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Fundamentals and Principles of Real Estate Value
Chapter 2: Fundamentals and principle❓s of Real Estate Value
I. What is Value?
Value, in its essence, represents the relative worth of an asset, good, or service, typically expressed in monetary terms. It is not an intrinsic property but rather a reflection of the perceived benefits an item offers to individuals or entities. A common definition of value is “the monetary worth of property, goods, or services to buyers and sellers.” Therefore, value is fundamentally tied to anticipated benefits. It is defined as the “present worth of future benefits,” quantified in monetary units. This notion incorporates time value of money concepts, suggesting that benefits expected further in the future are discounted to their present value. The theory of value is a unified whole, with interdependent principles that should be considered together.
II. Four Characteristics of Value
Modern economic theory posits that value is not inherent but created by external forces. The creation of value is determined by these four characteristics:
Utility
Scarcity
Transferability
Effective Demand
A. Utility
Utility signifies the ability of a good or service to satisfy a want or need. In real estate, utility arises from various purposes such as providing shelter, enabling production, facilitating recreation, and more. For example, a residential lot possesses utility because it is suitable for building a home. Without utility, there is no basis for demand and, consequently, no value.
B. Scarcity
Scarcity refers to the limited availability of a resource relative to demand. Even if a good possesses utility, it will not have value if it is abundant. Air is a prime example; it’s essential for survival but lacks economic value due to its abundance. Scarcity and demand are interconnected and critical in value theory. In instances where supply vastly exceeds demand, value declines. For example, waterfront properties are more valuable due to their scarcity compared to non-waterfront properties.
C. Transferability
Transferability refers to the ease with which ownership rights can be conveyed from one party to another. This includes the ability to sell, lease, bequeath, or give away a property. Without transferability, economic value cannot exist because value presumes exchange. A non-transferable asset cannot be traded in the market. For example, national parks are considered “priceless” because they are not subject to market exchange.
D. Effective Demand
Effective demand signifies the combination of desire and purchasing power. Buyers must desire a good, and they must also have the financial resources to acquire it. Desire alone is insufficient; purchasing power, which is influenced by economic conditions such as inflation, unemployment, and wage levels, is crucial. For example, real estate in areas with strong employment and high wages commands high value because of the convergence of desire (proximity to jobs) and purchasing power.
III. Value Distinguished from Price and Cost
Value, price, and cost, while related, have distinct meanings.
Value: Represents the theoretical worth of a property under specified conditions.
Price: Denotes the actual amount paid, offered, or asked in a transaction. Value is conceptual, while price is factual.
Cost: Represents the expense incurred to create, produce, or obtain a property, encompassing labor, materials, and services.
Example: If a house is bought for $100,000 with seller financing at a below-market interest rate, $100,000 is the price. The value may be lower due to the favorable financing terms. An appraiser cannot solely rely on price to determine value.
Mathematical representation:
Value (V) ≠ Price (P) ≠ Cost (C)
V = f(Utility, Scarcity, Transferability, Effective Demand)
P = Actual transaction amount
C = Sum of expenses for production
IV. Principles of Appraisal (Economic Value)
Several economic principles govern how value is created in the marketplace:
A. Principle of Supply and Demand
This fundamental principle asserts that value is determined by the interaction of supply and demand. An increase in demand, relative to supply, results in higher prices and vice versa.
Equation:
Price (P) ∝ Demand (D) / Supply (S)
Experiment:
A city experiences sudden population growth due to new industries. Housing supply remains constant. Observation: Housing prices increase significantly.
Another city experiences decline in industries, population outflow begins. Housing supply remains constant. Observation: Housing prices decrease significantly.
B. Principle of 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 all three approaches to value (cost, sales comparison, and income capitalization).
Practical application: In comparing two similar houses, a buyer will tend to choose the one that provides more utility for same or less price.
