Understanding Value: Principles and Agents of Production

Understanding Value: Principles and Agents of Production

Introduction

Value is a multifaceted concept at the heart of real estate appraisal. It is influenced by various economic forces and principles. This chapter explores the fundamental principles underpinning value, focusing on the agents of production and their contributions to wealth creation. Understanding these concepts is crucial for accurately assessing real estate value.

VI. Production as a Measure of Value

Economic theory defines PRODUCTION as the creation of wealth. This wealth-generating capability is a key determinant of the value of land and its improvements. Production provides a framework for understanding how resources are combined to create valuable goods and services, including real estate.

A. AGENTS OF PRODUCTION PRINCIPLE

The agents of production are the essential inputs required to create goods or services, including real estate. These agents are:

1. CAPITAL (Financial Resources): Capital encompasses the financial resources, including money, credit, and investments, used to fund the production process. It provides the means to acquire land, materials, and labor.

   • Role: Capital fuels the entire production process by enabling the acquisition of other factors.
   • Examples: Loans for construction, equity investments in development projects, and funds for purchasing building materials.
   • Mathematical Representation: Capital (K) contributes to the overall value through its return on investment (ROI). ROI = (Net Profit / Capital Invested) * 100.

2. LAND (Natural Resources): Land represents the natural resources available for production, including the site itself, minerals, water, and other resources inherent to the property.

   • Role: Provides the physical space and resources necessary for development or use.
   • Examples: Raw land for residential development, a site with mineral deposits, or a waterfront property with access to water resources.
   • Mathematical Representation: The value of land can be determined by discounted cash flow analysis, considering the present value of future income streams generated from the land. Land Value = ∑ (Future Income / (1 + Discount Rate)^Year).

3. LABOR (Employment): Labor refers to the human effort, skills, and expertise applied to the production process. It includes construction workers, architects, engineers, and other professionals involved in developing and managing real estate.

   • Role: Provides the physical and intellectual effort necessary to transform resources into valuable improvements.
   • Examples: Construction labor for building a house, architectural design services, and property management.
   • Mathematical Representation: The cost of labor (L) impacts the overall production cost and, consequently, the value. Total Cost = Material Cost + Labor Cost + Overhead.

4. COORDINATION (Management or Entrepreneurship): Coordination encompasses the organizational and managerial skills that combine the other agents of production effectively. It involves planning, decision-making, risk-taking, and innovation.

   • Role: Organizes and manages the other agents of production to maximize efficiency and profitability.
   • Examples: Real estate developers who oversee the entire development process, property managers who optimize property performance, and investors who make strategic decisions.
   • Mathematical Representation: Entrepreneurial profit is the reward for the coordinator’s risk and innovation. Profit = Total Revenue – (Land Rent + wages❓❓ + Interest on Capital).

These agents can operate independently or collaboratively to generate income or profit. The RATE OF RETURN (OR PROFIT) relative to the resources invested serves as a measure of production and value.

Case Example: Real Estate Development

In a real estate development, investors provide capital, the developer offers management (coordination), and construction workers provide labor. These three agents combine with the fourth agent, land, to create something of value, such as a housing development. The success of the project, measured by its profitability, demonstrates the effectiveness of the agents of production working together.

Adam Smith and Capitalism

The economic system based on private property ownership and personal rights, known as CAPITALISM, was articulated by Adam Smith in his 1776 book, “Wealth of Nations.” Smith proposed that value should be the sum of the contributions of the four agents of production.

• Land: Entitled to rent
• Labor: Entitled to wages
• Capital: Entitled to interest
• Management: Entitled to profit appropriate to the risk

Capitalistic Theory in Action (Numerical Example):

Assume a property can be purchased for $100,000. A builder wants to construct a home on the property. The builder estimates total lot preparation, construction, and landscaping costs at $190,000. The project will take nine months from land purchase to completion, with an additional three months to sell the property. The builder estimates interest payments at 10% and expects a 10% return on their cash investment. This total interest and return on capital are estimated at $28,000 before the anticipated sale. Given possible economic changes, delays, and other costs, the builder seeks a 22% profit for taking the risk.

Total Costs:
Land: $100,000
Improvements: $190,000
Interest: $28,000
Profit: $69,960
Price: $387,960

Therefore, the builder estimates that $387,960 would be a fair price for the home. However, market forces can result in a higher or lower price, even leading to a loss.

Practical Application:

1. Feasibility Studies: Developers use the agents of production framework to conduct feasibility studies for potential real estate projects. By estimating the costs associated with each agent (land acquisition, construction labor, capital financing, and management expertise) and projecting potential revenues, developers can determine whether a project is economically viable.

2. Valuation Methods: Appraisers utilize the agents of production principle as a theoretical foundation for cost-based valuation methods. For example, the cost approach to value estimates the value of a property by summing the costs of land, labor, materials, and entrepreneurial profit.

