Foundations of Real Estate Value: Defining Influences

Chapter 2: Foundations of Real Estate Value: Defining Influences

Introduction

Real estate value is a multifaceted concept, influenced by a complex interplay of economic, political, and environmental factors. Understanding these influences is crucial for accurate valuation, investment decisions, and effective real estate management. This chapter will explore the core factors that shape real estate value, providing a scientific foundation for analyzing market dynamics.

I. Economic Factors

Economic forces constitute a primary driver of real estate value. These forces impact demand, supply, and overall market conditions.

A. Employment and Economic Activity

• Description: The overall health of the economy, particularly employment rates and economic activity in a specific region, directly impacts real estate value. Strong employment leads to increased disposable income, boosting demand for housing and commercial space. Conversely, economic downturns and job losses can depress property values.
• Theory/Principle: Keynesian economics suggests that aggregate demand, driven by factors like employment and consumer spending, influences economic output and, consequently, property values. Regions with high employment rates tend to have stronger real estate markets due to increased demand and investor confidence.
• Practical Application: The impact of oil price fluctuations on communities dependent on oil and gas exploration demonstrates this principle.
  • High oil prices lead to high employment in the oil industry, increasing disposable income and driving up property values.
  • Declining oil prices result in business failures and high unemployment, causing property values to plummet.
• Equation:
  • ΔV ≈ α * ΔE
    • Where:
      • ΔV = Change in property value
      • α = Sensitivity coefficient (reflecting the responsiveness of property value to changes in employment)
      • ΔE = Change in employment rate

B. Interest Rates

• Description: Interest rates are a significant determinant of affordability and investment returns in real estate. Long-term interest rates heavily affect construction of residential and commercial property.
• Theory/Principle: The present value concept states that the value of an asset is the sum of its expected future cash flows, discounted back to the present using an appropriate discount rate (often tied to interest rates). Higher interest rates reduce the present value of future cash flows, decreasing the attractiveness of real estate investments.
• Practical Application: As interest rates drop, mortgages become more affordable, increasing demand for existing housing and new construction. This increased demand drives up property values.
• Equation:
  • PV = CF / (1 + r)^n
    • Where:
      • PV = Present Value of the property
      • CF = Expected cash flow (e.g., rental income)
      • r = Discount rate (influenced by interest rates)
      • n = Number of periods
  • As ‘r’ increases, PV decreases, and vice versa.

C. Rents

• Description: Rental rates are a direct indicator of demand for housing and commercial space.
• Theory/Principle: Supply and demand dynamics in the rental market influence rent levels, which in turn affect property values. High rents encourage home ownership and new construction as investment opportunities become more attractive.
• Practical Application: High rents signal strong demand, encouraging home ownership and new construction, while low rents discourage both.
• Equation:
  • Property Value ∝ Rental Income
    • Where:
      • Property Value = The estimated value of the property
      • Rental Income = The income generated by renting the property

D. Vacancy Factors

• Description: Vacancy rates reflect the balance between supply and demand in the real estate market.
• Theory/Principle: High vacancy rates indicate an oversupply of available properties, leading to lower rental income and decreased property valuations. This reflects a weak demand relative to the existing supply.
• Practical Application: Prior overbuilding can result in high vacancy factors, lowering income and valuations for commercial properties. High vacancy factors in residential rentals often mean lower rents or rent concessions, reducing net income and property valuation.
• Equation:
  • Effective Rental Income = Potential Rental Income * (1 - Vacancy Rate)
    • Where:
      • Effective Rental Income is the actual income received after accounting for vacancies.
      • Potential Rental Income is the income if the property were fully occupied.
      • Vacancy Rate is the percentage of units that are vacant.

E. Plottage

• Description: Plottage refers to the increase in value that results from combining two or more contiguous parcels of land into a single, larger parcel.
• Theory/Principle: Economies of scale and increased development potential contribute to the plottage increment. The combined site may accommodate a larger or more profitable development than the individual sites could separately.
• Practical Application: The possibility that an economic site can be combined with a contiguous site, where the combined value would be greater than the separate site values, would be a positive influence on value (plottage increment).

