Core Principles: Productivity, Contribution, and Highest & Best Use

Chapter 2: Core Principles: Productivity, Contribution, and Highest & Best Use

This chapter delves into fundamental economic principles crucial for understanding real estate valuation. We will explore productivity, contribution, and highest and best use. These principles provide a framework for analyzing how various factors influence property value and guide appraisers in making informed decisions.

I. Productivity

Productivity refers to the capacity of land to generate income or utility. It’s a key driver of land value. Different parcels of land possess varying levels of productivity due to factors like location, soil quality, accessibility, and zoning regulations.

• Factors Influencing Land Productivity:

  1. Location: Proximity to amenities, transportation, and employment centers significantly impacts productivity. Land in prime locations tends to be more productive.
  2. Physical Characteristics: Soil fertility, topography, and natural resources affect agricultural and developmental productivity.
  3. Infrastructure: Availability of utilities (water, electricity, sewage), roads, and communication networks enhances productivity.
  4. Legal and Regulatory Environment: Zoning laws, land-use regulations, and environmental restrictions can either promote or hinder productivity.
  5. Capital Improvements: Investments in buildings, landscaping, and other improvements can increase land productivity.

• Measurement of Productivity: Productivity can be assessed by examining the potential income generated by a property. For example, farmland productivity is measured by crop yields, while retail property productivity is gauged by sales revenue.

• Surplus Productivity: The principle of surplus productivity suggests that after accounting for the costs of labor, capital, and management, any remaining net income can be attributed to the land. This residual income❓ reflects the land’s productive capacity.

  Example: A property generates a net income of $10,000 per year. If labor, capital, and management costs total $8,000 annually, the remaining $2,000 represents the surplus productivity of the land. This concept forms the basis for residual techniques used to estimate land value.

  Formula:
  Surplus Productivity = Net Income - (Cost of Labor + Cost of Capital + Cost of Management)

II. Contribution

The principle of contribution emphasizes that the value of any component of a property is determined by the amount it adds to the overall value of the property, irrespective of its cost. This added value is termed its marginal productivity.

• Marginal Productivity vs. Marginal Cost: The marginal productivity of a component is the change in the property’s value resulting from the addition or removal of that component. The marginal cost is the actual cost of adding the component.

  Example: Installing new siding on a house increases its value by $5,000. The siding’s marginal productivity is $5,000. Whether the siding cost more or less than $5,000 is irrelevant to its contribution to the overall property value. If the siding cost less than $5,000, it added more value than it cost. If the siding cost more than $5,000, it added less value than it cost, suggesting that the investment might not have been worthwhile from a purely financial perspective.

• Application in Sales Comparison Approach: The principle of contribution is widely used in the sales comparison approach. It helps appraisers quantify the value differences between comparable properties due to variations in specific features or amenities.

  Example: In a neighborhood of similar residential properties, homes with two bathrooms sell for $140,000, while homes with three bathrooms sell for $145,000. The contribution of the third bathroom is $5,000. When adjusting the value of a comparable property for bathroom count, the appraiser would base the adjustment on this $5,000 market-derived difference rather than the actual cost of adding a third bathroom.

• Mathematical Representation: The change in the value of the property ΔV due to addition of a component is the Marginal Productivity MP. Therefore, MP = ΔV.

III. Increasing and Decreasing Returns

The principle of increasing and decreasing returns states that when one or more agents of production (such as land) are held constant, while investment in other agents (such as labor and capital) is increased, the rate of return on the investment will initially increase at an accelerating rate (increasing returns). As investment continues, the rate of return will increase but at a decelerating rate (diminishing returns). Eventually, the rate of return will decline (decreasing returns).

• Stages of Returns:

  1. Increasing Returns: Each additional unit of investment yields a proportionally larger increase in output or value.
  2. Diminishing Returns: Each additional unit of investment yields a smaller increase in output or value than the previous unit.
  3. Decreasing Returns: Additional units of investment result in a decrease in output or value.

• Optimization: The goal is to optimize the level of investment to achieve the highest rate of return. Beyond the point of diminishing returns, additional investment becomes less efficient and may even reduce overall profitability.

  Example: A builder plans to develop a lot with a single-family residence. The builder estimates the likely sales price of the residence, based on various potential square footages.