3. Investment Analysis: Investors apply the agents of production framework to analyze real estate investments. By evaluating the return on capital (ROI) generated by a property, investors can assess its profitability and compare it to other investment opportunities.

4. Conformity principle: The principle of conformity states that properties tend to achieve their maximum value when they are similar to other properties in the area. A house with modern design in a suburban setting could have a negative effect. In applying the principle of conformity, the appraiser needs a sound appreciation for local customs and standards.

Note that the racial or ethnic composition of an area is NOT a consideration when applying the principle of conformity. The appraiser should NEVER consider the presence or lack of ethnic diversity in an area to be an indicator of value. NOT only has time proven that ethnic composition does not affect value, but to assume that it does would run afoul of anti-discrimination laws.

Progression and regression are terms used to describe the effect on value when a property does not conform to the level of improvement of surrounding properties. When a property that is much more luxurious than surrounding properties suffers a decline in value, it is called REGRESSION. By the same token, a modest home in an area of more expensive houses would see a relative increase in value called PROGRESSION.

VII. Types of Value

Several types of value exist. During the appraisal process, distinguishing among these types and identifying the Standard of Value is vital. This is a critical aspect, and the appraisal must define the Standard of Value being estimated. Real estate appraisals may estimate various types of value, including investment value, value in use, liquidation value, insurance value, assessment value, going concern value, and market value.

A. MARKET VALUE

Market value is the type of value most often estimated in real estate appraisals. It is sometimes referred to as exchange value or value in exchange. It is the value of property as determined by the open market.

The Federal Register, V55, No. 251, December 31, 1990, Washington, D.C., offers the following definition:

“The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1. the buyer and seller are typically motivated;
2. both parties are well informed or well advised, and acting in what they consider their best interests;
3. a reasonable time is allowed for exposure in the open market;
4. payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and
5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.”

This definition of market value is a standard part of any form report used by lenders.

In other words, MARKET VALUE refers to the amount of cash (or cash equivalent) that is most likely to be paid for a property on a given date in a fair and reasonable open market transaction. For a market transaction to be fair and reasonable, several conditions must apply:

1. Both the buyer and seller must be typically well informed as to the conditions of the market and the subject property.
2. Both the buyer and seller must be acting reasonably, in their own self-interest, and without undue duress.
3. The property must be exposed to the market for a reasonable period of time.
4. No extraordinary circumstances, such as liberal financing or concessions, are involved.

When these four factors are present, the transaction is said to be an “arm’s length transaction.”

1. Market Value in Non-Cash Equivalent Transactions

As a practical matter, very few real estate transactions are “all cash” in today’s market. When the financing for a transaction is comparable to the typical financing available in the market, it is considered the equivalent of cash. However, if the financing includes concessions that are not typical in the market (such as a below-market interest rate in a seller-financed transaction), the non-cash equivalent terms must be identified by the appraiser in the appraisal report, and their affect on value must be taken into account.

2. Other Definitions of Market Value

The term market value has been in use for many years, and has been subject to varying interpretations by economists, judges, and legislatures. As a result, market value does not necessarily mean the same thing in all situations. For example, state laws pertaining to condemnation (the taking of private property for a public purpose) and tax assessment frequently include definitions of market value. When performing an appraisal for purposes governed by state law, the appraiser should use the law’s definition of market value.

B. PRICE

Market value is what a property should bring at sale, but price is entirely different. The PRICE is the amount actually paid for a property. While price could be equivalent to market value, it could also be greater or less than market value. A great deal of differentialism from market value could be the result of a number of factors or combination of factors such as:

1. an uninformed seller who did not know the market value;
2. an uniformed buyer who did not know the market value;
3. a seller who had to sell immediately;
4. a seller who did not really want to sell (not motivated to sell);
5. a buyer who was not highly motivated to buy;
6. a buyer who needed a particular property for a specific purpose; and
7. a sale where seller financing provided below-market financing costs.

Note: A nationally known investment guru once said, “If the terms are right, the price is immaterial.” What he was saying is if the terms allow a reasonable cash flow from the investment, it doesn’t matter what the price is.

C. VALUE IN USE

VALUE IN USE (also called “use value”) refers to the value of a property when used for a particular purpose only. This is in contrast to market value, which assumes that the market will set the value of the property in light of all its possible uses. In addition, use value is commonly viewed in terms of a property’s value to a particular ongoing business operation. Thus, use value is affected by the business climate in which the business is operating.

Conclusion

The principles of production and the contributions of land, labor, capital, and entrepreneurship are crucial for understanding and estimating real estate value. These agents working in concert create value and wealth. Moreover, distinguishing among different types of value, such as market value and value in use, is essential for accurate appraisal practices.