5
Chapter Five
The Real Estate
Marketplace
■■ Key Terms
absorption analysis
anticipation
assessed value
balance
beneficiary
capital market
change
competition
conformity
contribution
cost
cost of credit
decline
deed of trust
demand, utility, scarcity,
transferability
(DUST)
demography
equilibrium
externalities
feasibility study
forecasts
four factors of
production
growth
highest and best use
insurable value
investment value
law of decreasing returns
law of increasing returns
life cycle of property
market
market value
money market
mortgage
opportunity cost
physical, economic,
governmental, social
(PEGS)
price
progression
regression
revitalization
sales price
segmentation
substitution
supply and demand
surplus productivity
trustee
trustor
value in use
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■■ Learning Objectives
After successfully completing this chapter, you should be able to
discuss the characteristics of real estate markets,
explain why the market for real estate is not like other markets,
identify the types of market analysis that help define the market for real
estate,
discuss the ways in which real estate is financed,
name the elements that create value,
define market value and explain other types of value,
identify influences on real estate value, and
list and explain the basic value principles that must be considered in determining market value.
■■ Overview
The most significant investment for most Americans is the purchase of a home.
Whether a detached single-family house, a highrise condominium, a town house,
a farm, a ranch, or even a houseboat, such a purchase often is well rewarded at the
time of a subsequent sale, when the property’s value may have increased substantially over its initial purchase price. Less frequently, particularly if a resale occurs
within only a year or two, the property may not command a high enough sales
price to cover both the seller’s original purchase price and the expenses of sale
(such as a broker’s commission).
Of course, commercial property transactions are also important to the parties
involved, and commercial property values can be even more volatile than those
of other forms of real estate. The favorable economic indicators that encourage
office and retail development may lead to overbuilt markets and empty buildings.
Commercial property is typically leased, and unfavorable economic conditions
can quickly lead to vacant storefronts and lowered lease rates.
In either case, a property appraisal can be valuable in making a final decision on
whether to enter a transaction. An appraisal can assure either purchaser or seller
that the sales price is reasonable in light of prevailing market forces.
The forces that create and affect the real estate marketplace are the subjects of
this chapter. We first examine some of those forces, then define the term market
value. We conclude with a discussion of some basic economic principles that contribute to real property value.
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■■ The Market for Real Estate
A market is simply a place for selling and buying. While we refer in this text to
the local real estate market, in many respects there never can be a truly local real
estate market. There may be locally occurring transactions (such as within a city
or county), but all transactions are affected to some extent by the wider market
forces within the state, region, and nation. The major forces—population level,
strength of the economy, and availability of financing—can be identified separately, yet they are interconnected.
Characteristics of Real Estate Markets
Unlike the market for real estate, other goods and services are said to have efficient
markets. The factors that compose an efficient market include the following:
■■
Products that are readily exchangeable for other products of the same
kind
■■
Ample supply of knowledgeable buyers and sellers
■■
Little or no government regulation influencing value
■■
Relatively stable prices
■■
Easy product supply and transfer of title
A market that is at its most efficient is said to be a perfect market. Unfortunately,
the market for real estate is far from perfect.
We can begin to define a real estate market by understanding the special factors
that influence real estate as a commodity. Every parcel of real estate is considered
unique and thus not interchangeable with any other parcel. Buyers and sellers of
real estate frequently are unsophisticated and lack knowledge of the factors that
make one parcel of real estate more valuable than another. The number of buyers and sellers frequently moves away from a state of equilibrium to create either
a seller’s market (many more buyers than sellers) or a buyer’s market (many more
sellers than buyers). Real estate is intensely regulated, with regard both to the
uses to which it can be put and to the manner in which its ownership can be
transferred. As a result of all these factors, as well as the fact that real estate is
immovable, prices can be highly volatile.
Characteristics of land
Because every parcel of real estate is unique and immobile, some of the factors that ordinarily affect supply and demand must receive somewhat different
consideration.
A market is simply a forum for buying and selling, that is, a means for bringing
together buyer and seller. For products other than real estate, the location of the
product to be sold affects shipping costs and is only one of a number of determi-
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nants that affect value. The most important single factor in determining real estate
value is location. Land cannot be delivered to a location where it is in short supply
or warehoused until it is needed. The seller of real estate can improve the property by preparing it for building or constructing or renovating improvements. The
seller also can use advertising and other promotional tools to make the property’s
availability known to the greatest number of potential buyers. The one thing the
seller of real estate cannot do is change the property’s location. What the seller
can do is make the property more desirable by analyzing the needs and desires of
potential buyers and improving the property with those requirements in mind.
Market Analysis
An analysis of the real estate marketplace must include demographic data on the
area’s residents. Demography is the scientific study of population statistics, such
as births, deaths, and marriages. The overall market area can be further defined by
the process called segmentation into specific categories of consumer preferences,
including those relating to income, work, leisure activities, and other lifestyle
patterns.
By knowing as much as possible about the people who make up the market area,
it is possible to predict the probable demand for various types and price levels of
housing as well as the commercial and industrial establishments necessary to supply the required products and services. Such forecasts are published regularly by
various government agencies as well as research centers, industry-related companies, and trade associations.
