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Concepts of Real Estate Value
| | Monday, June 28, 2004 @ 12:00 PM EDT
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Contributed by: Nancy Chadwick
Nancy Chadwick Properties
Read more archived articles about Land and Development
All products, services and things have value, but the value is not static. It changes when events occur that increase or decrease the product's desirability. In addition, the value of the same product, service or thing isn't the same to everybody. Different people have different needs and wants at different times. Value is based on need and the ability of the product to satisfy that need. Real estate is no different from other commodities. Every property has value, and that value goes up or down over time. Property derives value from its capacity to be used. For value to increase, there must be a demand that exceeds current or projected supply, and the property must be capable of satisfying that need either at the present time or in the future. For example, only 6 home sites in a builder’s 30-home new construction community back up to property maintained by the municipality as permanent open space. Superior location
in limited supply increases demand for these home sites and allows the builder to charge hefty lot premiums for them.
Types of Property Value
It's virtually impossible to come up with an all-encompassing definition of "value" because its meaning varies widely depending on who's defining it. There are different types and sub-types of value -- for instance, insurance, replacement, reproduction, rehab (before and after), wholesale and retail value. The criteria used to measure these kinds of value are different.
Market Value & Highest and Best Use
Real estate appraisers define "market value" as the most probable price at which a property will sell in a competitive and open market where both buyer and seller are acting knowledgeably and without duress or abnormal pressures. With the sales comparison approach, appraisers identify properties that have recently sold that are similar to the subject property in several respects (e.g., use, type, location, size, condition). Estimating value is at best an inexact science because buyers and sellers often make decisions that can't be explained or rationalized. Consequently, determining value isn't a cut and dried process accomplished merely by applying objective criteria. The "highest and best use" used by appraisers in arriving at an opinion of value is the most profitable use that is legal, reasonably probable, supported by demand, physically possible and economically feasible. The potential use must meet all of these criteria.
"Warts & All" Value
Present or "as is where is" value is the value of the property as it currently exists. This value assumes that no change will occur. It's the value that is arrived at after taking into account the property's current uses, conditions and physical or other limitations, both known and unknown, and is usually discounted to reflect the property's "warts." If you bought a property in its as-is condition, you'd be taking it as you found it. You wouldn't be making your purchase contingent on satisfactory results of inspections or the seller making any repairs.
"What If" Value
Future value is based on the assumption that at some point in time there will be some change to how or if the property can be used. This value involves anticipation and is the one on which developers generally base their projections. They ask themselves: what can I do to this property that will increase its value? This might be getting some type of municipal approval (like subdivision or zoning) or it could involve a physical change, such as modifying or demolishing an existing structure or converting it so it can be used in a different and more profitable way. Future value is not guaranteed. The event or change may be probable but it won't become reality until it actually occurs.
Perceived Value
People's decisions are based in part on their perceptions and the reality becomes whatever they believe it to be. Perceptions as well as facts define value because perception is directly tied to demand. Increased demand for a property results from the perception that the property is desirable. E.g., property in a certain school district that is considered top-notch. Stigmatized properties have reduced demand. E.g., properties located next to power lines. The reality may be that the power lines don't present health hazards, but until people believe that and their perception changes, the properties will continue to be viewed as undesirable and their values will suffer.
Now v. Later Value
Property values do not necessarily increase over time, and the passage of time can actually reduce and not increase value. For example, the owner of 20 AC of land throws his fishing line in the water and puts an inflated price tag on the property. Nobody "bites." Months go by and the municipality declares a moratorium on issuing sewer permits, thus prohibiting new connections until the existing plant is expanded or another one is built. The owner here would have 3 options:
1. take the property off the market until the moratorium ends;
2. sign an agreement contingent on the buyer being able to subdivide and purchase sewer permits; or
3. sign a non-contingent agreement selling the property in its as-is state.
Site yield and sale price would be maximized with Option 2. If the owner doesn’t want to wait for the moratorium to end (Option 3), buyers would likely discount the purchase price to compensate for increased risk and holding period. If the owner weren't willing to discount the price, the property might not sell at all unless there were special circumstances, such as a very strong seller's market, a unique property or heightened demand.
Future value is greater than present value if changing its as-is state results in a broader market for the property. A municipality targets an area in its comprehensive or master plan for future growth, zones it accordingly and plans to extend public services to facilitate development. Investors scramble to control parcels suitable for development and land values spike. Some of these parcels are subdivided and communities of new homes emerge over time. These sell for higher prices than the existing homes. The older homes also increase in value because: (1) the higher prices of the new homes tend to raise the overall value of the neighborhood; and (2) the market for the resale homes now includes more buyers -- those, for instance, who only want to purchase properties that have public utilities.
Value is always relative to use. The price that a buyer is willing to pay for a property is directly proportionate to the ability of the property to satisfy that buyer's needs and wants. The greater the number or categories of buyers who can use the property, the greater the property's inherent value. The real value of any property is ultimately the price that a buyer is willing to pay for it in exchange for the terms and conditions agreed to by the seller. When buying property, think like a seller because some day you will be one. Don't over improve a property relative to the value of its surroundings.
Note: Nancy Chadwick has developed two books about developing land and conducting research as an investor.
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