To have value in the real estate market that is, to have monetary worth based on desirability a property must have the following four characteristics:
- Demand—The need or desire for possession or ownership backed by the financial means to satisfy that need
- Utility—The property’s usefulness for its intended purposes
- Scarcity—A finite supply
- Transferability—The relative ease with which ownership rights are transferred from one person to another
The market value of real estate is the most probable price that a property should bring in a fair sale.
This definition makes three assumptions.
- First, it presumes a competitive and open market.
- Second, the buyer and seller are both assumed to be acting prudently and knowledgeably.
- Third, market value depends on the price not being affected by unusual circumstances.
The following are essential factors in rendering an opinion of value:
- The most probable price is not the average or highest price.
- The buyer and seller must be unrelated and acting without undue pressure.
- Both buyer and seller must be well informed about the property’s use and potential, including both its defects and its advantages.
- A reasonable time must be allowed for exposure in the open market.
- Payment must be made in cash or its equivalent.
- The price must represent a normal consideration for the property sold, unaffected by special financing amounts or terms, services, fees, costs, or credits incurred in the market transaction.
Market value versus market price
Market value is an opinion of value based on an analysis of data. The data may include not only an analysis of comparable sales but also an analysis of potential income, expenses, and replacement costs (less any depreciation).
Market price, on the other hand, is what a property actually sells for its sales price. Cost may not equal either market value or market price.
Market value versus cost
An important distinction can be made between market value and cost. One of the most common misconceptions about valuing property is that cost represents market value. Cost and market value may be the same. In fact, when the improvements on a property are new, cost and value are likely to be equal. But more often, cost does not equal market value.
For example, a homeowner may install a swimming pool for a cost of $20,000; however, the cost of the improvement may not add $20,000 to the value of the property.
Basic Principles of Value
According to the principle of anticipation, value is created by the expectation that certain events will occur. Value can increase or decrease in anticipation of some future benefit or detriment.
No physical or economic condition remains constant. This is the principle of change. Real estate is subject to natural phenomena such as tornadoes, fires, and routine wear and tear. The real estate business is subject to market demands, as is any other business.
Competition is the interaction of supply and demand. Excess profits tend to attract competition. For example, the success of a retail store may cause investors to open similar stores in the area.
The principle of conformity means that maximum value is created when a property is in harmony with its surroundings. Maximum value is realized if the use of land conforms to existing neighborhood standards. In single-family residential neighborhoods, for instance, buildings should be similar in design, construction, size, and age.
Under the principle of contribution, the value of any part of a property is measured by its effect on the value of the whole. Installing a swimming pool, greenhouse, or private bowling alley may not add value to the property equal to the cost, but remodeling an outdated kitchen or bathroom might.
Highest and best use
The most profitable single use to which a property may be put, or the use that is most likely to be in demand in the near future, is the property’s highest and best use. The use must be:
- legally permitted,
- economically or financially feasible,
- physically possible, and
- the most profitable or maximally productive.
The highest and best use of a site can change with social, political, and economic forces. A parking lot in a busy downtown area, for example, may not maximize the land’s profitability to the same extent an office would. Highest and best use is noted in every appraisal.
Increasing and diminishing returns
The addition of more improvements to land and structures increases total value only to the asset’s maximum value. Beyond that point, additional improvements no longer affect a property’s value. As long as money spent on improvements produces an increase in income or value, the law of increasing returns applies. At the point where additional improvements do not increase income or value, the law of diminishing returns applies. No matter how much money is spent on the property, the property’s value will not keep pace with the expenditures. A remodeled kitchen or bathroom might increase the value of a house; adding restaurant-quality appliances and gold faucets, however, would be a cost that the owner probably would not be able to recover.
Plottage: The total value of two adjacent properties may be greater if they are combined than the sum of their individual values if each is sold separately. The principle of plottage holds that merging or consolidating adjacent lots into a single larger one produces a greater total land value than the sum of the two sites valued separately.
The process of merging two separately owned lots under one owner is known as assemblage.
This is the increasing of a property’s value due to its neighbors.
Buy the worst house on the best block.
Under the principle of substitution, the maximum value of a property tends to be set by how much it would cost to purchase an equally desirable and valuable substitute property. Substitution is the foundation of the sales comparison approach.
Supply and demand
The principle of supply and demand holds that the value of a property depends on the number of properties available in the marketplace—the supply of the product. When supply increases, value decreases and when demand increases, value increases. Other factors include the prices of other properties, the number of prospective purchasers, and the price buyers will pay.