An absorption analysis is a study of the number of units of residential or nonresidential property that can be sold or leased over a given period of time in a defined
location. Existing space inventory must be considered in light of present demand
and current or projected space surplus. In short, is there a need for new space? The
overbuilding of the commercial real estate market in the 1980s left many urban
areas with a supply of office space that did not approach acceptable occupancy
levels until the mid-1990s. The booming residential real estate market of the first
part of this century, helped by low interest rates and adjustable-rate mortgages,
was followed by the subprime lending crisis and resulted in a record number of
foreclosures and many vacant homes.
An absorption analysis usually is performed as part of a feasibility study, used
to predict the likely success of a proposed real estate development. The feasibility study also includes a cost analysis of the proposed construction and projected
return to investors.
Of course, the most complete statistics and best analyses are useless without a
thoroughly up-to-date knowledge of the political climate and government forces,
both local and otherwise, that may result in regulations affecting property ownership and use. A feasibility study of area growth projections for a new subdivision is
incomplete if it does not take into account a proposed highway expansion adjacent
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to the site. Without that knowledge, the use proposed by the owner or prospective
purchaser might be meaningless. With that knowledge, a recommendation that
the proposed use change from residential to commercial could result in a project
several times as valuable.
The Cost of Credit
Few buyers of real estate could afford, or would prefer, to pay all cash for property.
Interest paid on a loan used to purchase real estate is the cost of credit to the borrower. When the cost of credit is high, borrowers cannot qualify to buy property
that would be affordable when financing is not as expensive. The cost of credit to
borrowers thus has a direct impact on the price that can be paid for property.
The cost of credit depends on the availability of funds in relation to the number of
potential borrowers. Credit is said to be “tight” when there is not enough financing to accommodate easily all prospective borrowers.
Sources of capital
A money market fund consists of short-term financing instruments. These include
U.S. Treasury bills, notes, and other government securities; municipal notes; certificates of deposit; commercial paper (corporate borrowing to finance current
operations); Eurodollars (funds deposited outside the United States); and others. Because short-term loans are much in demand in the real estate industry for
construction financing and other interim or “bridge” loans, rates available on the
money market usually have a major impact on real estate development.
The capital market is the term used to describe the trading of longer-term financing
instruments such as mortgages, deeds of trust, bonds, stocks, and other obligations
generally maturing in more than one year. There is no one location or institution
that comprises either the money market or the capital market and no sharp line of
demarcation in the kinds of instruments handled by each.
Competing investments
Investors generally fall into one of two groups, debt investors and equity investors. Debt investors are the more conservative of the two groups because they
take a passive rather than an active role in management of their investments and
demand a security interest in property being financed. Equity investors, who make
use of what is termed venture capital, take a more active, though unsecured, role
in the investment.
Over the years, interest in the investment potential of real estate has increased to
parallel increases in real estate appreciation. In addition to financial institutions,
trusts, partnerships, syndications, joint ventures, pension funds, life insurance
companies, foreign investors, and other sources provided the equity capital that
allowed record levels of building in the 1980s.
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How Real Estate Is Financed
The lien on real estate demanded by the debt investor may take the form of either
a mortgage or a deed of trust, both of which are explained below. It is important
to note that even though the mortgage and deed of trust are different types of
security instruments, the term mortgage is also used to refer to any instrument by
which real estate is made security for a debt.
Mortgage terms and concepts
The security instrument is the document that hypothecates the real property that
serves as the lender’s assurance that the debt incurred will be repaid. Personal
property (anything that doesn’t qualify as real estate) can be pledged by a security
instrument, rather than hypothecated. One difference between the two forms of
security is that possession of personal property pledged to secure payment of a debt
may be turned over to the creditor. When real estate is used as security, the debtor
usually retains possession.
A mortgage creates a lien in favor of the mortgagee (lender) on the property of
the mortgagor (property owner). The lien is enforced by the mortgagee if the
mortgagor fails to meet the obligations imposed by the promissory note that states
the terms of the loan agreement. Enforcement of a mortgage may be through a
judicial foreclosure, which requires a court hearing, or by a sale on behalf of the
mortgagee, if provided for in the mortgage instrument.
A deed of trust, or trust deed, is an actual transfer of title from the trustor (property owner, who is the borrower) to a trustee (neutral third party, who acquires
equitable title with a power of sale that benefits the lender) to be held on behalf
of the lender, known as the beneficiary. When the debt is repaid, the beneficiary
notifies the trustee, who issues a reconveyance deed that returns title to the trustor. If the trustor defaults, the trustee may sell the property to repay the underlying
debt.
Mortgage payment plans
A mortgage debt (any debt secured by real estate, whether the security instrument
used is a mortgage or deed of trust) can be repaid through various payment plans.
