, and public works facilities are usually owned by governmental bodies for the benefit of all citizens in a jurisdiction. School districts own land on which school buildings, athletic fields, and other facilities are maintained. Library districts create public libraries. Park, recreation, and conservation districts acquire land for recreation, conservation, and preservation.

Conclusion

Land use regulations, economic principles, and ownership rights are fundamental value drivers in real estate appraisal. A thorough understanding of these factors is essential for appraisers to accurately estimate property values and provide reliable opinions. By considering the interplay of these forces, appraisers can ensure that their valuations are well-supported and reflect the true market conditions.