Principles of Contribution and Highest & Best Use

Chapter Title: Principles of Contribution and Highest & Best Use

Introduction

This chapter delves into two crucial economic principles that underpin real estate valuation: the principle of contribution and the principle of highest and best use. Understanding these principles is essential for accurately assessing the value of real estate assets. The principle of contribution dictates how individual components affect overall property value, while the principle of highest and best use determines the most profitable and reasonable use for a property, thereby driving its potential worth.

H. PRINCIPLE OF CONTRIBUTION

The principle of contribution, also known as marginal productivity❓❓❓, focuses on the incremental value added (or subtracted) by a specific component of a property. It emphasizes that the worth of an individual component is not necessarily equal to its cost but is instead determined by its contribution to the overall value of the property.

1. Definition: The principle of contribution states that the value of a component of a property is equal to the amount by which it adds to the value of the property as a whole, or the amount by which its absence detracts from the property’s value. This contribution to value is termed marginal productivity.

2. Marginal Cost vs. Marginal Productivity:

   • Marginal Cost: The actual cost of adding a component to the property.
   • Marginal Productivity: The increase in the property’s overall value resulting from the addition of the component.

   The principle highlights that a component’s value is determined by its marginal productivity, not its marginal cost. A component is economically justified only if its marginal productivity equals or exceeds its marginal cost.

3. Mathematical Representation (Conceptual):

   Let:

   • V_total = Total value of the property
   • V_component = Value of the component being considered
   • V_{total, without component} = Total value of the property without the component

   Then, the principle of contribution can be represented as:

   V_component = V_total - V_{total, without component}

4. Increasing and Decreasing Returns: The Principle of Increasing and Decreasing Returns is intrinsically linked to the Principle of Contribution. As you invest in improvements or additions to a property (agents of production), the initial returns may increase at an accelerating rate (increasing returns). However, as you continue to invest, the rate of return eventually starts to increase at a slower rate, ultimately reaching a point where further investment leads to diminishing returns and a decrease in overall profitability.

5. Application in Sales Comparison Approach:
   The principle of contribution is crucial in the sales comparison approach to valuation. When comparing a subject property to comparable properties, adjustments are made for differences in features and amenities. These adjustments should be based on the market’s perception of the value of those differences (marginal productivity), not simply on the cost of adding or removing those features.

   Example: In a neighborhood, houses with a finished basement consistently sell for $20,000 more than similar houses without a finished basement. The appraiser should adjust comparable sales by $20,000 to account for a finished basement, regardless of the actual cost to finish the basement.

6. Experiment/Case Study: Swimming Pool Valuation

   Objective: Determine the contribution of a swimming pool to residential property value in a specific market.

   Methodology:
   * Collect data on recent sales of comparable properties in the same neighborhood.
   * Divide properties into two groups: those with pools and those without pools.
   * Control for other variables (house size, lot size, age, condition, amenities) using regression analysis.

   Regression Model:

   Sale Price = b₀ + b₁(House Size) + b₂(Lot Size) + b₃(Age) + b₄(Pool) + Error

   Where:
   * b₀ is the constant term.
   * b₁, b₂, and b₃ are coefficients for house size, lot size, and age.
   * b₄ is the coefficient for the pool variable (1 if the property has a pool, 0 otherwise).
   * Error is the error term.

   Expected Outcome: The coefficient b₄ will represent the average contribution of a swimming pool to the sale price of a house, controlling for other factors. This value will be an estimate of the pool’s marginal productivity.

   Analysis: If b₄ = $15,000, this implies that, on average, a swimming pool contributes $15,000 to the overall value of a property in that market.

7. Case Example (from text):

   • Installing new siding on a house increases its value by $5,000. The siding’s marginal productivity is $5,000.
   • In a neighborhood, three-bath homes sell for $5,000 more than two-bath homes. The third bathroom’s contribution to value is $5,000.

I. PRINCIPLE OF INCREASING AND DECREASING RETURNS

1. Explanation: Closely related to the Principle of Contribution, the principle of increasing and decreasing returns states that adding increments of one agent of production (e.g., capital improvements) while holding other agents fixed (e.g., land) will initially❓ yield increasing returns. However, beyond a certain point, the additional investment will result in decreasing returns, meaning that each additional increment contributes less and less value.
   Example: A builder intends to develop a lot with a single-family residence, at a construction cost of $60 per square foot. As the house size increases, the builder’s rate of return (profit) initially increases at an accelerating rate. However, after a certain size (e.g., 2,100 square feet), further increases in size lead to diminishing returns and a lower rate of return.

V. EFFECT OF USE ON REAL ESTATE VALUE

The value of real estate is significantly influenced by its use. Understanding this relationship is critical for accurate valuation.