Repayment of a mortgage debt requires payment of both principal (the amount
borrowed) and interest (the charge for the borrowing). The interest rate can be
fixed (the same for the life of the loan) or adjustable (varying according to an
established index, such as the rate on six-month Treasury bills or the average
cost of funds of FDIC-insured institutions). With either fixed-rate or adjustablerate loans, the lender’s effective yield (and the borrower’s effective cost) often is
increased by some form of buydown, an advance payment of interest called points
or discount points. Each point equals 1 percent of the loan amount.
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Types of mortgages
The fully amortized fixed-rate mortgage requires regular payments of both principal and interest so that the loan is fully paid off at the end of the loan term. With
the adjustable-rate mortgage, individual payments can rise or fall as the interest
rate rises or falls in step with the index used.
The graduated payment mortgage provides lower monthly payments in the early
years of the loan term, with gradual increases over five to ten years, after which
payments level off for the remainder of the loan term. The growing equity mortgage provides a fixed interest rate but an increasing payment amount, allowing for
a more rapid payoff.
The reverse annuity mortgage, which provides a monthly payment to a homeowner
using a previously mortgage-free (or mostly mortgage-free) home as collateral with
the entire loan amount plus interest due at the end of the loan term, is attracting
increasing attention from older homeowners with substantial home equities. The
shared appreciation mortgage offers a below-market interest rate and lower payments in exchange for the transfer of some equity from borrower to lender.
Elements That Create Value
For real estate or any commodity to have value, the four elements that create value
must be present. These elements are demand, utility, scarcity, and transferability
(DUST). The element of demand is present when someone wants the property
and has the financial ability to purchase it. Utility means that the property can
serve a useful purpose. Scarcity is present when the property is in short supply
relative to demand. Transferability means that title to the property can be moved
readily from one person or entity to another. When all four elements of value are
present, property has a value that may be estimated by an appraiser.
When a good or service can be used to acquire another good or service, the commodities have what is termed value in exchange. A marketplace exists when there
is no impediment to the ready exchange of goods or services. Most often, goods
or services are exchanged for their equivalent in legal tender—money. The cost
to the owner of an item includes the labor and materials required to produce it.
The amount of money required to bring about the exchange is the price paid for
the good or service. As you will learn later in this chapter, the price paid or cost
to a subsequent owner of a good or service will be affected by both the number
of potential purchasers (demand) and quantity of the goods or services (supply).
Because it reflects conditions in the marketplace, value in exchange is what is
described as market value.
Many regulatory agencies and other government units, as well as individuals,
incorporate into their real estate decision criteria a variety of objectives and policies that are perceived as influencing value. These criteria often define a type of
value, such as one of those listed below. Nevertheless, they are typically anchored
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to a value-in-exchange concept, usually represented by a market value definition.
The types of value defined may include the following:
■■
Appraised value
■■
Investment value
■■
Assessed value
■■
Leased fee value
■■
Book value
■■
Leasehold value
■■
Capitalized value
■■
Liquidation value
■■
Cash value
■■
Market value
■■
Depreciated value
■■
Mortgage loan value
■■
Exchange value
■■
Rental value
■■
Going concern value
■■
Replacement value
■■
Improved value
■■
Salvage value
■■
Inheritance tax value
■■
Value in use
■■
Insurable value
To appraise something means to estimate the dollar amount that represents one
of its values. Appraisers for banks, savings associations, or other lenders will probably be seeking the market value of the properties they inspect for mortgage loan
purposes. Depreciated cost (value) is used in one appraising approach to estimate
market value; rental value may be used in another. City and county real estate
taxes are based on assessed value.
Definition of market value
The Uniform Standards of Professional Appraisal Practice defines market value as
a type of value, stated as an opinion, that presumes the transfer of a property
(i.e., a right of ownership or a bundle of such rights), as of a certain date,
under specific conditions set forth in the definition of the term identified by
the appraiser as applicable in an appraisal.
USPAP thus requires the appraiser to state the specific conditions under which
market value is determined. Those conditions generally will concern the
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■■
relationship, knowledge, and motivation of the parties;
■■
terms of sale, such as cash or cash equivalent; and
■■
conditions of sale, such as exposure on a competitive market for a reasonable time prior to sale.
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Another definition of market value states that it is
the most probable price which 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.
Market value thus typically assumes an arm’s-length transaction in which
■■
buyer and seller are typically motivated;
■■
both parties are well informed or well advised, and acting in what they
consider their best interests;
■■
a reasonable time is allowed for exposure in the open market;
■■
payment is made in terms of cash in U.S. dollars or in terms of financial
arrangements comparable thereto; and
■■
the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions.
To summarize, market value reflects a transaction in which there are no exceptional factors influencing the buyer, the seller, or the availability of financing.
What happens when an unusually high number of properties on the market are
in foreclosure or already owned by a lender? In this case, the appraiser must determine what is “normal” for the current market. Unfortunately, foreclosure sales are
likely to affect the value of all properties in the area—not just those that were
foreclosed or are being sold under imminent threat of foreclosure. In such a market, property condition becomes even more important than usual. If a foreclosed
property has suffered from lack of care, or even vandalism, what will be the cost to
bring that property up to the condition of other properties?
