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Real estate valuation is the process of estimating a single price one would realistically pay to own a particular property. The method for residential property valuation that is most familiar to brokers and agents, of course, is the comparative market analysis (or, CMA). This property valuation process involves an estimate of value based upon the sale prices for other similar properties (or comparables) within the local market area, and/or other similar markets. When preparing a CMA, a minimum of three recently sold comparable properties and three comparable properties currently for sale, are typically chosen to infer the price of the subject property. Differences between the comparable properties and the subject property are evaluated to add or reduce value in the analysis, and to estimate a fair market value of the subject property by using a comparison approach. Valuation of commercial properties (i.e. office buildings, apartment buildings, single family communities, and plots of land) is largely influenced by various principles of economics. These principles are not usually factored into the typical CMA report for residential properties. The objective of this article is to shed some light on these principles in because they can be applied to any property valuation effort. They are the basis of our focus in this discussion as we look at and summarize six applied economic principles that can help give you an idea of the impact they can have on the value of a property. 1) Anticipation This is the expectation of future benefits. In other words, real estate investors measure the value of real estate investment based on the anticipated future income stream generated by the property. They are more likely to value a property on the income it generates rather than the perceived market value inferred by a comparative analysis, or the construction and land costs required to replace the property. The expected, or anticipated, income generation capabilities of the asset is the primary focus. This approach is not a surprise to those that have some understanding of commercial real estate investing; However, it is not common knowledge to the average property owner or buyer. The focus on purchasing anticipated cash flows can help expand the understanding of value in residential properties as well. For example, instead of thinking “how much is the property worth now”, also think, “how much return would I purchased the property and rented it later”. In a competitive environment, this approach and knowledge can make all the difference. 2) Conformity This is defined as the need for reasonable similarity and compatibility in a given location. Compatible land uses, for instance, may generate higher values than those with limitations imposed upon the property due to location. For example, an apartment complex located in a primarily residential area will most likely have more value than one located in a highly industrial area. Savvy commercial real estate investors are keen to this concept, while many residential home buyers may not pay close attention to adjacent or nearby land uses. Taking a broader view of surrounding uses can provide a deeper understanding of value, or perceived value, from an investment perspective. 3) Supply and Demand This principal encompasses both the scarcity, and the demand for the subject property. Although investment real estate with similar physical and economic characteristics can sell for similar prices, real estate valuation can be greatly affected (higher or lower) within a market that lacks reasonable balance between supply and demand. For example, land in a metropolitan area where undeveloped land is scarce, would demand greater value than land in a rural area with large parcels of vacant land. Likewise, an apartment complex selling at a time when there is more than enough supply to meet the rental demand, would have less value to a real estate investor than the same complex during a time when the supply of apartments in the area is lower and does not appropriately meet the demand. 4) Highest and Best Use This is an important concept that relates to the highest possible use, and the best possible use of a property, as opposed to its current use. In other words, when it is legally possible, appropriately compatible, physically possible and financially viable to modify the use of a property, the value of the same property can be significantly increased. For example, an office building can be enlarged to add more rentable office space or a retail on the first floor; or, an apartment complex can add more units or add mixed use features to the community enhancing its value. Commercial real estate investors and developers use this principle to create value and to enhance cash flow. The principle can also be used in residential real estate when a buyer or owner of a residential property evaluates the highest and best use of the land per the municipal zoning and building codes, and considers adding or expanding the property’s features and characteristics to enhance its value. 5) Contribution This, essentially, means that the value of an income property can be impacted when it is physically, legally, and economically feasible to contribute more space to the property at a cost equal to, or less than, the marginal revenue that it generates. In other words, when value added offsets the cost of making the contribution or investment. In contrast to the principle of Highest and Best Use, this principle compares revenues or value to the benefits that the investment or contribution may produce. The question to ask after you’ve identified the highest and best use of your property is, does the investment or contribution required to achieve the highest and best use for the property make financial sense, or is it justifiable. You can add features to a home such as a pool and a deck, and you can add units to a multifamily building; The contribution question is, “will you be able to sell the home for the added value that you perceive you are creating, or will the new apartment units rent?” 6) Substitution This is an opportunity cost concept. In other words, a rational real estate investor will not pay mor for an investment property than what the next best substitute with similar levels of risk will yield in financial benefit. For the residential buyer, owner or investor this means, examine all other options well. Often, residential home buyers fall in love with the first or second home they see, and can easily forego better opportunities as a result. This principle suggests evaluating and comparing numerous opportunities in the market before making a decision. The six principles mentioned in this article are intended as an overview, to give you an idea of how other economic factors can affect the valuation of properties. While these principles are demonstrated in commercial real estate valuation, they also affect residential properties and should be observed when analyzing the value of any real estate property. Six Economic Principles of Real Estate Valuation July 26th, 2017
The second part of this series covers the remaining economic concepts used in the appraisal of real estate. Click here for Part I. Advanced economic theory in appraisalsNumerous economic principles are employed in the appraisal of real estate. The economic principles of appraisal covered in Part II of this series includes the principles of:
The consistent-use principle: Once improvements on a property have been built, the consistent-use principle comes into play. Land and improvements are to be valued on the same basis. When the highest and best use of land as vacant is established, the principle of consistent use holds the improvement is to be valued on that same basis. Similarly, consider an appraiser valuing a single family residence (SFR) built on land which could also be developed to support a multi-unit income property. Here, the appraiser is not to combine the value of the single family residence and the value of the land if it were used to for a multi-unit property – again, the appraiser values the land and the structure on the same basis. The principle of balance: The principle of balance holds a property’s maximum value is realized and sustained when each of the four elements of the factors of production are in economic balance. Thus, the value of a property depends on the balance of:
The principle of contribution: The principle of contribution relates to how the value of an added improvement affects the value of the underlying property. Under this principle, the value of one component (an improvement) is measured in terms of its contribution to the value of the whole property, rather than its individual cost taken by itself. A related principle is that of an increasing or decreasing return. When a contribution exceeds the cost, this creates an increasing return, and vice versa. Consider a swimming pool added to a property otherwise valued at $500,000. The swimming pool costs $25,000 to install. The property’s fair market value increases $518,000 due to the additions which are added. This is an example of a decreasing return since the fair market value of the property increased, but less than the cost to install the pool. The principle of substitution: Under this principle, a buyer will not pay more for a property if it will cost less to buy a similar property of equal desirability. The principle of substitution is a truism of the real estate industry, both in the context of sales and appraisals. The principle of substitution is the most basic principle of appraisal as it is used in each of the three approaches to value. The principle of anticipation: The principle of anticipation concerns how a property will benefit the owner over time and into the future. Essentially, it represents the present worth of the rights to all prospective future benefits, both tangible and intangible. In this context, the owner is anticipating the future benefits they will derive from the property. The principle of anticipation is most commonly used in commercial and income properties. The principle of competition: The principle of competition holds excessive profits in any line of business will trigger excessive competition – and this excessive competition will, in turn, destroy profits. Consider a store that opens in a stable area. The store does extremely well and provides a significant return on the investment. Two entrepreneurs separately, and independently, observe the success of the business and open two similar stores in the same neighborhood simultaneously. As a result, the revenue and profits of the original store drops – as does its value. Further, the two new stores don’t perform as well as anticipated. The other economic principles used in the appraisal of real estate covered in Part I of this series include the principles of:
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