CONCEPTS OF VALUE

Market cost/price/value

Real estate value types

Fundamental value characteristics

Valuation principles

Market cost/price/ value                            

What is a market? A market is a place where supply and demand encounter one another: suppliers sell or trade their goods and services to demanders, who are consumers and buyers. It is a transaction arena where the price mechanism is constantly defining and quantifying the value produced by the relative elements of supply and demand.

Supply and demand. The goal of an economic system is to produce and distribute a supply of goods and services to satisfy the demand of its constituents. Economic activity therefore centers on the production, distribution and sale of goods and services to meet consumer demand. Consumers demand goods and services; suppliers and sellers produce and distribute the goods and services for a negotiated price.

Cost, price, and value. To produce a good or service, a supplier incurs costs, or those expenses necessary to generate and deliver the item to the market. The essential production costs are the costs of capital, materials, and supplies; labor; management; and overhead.

Costs play an important role in the dynamics of supply, demand, and value. Since a producer has limited resources, it is imperative to maximize the efficiency of the production process and minimize its costs. Moreover, since consumers will pay the lowest possible price for comparable goods and services, the producer must be price-competitive to stay in business. A competitor who can produce an item of similar quality for less will eventually force higher-priced items out of the market. At that point, the elements of value– desire, utility, scarcity, and purchasing power– do not matter: if the consumer wants the item at all, he or she must cover the producer’s costs and profit.

In addition to supply and demand, the other critical component of an economic system is the price mechanism, or simply, price. A price is the amount of money or other asset that a buyer has agreed to pay and a seller has agreed to accept to complete the exchange of a good or service. It is a quantification of the value of an item traded.

Price in this context means the final trading price; it is not the preliminary asking price of the seller nor the initial bidding price of the purchaser. Asking and bidding prices are pricing positions in a negotiation between the parties prior to the exchange. The true price of an item or service is the final number the parties agree to.

Real estate value types                  

The purpose of an appraisal influences an estimate of the value of a parcel of real estate. This is because there are different types of value related to different appraisal purposes. Some of the possibilities are listed below.

Types of Real Estate Value

market
reproduction
replacement
salvage
plottage
assessed
condemned
reversionary
appraised
rental
leasehold
insured
book
mortgage

Market value. Market value is an estimate of the price at which a property will sell at a particular time. This type of value is the one generally sought in appraisals and used in brokers’ estimates of value.

Reproduction value. Reproduction value is the value based on the cost of constructing a precise duplicate of the subject property’s improvements, assuming current construction costs.

Replacement value. Replacement value is the value based on the cost of constructing a functional equivalent of the subject property’s improvements, assuming current construction costs.

Going concern value.  The value of a property plus the operating business located on it as determined by a commercial appraisal

Salvage value. Salvage value refers to the nominal value of a property that has reached the end of its economic life. Salvage value is also an estimate of the price at which a structure will sell if it is dismantled and moved.

Plottage value. Plottage value is an estimate of the value that the process of assemblage adds to the combined values of the assembled properties.

Assessed value. Assessed value is the value of a property as estimated by a taxing authority as the basis for ad valorem taxation.

Condemned value. Condemned value is the value set by a county or municipal authority for a property which may be taken by eminent domain.

Depreciated value. Depreciated value is a value established by subtracting accumulated depreciation from the purchase price of a property.

Appraised value. Appraised value is an appraiser’s opinion of a property’s value.

Rental value. Rental value is an estimate of the rental rate a property can command for a specific period of time.

Leasehold value. Leasehold value is an estimate of the market value of a lessee’s interest in a property.

Insured value. Insured value is the face amount a casualty or hazard insurance policy will pay in case a property is rendered unusable.

Book value. Book value is the value of the property as carried on the accounts of the owner. The value is generally equal to the acquisition price plus capital improvements minus accumulated depreciation.

Mortgage value. Mortgage value is the value of the property as collateral for a

Fundamental value characteristics            

Value and value determinants. Price is not something of value in itself. It is only a number that quantifies value. The economic issue underlying the interplay of supply and demand is, how do trading parties arrive at the value of a good or service as indicated by the price?

Consider consumer demand for air conditioners. Why do air conditioners have value? How do they command the price they do?

The value of something is based on the answers to four questions:

  • How much do I desire it?
  • How useful is it?
  • How scarce is it?
  • Am I able to pay for it?

Desire. One determinant of value is how dear the item is to the purchaser. Returning to the air conditioner example, the question becomes “how much do I desire to be cool, dry, and comfortable?” To a person who lives in the tropics, it is safe to say that air conditioning is more valuable than a heating system. It is also safe to say the opposite is true for residents of northern Alaska.

Utility. The second determinant of value is the product’s ability to do the job. Can the air conditioner satisfy my need to stay cool? How cool does it make my house? Does it even work properly? Of course, I won’t pay as much if it is old or ineffectual.