Sales price
Sales price is what a property actually sells for—its transaction price. This price
may differ from market value because many factors can prevent a sale from being
an arm’s-length transaction. The need of either of the principals (buyer or seller)
to close the transaction within a short period of time will limit that party’s bargaining power. On the other hand, if a seller receives an offer for less than the
asking price, which is the market value of the property, but the offer is made only
one week after the property is put on the market, the seller may decide that a
quick sale is worth losing the higher price that might be received if the property
were left on the market longer. The buyer and the seller may be relatives, friends,
or related companies, and one or both could voluntarily limit their bargaining
power. Also, the buyer may have a pressing need to acquire the property, such as
the need to add to an adjoining site.
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Cost
The amount paid for a good or service is its cost. The cost to purchase a parcel
of real estate may or may not be the same as the price it can command when it is
sold to someone else. A developer may pay $5 million for a prime downtown lot
and another $20 million to construct a highrise office building on the site. Yet if
the market is flooded with similar properties and market demand thus is very low,
the developer may not recoup the cost of the lot and building when the property
is eventually sold.
Investment value
Investment value is the value of a property to a particular investor, considering
the investor’s cash flow requirements. Cash flow is the amount of income left over
after all expenses of ownership have been paid. Different investors will have different income expectations, as well as different expenses of ownership.
Before the Tax Reform Act of 1986 eliminated many of the tax advantages of real
estate ownership, a property could be desirable even if it offered a negative cash
flow (that is, it cost more to own than the income it produced) in the early period
of ownership. The loss generated by the real estate could be used as a deduction to
shelter other income from taxation. The amount of loss that can be carried over
from real estate investments now has been greatly restricted. Determination of
an individual real estate investor’s after-tax position requires the services of a tax
accountant or attorney.
Other values
Value in use is property value based on a particular use, often considered as part
of a broader operation or process. An example is a driving range adjacent to a golf
course. The value-in-use concept offers an analytical framework to support real
estate value in the context of a business’s overall going-concern value, which also
takes into account the intangible but valuable assets of an established, profitable
business, such as customer goodwill.
The value determined by a local taxing authority as the basis for ad valorem property taxation is called assessed value. The amount for which property may be
insured is its insurable value.
Influences on Real Estate Value
The forces of nature, as well as the human-generated effects of government,
economic, and social systems, all affect the value of real estate. The physical,
economic, governmental, and social (PEGS) forces are discussed next.
Physical and environmental
Climatic and other environmental conditions, exacerbated by ill-planned development, can wreak havoc on both land and buildings.
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P r a c t i c e
In California, many residential and commercial buildings have been built directly
over or in close proximity to known earthquake fault lines. Earthquakes also can
occur in many other states, which may not be as well prepared as California to deal
with them. In some tornado-prone areas of the Midwest, new subdivisions stand
directly in the path of potential catastrophe. In the past two decades, multiple hurricanes inflicted heavy damage on communities in Florida, Louisiana, and other
coastal states. Fires have ravaged parts of Southern California, Texas, and Florida.
The range of possible liabilities imposed on property owners for environmental
reasons, including the presence or proximity of hazardous substances as well as
noise and dangerous conditions, can be overwhelming. A special area of appraisal
focusing on discovery and analysis of environmental problems has emerged.
Economic
Real estate values tend to move in cycles, mirroring the economy as a whole.
With a high level of employment and regular salary increases, demand for housing
and other forms of real estate will increase and prices will follow suit. When the
unemployment rate rises and wage levels stagnate or decrease, or interest rates
(particularly on adjustable-rate loans) increase at a greater rate than anticipated,
the number of mortgage loan foreclosures will increase. As more properties become
available, yet fewer persons are able to afford them, market values decline. When
economic conditions become more favorable, market values are stabilized and, as
conditions continue to improve, may begin to rise once again.
Government and legal
The increasing number and complexity of regulations affecting ownership and
use of real estate have proven to be major influences on the cost of acquiring and
owning real estate. Although an appraiser cannot make a legal judgment, determination of the highest and best use of the property being appraised must always
take into account both existing and proposed zoning, which will specify the range
of uses available to the property owner.
I n
P r a c t i c e
In some states, property tax exactions require voter approval, which can be difficult
to obtain. As a result, increases in development fees have been used to pass new
infrastructure costs on to developers and, ultimately, property buyers.
Social
Social influences are gaining increasing recognition as harbingers of future market
demand. Although the single-family detached home still is the most desired form
of housing, the condominium form of ownership, typically in a multiunit building, has become popular in urban areas. Mixed-use developments providing both
residential and retail units have stimulated interest in downtown areas of both
large and small cities. As more people show evidence of environmental as well
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as personal concerns, builders will respond to those desires, as well. The “green”
house that makes a minimal impact on the environment is already being built.
Of course, one of the most interesting phenomena of the past several decades has
been the influence of the great wave of post–World War II baby boomers born
between 1946 and 1964 as they have grown to maturity. The economic effects
of this sector of the population have been impossible to ignore. While the baby
boomers were children, record levels of building were required to provide them
with schools. Universities blossomed with record enrollments. When the baby
boomers demanded housing, builders complied. When the baby boomers decided
to have their own babies, they created a baby boomlet. As they reach retirement age, baby boomers are creating new opportunities for developers of housing
designed to accommodate the needs of seniors. The concept of “universal design”
includes features to enhance the accessibility of homes and fixtures, which can
appeal to homeowners in all age groups.