A. HIGHEST AND BEST USE PRINCIPLE

The principle of highest and best use is a cornerstone of real estate valuation. It dictates that the value of a property is determined by its most profitable, legal, physically possible, and financially feasible use.

1. Definition: The highest and best use is the reasonably probable and legal use of a property that results in the highest value.

2. Four Tests of Highest and Best Use (Must be met sequentially):

   a. Legally Permissible: The use must be allowed by zoning ordinances, building codes, and other legal restrictions. If the current zoning doesn’t allow for the most profitable use, it must be reasonably probable that a zoning change or variance could be obtained.

   b. Physically Possible: The use must be physically viable given the site’s characteristics (size, shape, topography, soil conditions, etc.).

   c. Financially Feasible: The use must generate sufficient income or return to justify the investment. This requires analyzing potential revenues, operating expenses, and development costs.

   d. Maximally Productive: Of all the legally permissible, physically possible, and financially feasible uses, the highest and best use is the one that results in the highest value or return to the property owner.

3. Highest and Best Use as Vacant vs. As Improved:

   • As Vacant: The highest and best use of the land assuming it is vacant and available for development.
   • As Improved: The highest and best use considering the existing improvements on the property. This analysis determines whether the existing improvements should be retained, renovated, or demolished.

   The highest and best use as improved should consider:
   If the property is improved, should it be demolished? Demolishing a property is feasible when the value of the land vacant exceeds the value of the property as improved, minus the demolition costs.

4. Mathematical Representation (Conceptually):

   Let:

   • V_{land, vacant} = Value of the land if vacant and used for its highest and best use
   • V_{property, as improved} = Value of the property with existing improvements
   • C_demolition = Cost of demolishing the existing improvements

   The property should be demolished if:

   V_{land, vacant} > V_{property, as improved} + C_demolition

5. Applications of Highest and Best Use Analysis:

   a. Comparable Property Selection: Identifying comparable properties with the same or similar highest and best uses as the subject property.

   b. Investment Decisions: Guiding decisions about property development, renovation, and disposition.

   c. Property Tax Assessment: Determining the fair market value of a property for tax purposes.

6. Experiment/Case Study: Re-Development Potential

   Objective: Determine whether an older commercial building in a downtown area should be retained or demolished for redevelopment.

   Methodology:

   a. Highest and Best Use as Vacant: Analyze the potential uses for the land if vacant (e.g., new office building, residential apartments, retail complex). Conduct a market study to estimate the value of the land for each potential use.

   b. Highest and Best Use as Improved: Analyze the existing building’s condition, operating expenses, and potential income. Estimate the building’s value using income capitalization or sales comparison approaches.

   c. Financial Feasibility Analysis: Compare the net present value (NPV) of retaining and operating the existing building with the NPV of demolishing the building and developing a new project. The NPV calculation should consider all relevant costs and revenues over the project’s life.

   NPV = ∑ [Cash Flow_t / (1 + r)^t]

   Where:
   * Cash Flow_t is the net cash flow in period t
   * r is the discount rate
   * t is the time period

   d. Decision: If the NPV of redevelopment exceeds the NPV of retaining the existing building (after accounting for demolition costs), then demolition and redevelopment is the highest and best use.

7. Case Examples (from text):

   • A property improved with a single-family residence is worth $50,000 for the land and $70,000 for the residence. If vacant, the land would be worth $80,000 for multi-family use. In this case, the current use is the highest and best use ($50,000 + $70,000 = $120,000 > $80,000).
   • Same situation as above, but the residence is worth only $20,000. Now, the total value is $70,000. If the cost of demolition is less than $10,000, the highest and best use is multi-family residential.

B. CONSISTENT USE PRINCIPLE

1. Definition: The consistent use principle requires that when valuing an improved property, the land and improvements must be valued based on the same use. It’s improper to value the land for one use and the improvements for another.

2. Application: This principle ensures that the valuation is internally consistent. You cannot value the land as if it were used for its highest and best use vacant while simultaneously valuing the improvements based on the current use if those uses are different.

3. Case Example (from text):
   An appraiser cannot value improvements for single-family residential use and value the land for multi-family residential use. Both must be valued for single-family or multi-family use, consistently.

C. CONFORMITY, PROGRESSION, AND REGRESSION PRINCIPLES

1. Principle of Conformity: Property values are maximized when the uses of surrounding properties are similar and compatible. Zoning regulations are based on this principle.

2. Principle of Progression: The value of a lower-quality property tends to increase when it’s located near higher-quality properties.

3. Principle of Regression: The value of a higher-quality property tends to decrease when it’s located near lower-quality properties.

Conclusion

The principles of contribution and highest and best use are fundamental to accurate real estate valuation. By understanding how individual components contribute to overall value and by identifying the most profitable and reasonable use for a property, appraisers can arrive at credible and reliable value estimates. These principles are essential tools for investors, developers, lenders, and anyone involved in the real estate industry.