F. Parking

• Description: Availability of adequate parking significantly impacts the value of both commercial and residential properties.
• Theory/Principle: Accessibility and convenience are key factors in property value. Ample parking enhances accessibility, particularly for commercial properties reliant on customer traffic.
• Practical Application: The availability of adequate on-site and/or off-site parking will affect value for both commercial and residential property.

G. Corner Influence

• Description: Corner lots often possess a value premium, particularly for commercial properties.
• Theory/Principle: Increased visibility and accessibility contribute to corner influence. Corner properties benefit from greater exposure to foot and vehicular traffic, enhancing business potential.
• Practical Application: Commercial property located on a corner is generally regarded as being more valuable than property in the center of a block due to increased visibility and exposure. Residential corner lots may experience more traffic, noise, and less privacy, potentially affecting their value differently.

II. Political Factors

Government policies and regulations exert a substantial influence on real estate value.

A. Taxes

• Description: Property taxes directly impact the cost of ownership and investment returns.
• Theory/Principle: High tax rates reduce the net operating income (NOI) of a property, lowering its value. Conversely, lower tax rates can increase demand and property values.
• Practical Application: High tax areas might result in lower valuations, while lower tax areas might result in greater demand and higher property valuations.
• Equation:
  • NOI = Gross Income - Operating Expenses - Property Taxes
    • Where:
      • NOI is the Net Operating Income
      • Gross Income is the total income from the property
      • Operating Expenses are the costs of operating the property
      • Property Taxes are the taxes levied on the property

B. Zoning

• Description: Zoning regulations dictate permissible land uses and development densities.
• Theory/Principle: Zoning significantly impacts the highest and best use of a property, which is a key determinant of its value. Restrictive zoning can limit development potential❓, while favorable zoning can unlock significant value.
• Practical Application: The zoning of a property can materially affect value as it determines the use to which a property can be put. Zoning which allows a shopping center is likely to result in a valuation many times higher than if the parcel were zoned for single-family dwellings.
• Experiment:
  • Hypothesis: A parcel of land zoned for commercial use will have a significantly higher value than a similar parcel zoned for residential use.
  • Method: Obtain data on comparable land sales for commercial and residential parcels in the same area. Analyze the price per square foot for each zoning type.
  • Expected Result: Commercial parcels will exhibit a higher price per square foot due to their greater income-generating potential.

C. Rent Control

• Description: Rent control ordinances limit the rents that landlords can charge, affecting property income and value.
• Theory/Principle: Rent control can distort market signals❓ and create inefficiencies. By suppressing rental rates below market levels, it reduces the profitability of rental properties, leading to decreased investment and potential property deterioration.
• Practical Application: Controls that limit rent to less than the market forces will limit value.

D. Growth Limitations

• Description: Policies that restrict new construction, such as moratoriums, permit limitations, and high development fees, influence property values.
• Theory/Principle: Restricting supply can lead to higher rents and property values for existing structures, while decreasing the value of undeveloped land due to limited development opportunities.
• Practical Application: Moratoriums on new construction, limitation on the number of building permits being issued and high development fees limit new construction. The effect is generally higher rents and higher values for existing structures and lower evaluations for undeveloped land.

E. Environmental Restrictions

• Description: Environmental regulations, such as those protecting endangered species, wetlands, and greenbelts, can restrict development and affect property value.
• Theory/Principle: Environmental regulations can increase development costs and reduce the developable area of a property, impacting its value.
• Practical Application: Environmental restrictions may increase the cost of housing development by requiring developers to mitigate adverse environmental affects of construction or to set aside land for open space.

F. Building and Health Codes

• Description: Building and health codes establish minimum standards for construction and safety.
• Theory/Principle: While designed to protect public health and safety, outdated or overly stringent codes can add to development costs, potentially affecting property value.