Exercise 5-1
Which factors are likely to prevent an arm’s-length transaction?
Seller’s immediate job transfer to another city
New highway construction
Delinquent tax sale
Location across the street from a grade school
Flooding in crawlspace not revealed by seller
Purchase of adjacent property for business expansion
Check your answers against those in the answer key at the back of the book.
■■ Basic Value Principles
While some property owners could probably make a fairly accurate guess as to the
current value of their properties, they would still be unable to identify all or most
of the factors that contribute to that value. The knowledge of precisely what those
factors are, and how they influence and can be expected to influence property
value, is part of what lends credence to the appraiser’s opinion of market value.
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The basic value principles discussed in the next 16 sections of this chapter are
interrelated, and their relative importance will vary depending on particular local
conditions. Supply and demand may be the strongest factor in a popular resort
area; in an urban area, a period of economic recession may deter development of
new stores. Even climatic or geological conditions are important, as when unexpected heavy rainfall creates the threat of destructive mudslides.
It is the appraiser’s task, then, to consider the subject property in light of all the
factors applicable to the property’s type and location, as well as the purpose of the
appraisal. Principles affecting marketability (such as supply and demand) will have
greater influence in the sales comparison and cost approaches, while principles
affecting productivity (such as opportunity cost) will have the greatest influence
in the income approach.
1. Anticipation
According to the principle of anticipation, property value may be affected by
expectation of a future event. The expectations of a real estate buyer will depend
to some extent on the type of property purchased. The buyer of a single-family
residence usually expects to take advantage of the property’s amenities as a shelter, as well as the prestige value of ownership. In the same way, some owners
of commercial property enjoy the use of the facilities in conducting a business
on the premises. The ability of the property to generate income is the primary
expectation of most buyers of commercial and multifamily residential property.
Determining the present value of the future income stream is the basis of the
income approach to appraising, discussed in Chapters 13 and 14.
In addition to the benefits that flow from possession, real estate may offer a benefit
that is realized only when property is sold. Real estate has historically proved to
be a generally appreciating asset. As such it is usually bought with the expectation of future higher value. This anticipation of higher value is usually fulfilled
because land offers a fixed supply to satisfy what has proved to be a continually
growing demand. However, anticipation may also lower value if property rights
are expected to be restricted or if the property somehow becomes less appealing to
prospective buyers.
For example, a residential area scheduled to undergo condemnation for highway
construction might represent anticipation in either of its forms. Owners of residential property immediately adjacent to the highway may expect property values
to decline as traffic noise and pollution increase. Owners of residential property
far enough away from the highway to avoid those problems may expect property
values to rise as their property is made more accessible to surrounding business and
shopping areas.
Land-use requirements are often anticipated by developers, who wish to be ready
with the necessary residential, commercial, or industrial facilities to meet the
demand they expect. The predicted need might or might not materialize, how-
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ever, which is why real estate as an investment still contains an element of risk.
In short, real property is very often purchased for its anticipated future benefits,
whether for production of income, a tax shelter (to the extent allowed by law), or
future appreciation.
2. Balance
Real estate is a unique, immovable product, yet it is affected by the same market
forces that influence the production of other, movable items. Land will tend to be
at its highest value when the four factors of production (discussed below) are in
balance.
Balance also is the term used to describe a mix of land uses that maximizes land
values. With the appropriate proportion of residential, commercial, and other
land uses, all properties benefit by the ability of the area to attract and keep both
residents and businesses.
3. Change
All property is influenced by the principle of change. No physical or economic
condition remains constant. Just as real estate is subject to natural phenomena—
earthquakes, tornadoes, fires, violent storms, and routine wear and tear by the
elements—the real estate business (as any business) is subject to the demands of
its market. It is the appraiser’s job to keep aware of past and perhaps predictable
effects of natural phenomena as well as the changes in the marketplace.
4. Competition
According to the principle of competition, when the supply of property in the
marketplace is low relative to the demand for such property, creating excess
profits for present property owners, the result is to attract more properties to the
marketplace.
All types of real estate are subject to the effects of competition in some form. The
value of a house will be affected by the number of other, similar houses available in
the same area. If only a few properties are competing for the attention of a much
larger number of buyers, those properties will command much higher prices than
they would if there were many such properties for sale.
Income-producing properties are always susceptible to competition. For example,
if demand produces excess profits for a retail store, similar stores will be attracted
to the area. This competition tends to mean less profit for the first business. Unless
total market demand increases, there probably will not be enough sales to support
very many stores, and one or more will be forced out of business. Occasionally, the
opposite is true, and additional competitors serve as a stimulus to the area, making
a center of trade for the products being sold, as in a shopping center.
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5. Conformity, Progression, and Regression
In general, particularly in residential areas of single-family houses, buildings
should follow the principle of conformity; that is, they should be similar in
design, construction, age, condition, and market appeal to other buildings in the
neighborhood.