C. Principle of Competition
Competition arises when profits are excessive, leading to increased supply and lower prices. Conversely, lack of competition can lead to higher prices.
Example: A new shopping mall development draws businesses, which compete for customers, affecting rents and property values.
D. Principle of Change
Real estate values are dynamic and influenced by constant changes in social, economic, political, and environmental factors. Anticipating these changes is crucial for accurate valuation.
E. Principle of Anticipation
Value is based on the expectation of future benefits, such as income or appreciation. Present value is a reflection of anticipated future returns.
Present Value (PV) = Σ [Future Cash Flow (CFt) / (1 + Discount Rate (r))^t]
Where:
* t = Time period
* r = Discount rate (reflecting risk and opportunity cost)
F. Principle of Balance
Balance pertains to the optimal combination of land, labor, capital, and entrepreneurial coordination to maximize value.
Example: Adding too much capital (improvements) to a site may not increase value proportionally and may lead to diminishing returns.
- Point of Diminishing Returns
At the point of diminishing returns, adding more of a factor of production yields progressively smaller increases in output or value.
G. Principle of Surplus Productivity
Surplus productivity refers to the net income remaining after the costs of labor, capital, and coordination have been paid. This surplus is attributable to the land.
Surplus Productivity = Net Operating Income – (Labor Costs + Capital Costs + Coordination Costs)
H. Principle of Contribution
The value of a component part of a property is determined by its contribution to the overall value, not by its individual cost.
Example: A swimming pool’s value is not its cost but the amount it adds to the property’s Market Value❓❓.
I. Principle of Increasing and Decreasing Returns
Increasing returns occur when adding more of a factor of production results in a higher rate of value increase. Decreasing returns occur when adding more of a factor of production results in a lower rate of value increase.
V. Effect of Use on Real Estate Value
A. Highest and Best Use Principle
Highest and best use is the most probable legal and physically possible use of a property that is financially feasible and results in the highest value. This use must be:
Legally permissible: Compliant with zoning and other regulations.
Physically possible: Suitable for the site's characteristics.
Financially feasible: Generating sufficient income to cover expenses and provide a return on investment.
Maximally productive: Yielding the highest value.
Land should not be valued based on one use while improvements are valued based on another. The land and improvements must be valued consistently based on the same use.
C. Conformity, Progression, and Regression Principles
Conformity: Maximum value is realized when a property conforms to surrounding properties in terms of style, size, and quality.
Progression: The value of a lower-quality property is increased by its proximity to higher-quality properties.
Regression: The value of a higher-quality property is decreased by its proximity to lower-quality properties.
VI. Production as a Measure of Value
A. Agents of Production Principle
Value is created through the interaction of four agents of production: land, labor, capital, and entrepreneurship. Each contributes to the creation of value.
VII. Types of Value
A. Market Value
Market value is the most probable price 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.
B. Price
The amount asked, offered, or paid for a property.
C. Value in Use
The value of a property to a specific user for a specific purpose.
D. Investment Value
The value of a property to a specific investor based on their investment criteria.
E. Liquidation Value
The value of a property in a forced sale, typically below market value.
F. Assessed Value
The value assigned to a property for property tax purposes.
G. Insurable Value
The cost of replacing or reproducing a property for insurance purposes.
H. Going Concern Value
The value of a business as an operating entity, including intangible assets like goodwill.
VIII. Forces Affecting Value
A. Social Factors
Social trends and demographics influence real estate values. Examples include:
Prestige
Recreation
Culture
Family Orientation
Homeowner Restrictions
B. Economic Factors
Economic conditions significantly impact property values. Key factors include:
Local Economy
Interest Rates
Rents
Vacancy Factors
Plottage (assemblage of smaller lots into a larger, more valuable parcel)
Parking
Corner Influence
C. Political Factors
Government regulations and policies influence property values:
Taxes
Zoning
Rent Control
Growth Limitations
Environmental Restrictions
Building and Health Codes
D. Environmental (Physical) Factors
Physical characteristics of a property and its surroundings affect value:
Location
Climate
Water
Transportation
View
Soil
Size and Shape
Exposure
Environmental Hazards
Topography
Chapter Summary
Scientific Summary: Fundamentals and Principles of Real Estate Value
This chapter, “Fundamentals and Principles of Real Estate Value,” from the training course “Real Estate Valuation: Principles and Practices,” provides a foundational understanding of value creation and the factors that influence real estate worth. It moves beyond a simple definition of value as monetary worth to explore its underlying characteristics, differentiate it from price and cost, and elucidate key appraisal principles.