Scarcity. The third critical element of value is a product’s availability in relation to demand. The air conditioner is quite valuable if there are only five units in the entire city and everyone is hot. On the other hand, the value of an air conditioner goes down if there are ten thousand units for sale in a 500-person market.

Purchasing power. A fourth component of value is the consumer’s ability to pay for the item. If one cannot afford to buy the air conditioner, the value of the air

conditioner is diminished, since it is financially out of reach. If all air conditioners are too expensive, consumers are forced to consider alternatives such as ceiling fans.

In the marketplace, the relative presence or absence of the four elements of value is constantly changing due to innumerable factors. Since price is a reflection of the total of all value factors at any time, changes in the underlying factors of value trigger changes in price.

Valuation principles   

A number of economic forces interact in the marketplace to contribute to real estate value. Appraisers must consider these forces in estimating the value of a property. Among the most recognized of these principles are those listed below.

Economic Principles Underlying Real Estate Value

supply and demand
utility
transferability
anticipation
substitution
contribution
change
highest and best use
conformity
progression and regression
assemblage
subdivision

Supply and demand. The availability of certain properties interacts with the strength of the demand for those properties to establish prices. When demand for properties exceeds supply, a condition of scarcity exists, and real estate values rise. When supply exceeds demand, a condition of surplus exists, and real estate values decline. When supply and demand are generally equivalent, the market is considered to be in balance, and real estate values stabilize.

Utility. The fact that a property has a use in a certain marketplace contributes to the demand for it. Use is not the same as function. For instance, a swampy area may have an ecological function as a wetland, but it may have no economic utility if it cannot be put to some use that people in the marketplace are willing to pay for.

Transferability. How readily or easily title or rights to real estate can be transferred affects the property’s value. Property that is encumbered has a value impairment since buyers do not want unmarketable title. Similarly, property that cannot be transferred due to disputes among owners may cause the value to decline, because the investment is wholly illiquid until the disputes are resolved.

Anticipation. The benefits a buyer expects to derive from a property over a holding period influence what the buyer is willing to pay for it. For example, if an investor anticipates an annual rental income from a leased property to be one million dollars, this expected sum has a direct bearing on what the investor will pay for the property.

Substitution. According to the principle of substitution, a buyer will pay no more for a property than the buyer would have to pay for an equally desirable and available substitute property. For example, if three houses for sale are essentially similar in size, quality and location, a potential buyer is unlikely to choose the one that is priced significantly higher than the other two.

Contribution. The principal of contribution focuses on the degree to which a particular improvement affects market value of the overall property. In essence, the contribution of the improvement is equal to the change in market value that the addition of the improvement causes. For example, adding a bathroom to a house may contribute an additional $15,000 to the appraised value. Thus the contribution of the bathroom is $15,000. Note that an improvement’s contribution to value has little to do with the improvement’s cost. The foregoing bathroom may have cost $5,000 or $20,000. Contribution is what the market recognizes as the change in value, not what an item cost. If continuous improvements are added to a property, it is possible that, at some point, the cost of adding improvements to a property no longer contributes a corresponding increase in the value of the property. When this occurs, the property suffers from diminishing marginal return, where the costs to improve exceed contribution.

Change. Market conditions are in a state of flux over time, just as the condition of a property itself changes. These fluctuations and changes will affect the benefits that can arise from the property, and should be reflected in an estimate of the property’s value. For example, the construction of a neighborhood shopping center in the vicinity of a certain house may increase the desirability of the house’s location, and hence, its value.

Highest and best use. This principle holds that there is, theoretically, a single use for a property that produces the greatest income and return. A property achieves its maximum value when it is put to this use. If the actual use is not the highest and best use, the value of the property is correspondingly less than optimal. Technically, highest and best use must be legally permissible, physically possible, financially feasible, and maximally productive.

For example, a property with an old house on it may not be in its highest and best use if it is surrounded by retail properties. If zoning permits the property to be converted to a retail use, its highest and best use may well be retail rather than residential.

Conformity. This principle holds that a property’s maximal value is attained when its form and use are in tune with surrounding properties and uses. For example, a two-bedroom, one-bathroom house surrounded by four-bedroom, three-bathroom homes may derive maximal value from a room addition.

Progression and regression. The value of a property influences, and is influenced by, the values of neighboring properties. If a property is surrounded by properties with higher values, its value will tend to rise (progression); if it is surrounded by properties with lower values, its value will tend to fall (regression).

Assemblage. Assemblage, or the conjoining of adjacent properties, sometimes creates a combined value that is greater than the values of the unassembled properties. The excess value created by assemblage is called plottage value.

Subdivision. The division of a single property into smaller properties can also result in a higher total value. For instance, a one-acre suburban site appraised at $50,000 may be subdivided into four quarter-acre lots worth $30,000 each. This principle contributes significantly to the financial feasibility of subdivision development.