Nonconformity may work to the advantage or disadvantage of the owner of the
nonconforming property. A house that has not been well maintained but is in a
neighborhood of well-kept homes will benefit from the overall good impression
created by the neighborhood and its probable desirability. This is an example of
the principle of progression. In an example of the principle of regression, a house
that has been meticulously maintained but is in a neighborhood of homes that
have not received regular repair will suffer from the generally unfavorable impression created. In the same way, an elaborate mansion on a large lot with a spacious
lawn will be worth more in a neighborhood of similar homes than it would be
in a neighborhood of more modest homes on smaller lots. From the appraiser’s
viewpoint, the major concern is whether the improvements, or components, are
typical.
6. Contribution
In an appraisal for market value, any improvement to a property, whether to vacant
land or a building, is worth only what it adds to the property’s market value, regardless of the improvement’s construction cost. In other words, an improvement’s
contribution to the value of the entire property is counted, not its intrinsic cost.
The principle of contribution is easily applied to certain housing improvements.
An extensively remodeled kitchen usually will not contribute its entire cost to the
value of a house. A second bathroom, however, may well increase a house’s value
by more than its installation cost.
The principle of conformity may overlap with the principle of contribution and
can be quite obvious in older neighborhoods.
I n
P r a c t i c e
If a house’s out-of-date asbestos shingle exterior is its major flaw and other houses
nearby have wood siding or masonry exterior finishes, the addition of new siding
may be worth several times its cost because a hazardous material will be eliminated
and the house that was out of date will blend in with those nearby. The appraiser’s
opinion, therefore, should be governed by a feature’s contribution to market value—
not by its reported cost.
7. Externalities
The principle of externalities states that influences outside a property may have
a positive or negative effect on its value. For example, the federal government’s
direct participation in interest rate controls, in mortgage loan guarantees, in providing tax incentives for rehabilitation of older homes, and so forth, has had a
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powerful impact on stimulating or retarding the housing supply and increasing
or decreasing the level of home ownership. Values of homes and all other types
of real property are directly affected by governmental action or inaction. External influences affecting value exist at regional, city, and neighborhood levels.
Information on some of these factors is readily available. Crime rates, population
density, income level, and even the results of student performance on standardized
tests can all be found on the Internet.
8. Four Factors of Production
The concept of value cannot exist without consideration of the four factors of
production (capital, labor, land, and management) and the return required by
each in a specific enterprise. Return on capital is characterized as interest or yield.
The use of labor requires compensation in the form of wages or salaries. Return on
land is rent. Finally, the return to the entrepreneurial risk taker and/or coordinator
of an enterprise—the management function—is profit.
9. Life Cycle of Property—GEDR
Ordinary physical deterioration and market demand create a life cycle of four
stages through which an improved property will pass: (1) growth, when improvements are made and property demand expands; (2) equilibrium or stability, when
the property undergoes little change; (3) decline, when the property requires an
increasing amount of upkeep to retain its original utility while demand slackens;
and (4) revitalization or rehabilitation, which may occur if demand increases,
serving to stimulate property renovation. They can be remembered by the acronym GEDR.
The principle of growth, equilibrium, decline, and revitalization also applies to
an entire neighborhood. Whether it is an area of long-established housing within
the city limits, an older close-in suburb, or a new development at the edge of the
metropolitan area, a neighborhood will show the effects of the life cycle.
10. Highest and Best Use
Of all the factors that influence market value, the primary consideration is the
highest and best use of the real estate. The highest and best use of a property is its
most profitable legally and physically permitted use—that is, the use that will at
present provide the highest property value. The highest and best use evolves from
an analysis of the community, neighborhood, site, and improvements.
A highest and best use study may be made to find the most profitable use of a vacant
site or to determine the validity of a proposed site utilization. If there already is a
structure on the property, the highest and best use study may make one of several
assumptions: the site could be considered vacant, with the cost of demolishing the
existing structure taken into account when estimating profits from any other use
of the site; the cost of refurbishing the existing structure could be considered in
light of any increased income that might result; the structure could be considered
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as is, that is, with no further improvements; and the structure might be considered
adaptable to new uses. Every case must be studied on its own merits, considering
zoning or other restrictive ordinances as well as current trends.
I n
P r a c t i c e
Many gas stations have closed since the early 1970s. Before that time, if those
facilities reopened, most of them would probably have been used again only as gas
stations. With the modern trend toward drive-in facilities, from restaurants and drycleaning shops to almost every other type of retail outlet, many former gas stations
were converted to other types of drive-in businesses. With the present emphasis
on the environment and federal and state regulations that require the cleanup of
contaminated sites, including the storage tanks and ground contamination found on
property that has been used for a gasoline station, such properties are considerably
less desirable than those that do not require such extensive remediation.
The depth of analysis required to support the appraiser’s conclusion of a property’s
highest and best use will depend on the nature of the report. A property’s highest
and best use may also be redefined at a later date, just as its appraised value may
fluctuate downward or upward. The process of determining a property’s highest
and best use is discussed in more detail in Chapter 9, “Site Valuation.”