Main Scientific Points and Conclusions:
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Definition of Value: Value is defined as the present worth of future benefits, typically expressed in monetary terms. It is a theoretical concept representing worth under specific conditions.
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Four Characteristics of Value: The chapter emphasizes that value is not intrinsic but is created by the interplay of four key characteristics:
- Utility: The ability of a property to satisfy a want or need.
- Scarcity: Limited availability relative to demand.
- Transferability: The ability to transfer ownership rights.
- Effective Demand: The combination of desire and purchasing power.
The absence of any one of these characteristics diminishes or eliminates value.
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Distinction Between Value, Price, and Cost: The chapter clarifies that value, price, and cost are distinct concepts. Price is the actual amount paid in a transaction, a historical fact. Cost represents the expenses incurred in creating or obtaining a property. Value is the estimated worth or expected price under a defined set of assumptions.
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Principles of Appraisal (Economic Value): The chapter outlines core economic principles that drive real estate valuation:
- Supply and Demand: Value is influenced by the relationship between the availability of properties and the desire/ability of buyers to acquire them.
- Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
- Competition: Profit attracts competition, which can eventually reduce profitability and impact value.
- Change: Real estate values are dynamic and constantly influenced by various forces.
- Anticipation: Value is influenced by the expectation of future benefits or detriments.
- Balance: Value is maximized when the various agents of production (land, labor, capital, and entrepreneurship) are in equilibrium.
- Surplus Productivity: The net income remaining after the costs of labor, capital, and coordination have been paid.
- Contribution: The value of a component is measured by its contribution to the overall value of the property, not its individual cost.
- Increasing and Decreasing Returns: Adding more of a production input initially increases value (increasing returns), but eventually, further additions yield less incremental value (decreasing returns).
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Effect of Use on Real Estate Value: The chapter highlights the importance of:
- Highest and Best Use: The most profitable, legally permissible, physically possible, and financially feasible use of a property.
- Consistent Use: Land and improvements must be valued based on compatible uses.
- Conformity, Progression, and Regression: Value is enhanced when a property conforms to its surrounding properties and diminished when it stands out significantly from its surroundings.
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Types of Value: The chapter identifies and defines different types of value relevant to real estate: market value, price, value in use, investment value, liquidation value, assessed value, insurable value, and going concern value.
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Forces Affecting Value: The chapter categorizes the factors influencing value into:
- Social Factors: Trends, demographics, and lifestyle preferences.
- Economic Factors: Employment, interest rates, rents, vacancy rates, and local economic conditions.
- Political Factors: Zoning regulations, taxes, rent control, and environmental restrictions.
- Environmental (Physical) Factors: Location, climate, topography, views, and potential environmental hazards.
Implications:
- Foundation for Appraisal Practice: This chapter lays the groundwork for understanding how appraisers develop credible opinions of value.
- Market Analysis: The principles and factors discussed are essential for conducting thorough market analyses, which are critical to accurate valuations.
- Investment Decisions: Understanding the drivers of value allows investors to make informed decisions about property acquisitions, development, and management.
- Policy Implications: The influence of political factors on value highlights the importance of sound land use planning and regulation.
- Dynamic Nature of Value: Recognizing the constant state of change in real estate markets requires appraisers and other real estate professionals to continuously monitor and adapt to new information.