  Size in Sq. Ft.	Estimated Sales Price	Marginal Productivity of Additional 100 Sq. Ft.	Marginal Cost of Additional 100 Sq. Ft.	Marginal Return on Additional 100 Sq. Ft.	Overall Rate of Return
  1,500	$94,500	N/A	N/A	N/A	5%
  1,600	$101,800	$7,300	$6,000	$1,300	6%
  1,700	$110,200	$8,400	$6,000	$2,400	8%
  1,800	$119,900	$9,700	$6,000	$3,700	11%
  1,900	$128,800	$8,900	$6,000	$2,900	13%
  2,000	$136,800	$8,000	$6,000	$2,000	14%
  2,100	$143,600	$6,800	$6,000	$800	14%
  2,200	$149,200	$5,600	$6,000	<$400>	13%
  2,300	$153,200	$4,000	$6,000	<$2,000>	11%

  In this scenario, increasing the house size up to 2,100 square feet increases the builder’s rate of return. Above 2,100 square feet, the rate of return declines.

  Mathematical Representation:

  Return = Revenue - Cost

  Marginal Return (MR) = Change in Return / Change in Investment

  The optimum level of investment occurs where MR is maximized or where marginal revenue equals marginal cost❓ (MR = MC).

IV. Highest and Best Use

The principle of highest and best use (HBU) is foundational to real estate valuation. HBU is defined as the most probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. This principle dictates that the value of a property is determined by its most profitable use.

• Criteria for Highest and Best Use:

  1. Legally Permissible: The use must be allowed under current zoning regulations and other legal restrictions. A variance might be considered if easily obtainable.
  2. Physically Possible: The use must be physically feasible, given the size, shape, topography, and other physical characteristics of the site.
  3. Financially Feasible: The use must generate sufficient income or utility to justify the cost of development.
  4. Maximally Productive: Among all feasible uses, the highest and best use is the one that maximizes the property’s value.

• Highest and Best Use Analysis: Appraisers conduct a thorough analysis to determine the HBU of a property. This involves researching zoning regulations, market conditions, and potential development options.

• HBU as Vacant vs. HBU as Improved: When analyzing improved real estate, appraisers consider both the HBU of the property as if vacant and the HBU of the property as currently improved. The HBU as vacant represents the use that would maximize value if the existing improvements were removed.

  Example 1: A property improved with a single-family residence. The value of the land for its current use is $50,000, and the value of the residence is $70,000. If vacant, the HBU of the land would be multi-family residential, valued at $80,000. In this case, the HBU of the property is its current use because the total value of the land and improvements ($120,000) exceeds the value of the land alone for multi-family use.

  Example 2: Same scenario as above, but the residence is run-down and estimated to be worth only $20,000. The total value of the land and improvements for its current use is $70,000. In this case, the HBU of the land could be for multi-family residential use, assuming the cost of removing the existing improvements is less than $10,000 ($80,000 value if vacant for new use less $70,000 value as improved for current use).

• Functions of Analyzing Highest and Best Use:

  1. Identifying Comparable Properties: HBU helps identify comparable properties with similar uses.
  2. Deciding on Demolition, Renovation, or Retention: HBU helps decide whether to demolish, renovate, or retain existing improvements.

V. Consistent Use

The principle of consistent use dictates that both the land and improvements on a property must be valued for the same use, even if they are being valued separately. It is improper to value the land for one use and the improvements for a different use.

• Application: The consistent use principle applies when valuing improved property.
• Example: An appraiser cannot value improvements for single-family residential use and value the land for multi-family residential use. Land and improvements must be valued for either both single-family or both multi-family use.

VI. Conformity, Progression, and Regression

• Principle of Conformity: Property values are enhanced when the uses of surrounding properties conform to the use of the subject property. Zoning regulations aim to group compatible uses and separate incompatible uses.

• Principle of Progression: The value of a less expensive property increases when it is located near more expensive properties.

• Principle of Regression: The value of a more expensive property decreases when it is located near less expensive properties.

Conclusion

Understanding the principles of productivity, contribution, increasing and decreasing returns, and highest and best use is essential for accurate real estate valuation. These principles provide a framework for analyzing the factors that influence property value and making informed decisions about property use and investment.