11. Law of Increasing Returns
Improvements to land and structures eventually will reach a point at which they
will have no positive effect on property values. As long as money spent on such
improvements produces a proportionate or greater increase in income or value,
the law of increasing returns is in effect.
12. Law of Decreasing Returns
At the point when additional property improvements bring no corresponding increase in the property’s income or value, the law of decreasing returns is
operating.
13. Opportunity Cost
In the appraisal of income-producing property, opportunity cost is the value
differential between alternative investments with differing rates of return. The
appraiser considers the alternatives in selecting a rate of return for the property being appraised, which in turn will affect the final value estimate for the
property.
14. Substitution
The value of real property is basically determined by using what is called the
principle of substitution. The price someone is willing to pay for a property is
influenced by the cost of acquiring a substitute or comparable property. If the asking price for a house is $495,000, yet a nearby, very similar property is available for
only $450,000, no one is likely to offer $495,000 for the first property.
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Every appraisal makes use of the principle of substitution to some extent. Its
most conspicuous use is in the appraisal of single-family residences using the sales
comparison approach. In that approach, the appraiser collects selling price information and other data on homes similar to the property being appraised (called
the subject property) that are located in the same or a similar neighborhood and
that have sold recently. The appraiser then adjusts the selling prices of those properties to account for significant differences between them and the subject property
in size, style, quality of construction, and other factors likely to affect the market
value of the property being appraised.
I n
P r a c t i c e
If the subject property has only two bathrooms and an otherwise comparable
property in the same neighborhood that has sold recently has three bathrooms, the
appraiser will adjust the selling price of the comparable property downward by the
market value in that area of a third bathroom. Thus, if the comparable property has
sold for $325,000 and the market value of a third bathroom is $16,000, the selling
price of the comparable is reduced by $16,000 (to $309,000) to approximate the
effect on the subject’s estimated market value of the absence of a third bathroom.
Some property differences may result in the selling price of a comparable property
being increased to accurately reflect the estimated market value of the subject property if the subject property has a valuable feature that the comparable property lacks.
The sales comparison approach is discussed further in Chapters 8 and 12.
15. Supply and Demand
As with any marketable commodity, the law of supply and demand affects real
estate. Property values will rise as demand increases and/or supply decreases. The
last building lot in a desirable residential development will probably be worth
much more than the first lot that was sold in the development, assuming a consistent demand.
The effect of supply and demand is most obvious on the value of older buildings
in very desirable areas, usually in cities, where demographic trends (population
size and distribution) may bring heavy demand for housing to neighborhoods that
have already seriously deteriorated. A building in such an area, even if it required
extensive remodeling to meet current building codes, might have increased in
value several times because of the increased demand. The property might be valued primarily as a “teardown”—that is, for the potential its site offers for new
construction, as permitted by local zoning and building codes. Thus it should be
remembered that demand relates to the supply of a particular type of property in a
given location—not to property in general.
16. Surplus Productivity
The income capitalization approach to appraising, discussed in Chapters 13 and
14, makes use of the concept of the residual value of property purchased for investment purposes. If the expenses of ownership (capital, labor, and management) are
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deducted from net income, the remaining amount is termed surplus productivity
and is considered the investor’s return on the use of the land, or land rent. The
expectation of profit is also expressed as the entrepreneurial incentive that motivates a developer to assume the risks involved with taking on a project.
Conclusion
The principles discussed in this chapter are the keys to understanding why, when,
and how certain factors act to influence the value of real property. The appraiser
who understands these principles can form opinions based on knowledge and
understanding, not guesswork.
Exercise 5-2
Which basic value principle(s) does each of the following case problems
illustrate?
1.Carl Snyder owns a vacation home near a small town almost 300 miles from
the city in which he lives and works. He doesn’t use his vacation house more
than three weeks every year. The last time he stayed there, he noticed that a
gas station had been built a few hundred yards down the road. After talking
to the owner, he discovered that a zoning change had been put into effect
to allow construction of a new shopping center on land adjacent to the gas
station. While Snyder’s property was not rezoned, he realizes that it won’t be
suitable as a vacation retreat once the shopping center is built.
2.Marian Nelson customized the family room of her new home by adding a
cedar-lined steam room, six-person whirlpool spa, and special ventilating
system. Nelson decided that the improvements were justified because even
though she knew she would only be living in the home for a few more years,
she could realize the worth of the improvements when she sold her home.
3.A structurally sound office building rents for $20 per square foot but lacks
air-conditioning. A similar, air-conditioned building in the same neighborhood
rents for $25 per square foot.
4.Two bookstores are located on the same city block, and both have had good
business for ten years. One store is modernized with new displays, better
lighting, computerized inventory control, and a coffee bar. Because the store
is part of a chain, remodeling costs are absorbed without a general increase
in prices. The other bookstore begins losing customers.