III. Environmental (Physical) Factors

The physical characteristics of a property and its surroundings play a crucial role in determining value.

A. Location

• Description: Location is arguably the most important factor influencing real estate value.
• Theory/Principle: Location influences accessibility, desirability, and the availability of amenities. Properties in desirable locations command a premium due to their proximity to employment centers, schools, shopping, and other attractions.
• Practical Application: “The three most important factors influencing value are location, location, location.” The location in relation to desired amenities and to developed and natural assets affect value.

B. Climate

• Description: Climate conditions impact the desirability and usability of properties, particularly for recreation and quality of life.
• Theory/Principle: Favorable climates attract residents and businesses, increasing demand for real estate.
• Practical Application: Temperature, wind, rain, and snow all affect the desirability of areas for recreation and quality of life, which, in turn, influences value.

C. Water

• Description: The availability of a sufficient and affordable supply of quality water is essential for development and residential use.
• Theory/Principle: Water scarcity can limit development potential and depress property values.
• Practical Application: The availability of a sufficient and affordable supply of quality water plays a significant role in expansion and relocation of industries, as well as residential development.

D. Transportation

• Description: Access to transportation networks, including highways, rail, airports, and public transportation, significantly impacts property value.
• Theory/Principle: Good transportation infrastructure enhances accessibility and reduces commuting times, making properties more desirable.
• Practical Application: A new freeway is built that allows commuters from a small town to reach jobs in the city in half the time it used to take. Suddenly, it is practical for those with jobs in the city to live in the town, and property values go❓❓ up.

E. View

• Description: A desirable view can significantly enhance property value.
• Theory/Principle: Scarcity and aesthetic appeal drive the value of properties with exceptional views.
• Practical Application: A water view can more than double the value of a property when compared to similar properties lacking such a view.

F. Soil

• Description: Soil conditions impact the suitability of a site for construction.
• Theory/Principle: Soil that can support a structure without extensive remediation is more valuable than soil requiring significant preparation.
• Practical Application: Parcels with soil that exhibits liquefaction during an earthquake have diminished value.

G. Size and Shape

• Description: The size and shape of a parcel influence its development potential and value.
• Theory/Principle: Larger sites offer greater development flexibility, but value is not always directly proportional to size. Regular-shaped lots are generally more valuable than irregular ones due to ease of development.
• Practical Application: A larger site is more valuable than a smaller site, but value is not necessarily proportionate to size. A regular shaped lot with reasonable width and depth is generally more valuable on a square foot basis than an irregular shaped lot.

H. Exposure

• Description: The orientation of a property in relation to sunlight can impact its desirability.
• Theory/Principle: Exposure affects natural lighting, heating and cooling costs, and overall comfort.
• Practical Application: Residential property where the morning sun lights up the kitchen and dining areas and where the patio enjoys a sunset view are likely to be more valuable than similar properties lacking these amenities.

I. Environmental Hazards

• Description: The presence of environmental hazards can negatively impact property value.
• Theory/Principle: Environmental contamination can pose health risks and require costly remediation, reducing the desirability and marketability of a property.
• Practical Application: The presences of any negative environmental problem like contaminated soil, asbestos building products or even a chemical plant in the area could adversely effect value.

J. Topography

• Description: The slope and drainage characteristics of the land influence its suitability for development.
• Theory/Principle: Flat or gently rolling land with good drainage is generally more valuable than steep or flood-prone land due to lower development costs and reduced risk.
• Practical Application: Flat or rolling land with good drainage would be more valuable than land prone to flood or with steep slopes that would limit development or increase costs.

Conclusion

Understanding the economic, political, and environmental factors that influence real estate value is essential for informed decision-making in the real estate industry. These factors interact in complex ways, requiring a comprehensive and analytical approach to valuation and investment. By applying the principles and theories discussed in this chapter, professionals can gain a deeper understanding of the forces shaping real estate markets and make more effective decisions.