5.A 100-unit apartment building designed for middle-income persons at least
55 years of age is in very good condition. The owners plan extensive remodel-
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ing and redecorating to be financed by raising rents as needed. The plans will
probably take four years to complete. None of the apartments will be altered,
but the building’s exterior will be completely redone, and the lobby will be
furnished with expensive carpeting, chairs, and a chandelier. The lobby
remodeling is done first; the tenants seem pleased, and no major objection is made to the resultant rent increases. After the second year, however,
many tenants object to the continued increases and choose not to renew their
leases. The owners have difficulty finding new tenants.
6.A single-family neighborhood is located adjacent to property that was recently
used for an airport expansion. Excessive noise caused by airplanes flying
overhead and the potential danger they create have adversely affected the
value of homes in the immediate area.
Check your answers against those in the answer key at the back of the book.
■■ Summary
The market for real estate is a product of statewide, regional, and national, as well
as local, forces. Population level, the strength of the economy, and the availability
of financing all affect the real estate market.
Markets for goods and services are called efficient when the products are readily
exchangeable and easily transported, there is an ample supply of buyers and sellers, government regulation has little or no effect on value, and prices are stable.
The market for real estate functions differently. Real estate is immobile, unique,
and heavily regulated. In addition, buyers and sellers of real estate frequently lack
knowledge of the factors that contribute to market value.
Market analysis begins with a study of area demographics. The market is then
segmented into areas of preference, and the activities of the people that make up
the segments are forecast. A feasibility study of the financial success of a proposed
development includes an absorption analysis of the number of units likely to be
sold within a specified period of time.
Sources of capital for real estate development include short-term money market
funds as well as longer-term capital markets. Debt investors require a security
interest in the property financed, while equity investors are willing to take a riskier unsecured role.
Although we commonly refer to any financing instrument as a mortgage, there
are differences in the creation and effect of the mortgage and deed of trust. With
a mortgage, the property owner is the mortgagor, and the lender is the mortgagee.
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With a trust deed, the property owner is the trustor, the lender is the beneficiary,
and a neutral third party is the trustee, who holds title to the secured property
until the debt is paid.
Mortgage payment plans include both fixed-rate and adjustable-rate loans. Value
in exchange is the ability of a good or service to command another good or service.
Market value is the most probable price real estate should bring in an arm’s-length
transaction in which neither party is acting under duress; the property has been on
the market a reasonable length of time; the property’s assets and defects are known
to both parties; and there are no unusual circumstances, such as favorable seller
financing. Its sales price is what a property actually sells for.
The amount initially paid for a good or service is its cost to the person who owns
it. Cost may or may not be the same as the item’s estimated market value and
its subsequent resale price. Investment value is the value to an individual investor. Value in use is based on a particular use. Assessed value is used for taxation
purposes. Insurable value is the amount for which property may be insured. Goingconcern value is the value of a business exclusive of the value of the real estate it
occupies.
Forces affecting value include the physical and environmental, economic, governmental and legal, and social.
The basic value principles that are among the factors contributing to price
increases and decreases include anticipation; change; competition; conformity,
progression, and regression; contribution; externalities; the stages of growth, equilibrium, decline, and revitalization; highest and best use; the laws of increasing
and decreasing returns; the principle of substitution; and the effects of supply and
demand.
The four factors of production are land, labor, capital, and management. When
these factors are in balance, land value should be at its highest. Opportunity cost
is the difference in value created by differing rates of return. When the expenses of
ownership are deducted from net income, the remainder, or surplus productivity,
is attributable to land value.
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Fundamentals of Real Estate Appraisal, Eleventh Edition
Review Questions
1. The scientific study of population statistics is
a. scientography.
b. segmentation.
c. demography.
d. forecasting.
2. The amount initially paid for a good or service is its
a. price.
b. market value.
c. investment value.
d. cost.
3. Market value is based on
a. insurable value.
b. most probable price.
c. cost.
d. value in use.
4. Short-term financing instruments are part of the
a. money market.
b. capital market.
c. absorption analysis.
d. feasibility study.
5. Longer-term financing instruments are part of the
a. money market.
b. capital market.
c. absorption analysis.
d. feasibility study.
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6. Under a deed of trust, the property owner is the
a. trustor.
b. trustee.
c. beneficiary.
d. reconveyancer.
7. Under a mortgage, the lender is the
a. mortgagor.
b. mortgagee.
c. equity investor.
d. reconveyancer.
8. Explain the difference between market value and sales price.
Identify the major value principle described in each case below.
9. A less expensive house tends to gain in value because of more expensive
neighborhood houses.
10. The value of a property tends to be limited by what it costs to buy another
property similar in physical characteristics, function, or income.
11. Plans have been announced for a multi-million-dollar shopping center to be
built next door to a vacant lot you own. Property values in the area of the
proposed site will tend to increase as a result of this announcement.
12. The rental value of vacant land can sometimes be greater than it would be
if the land were improved with a building.
13. In many downtown areas, parking lots make more profit than older office
buildings.
14. An investor will probably pay more for the last 20 lots in an area where the
demand for houses is great than for the first 20 lots in the same area.
15. The cost of installing an air-conditioning system in an apartment building
is justified only if the rental increase that can be expected as a result of the
installation exceeds the amount spent.
Check your answers against those in the answer key at the back of the book.
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