Real Estate Valuation Flashcards
In this chapter, we’ll go over the physical and economic characteristics that help appraisers, real estate agents, and the average consumer make judgments about what a property is worth.
The value of land is tied to the unique characteristics that set it apart from other commodities. A commodity is a product that can be bought and sold. The physical characteristics that make land or real estate a distinctive commodity are:
Immobility
Durability (indestructibility)
Uniqueness (non-homogeneity)
Does this sound familiar? We talked about these characteristics way back in the very first level. But let’s do a quick review with an eye toward putting a valuation on land.
Immobility
While it is true that some parts of what we usually call “land” can be removed, such as soil or plants, a parcel has a particular geographical location that remains constant, barring erosion or slow, geological changes.
The actual land itself – the tract or lot that an individual purchases – is immovable. Nobody’s loading an entire slice of earth, down to the molten core, into a pickup truck and driving it across town. This characteristic is called immobility.
Durability or Indestructibility
Indestructibility, or physical durability, refers to the permanence of land. While its economic value and surface appearance may change, land itself is indestructible for all practical purposes.
Land can’t be destroyed, and it doesn’t wear out. There is no “usable life” to land. Even if you let it get overgrown, poison it with toxic chemicals, or blast a giant hole in it, it’s still there, and could still potentially have value.
Uniqueness or Non-homogeneity
The physical location of a lot or parcel is an integral feature of its identity. Because land occupies a specific site that no other piece of land may also occupy, it is unique unto itself and not interchangeable with an exact substitute.
Non-Fungible Commodity
Because of its uniqueness, land is said to be a non-fungible commodity.
What does fungible mean? Is it a kind of mushroom? No, Anthony, fungible just means something that can be exactly replaced by another item. No two tracts of land are exactly alike because no two lots can occupy exactly the same space. Each parcel of land is an object that has no precise equal or substitute.
Even in a subdivision where each neighboring parcel of land had the exact same house built on it, and even if they were both priced exactly the same, they’re not exactly the same (and not fungible), because they occupy two different points in space.
Physical Characteristics
The value of a property depends in part on the purpose it serves. A property’s highest and best use is achieved when the property is used for the most appropriate purpose and yields its highest possible returns.
Appraisers determine whether a property is serving its highest and best use by considering the zoning regulations, size of the lot, deed restrictions, and potential value of the property if it were to be used for something else (such as if a commercial building were used as a single-family residence, etc.).
Assemblage
Sometimes property is most valuable when combined with the neighboring property via the process of assemblage. The larger parcel is then worth more than the sum of its parts. Isn’t that sweet? 😄
Plottage is the increase in value by successful assemblage.
Assemblage 👉 the act of combining parcels
Plottage 👉 the resulting increase in value
Assemblage Example
How about an example? In this illustration, you can see two neighboring properties that are worth $200,000 each. Through the process of assemblage, the two properties are combined into one larger property.
Two properties being combined into one property through assemblage and therefore increasing the overall value.
The previous combined value of the two smaller properties was $400,000 ($200,000 + $200,000). But after the assemblage, the resulting mega-property is worth $450,000. That $50,000 increase in value – without any increase in square footage – is plottage.
Highest and Best Use
Land also has economic characteristics that set it apart from personal property. They are:
Scarcity
Situs
Modification
Fixity
Illiquidity
Let’s talk about them!
Scarcity
Although good, usable land may be physically scarce in the world, this is not what the term “economic scarcity” describes. Economic scarcity is created solely by demand for land in particular areas.
Like all commodities, land is most valuable when it is in short supply and in high demand, and some land is more desirable than other land.
Think about it this way: The economic scarcity of land changes over time, even if the physical amount of available land does not change. That’s because a particular area increases or decreases in demand.
Land in densely populated cities or on tropical beachfronts is scarce. However, this economic scarcity is due to the high demand for land in that particular geographical region, NOT because some catastrophe destroyed large parcels of earth.
EXAMPLE
Let’s say you live in a very small town but decide to move to Chicago. When you move, you find that property prices in downtown Chicago are much higher than they were in your hometown. This is partially due to scarcity.
Technology and Scarcity
Technology can also affect the economic scarcity of land.
For example, new farming techniques may make food production possible on previously unusable land. In this case, farmers would be eager to purchase the land in order to grow more crops. This could make previously useless land become economically scarce, even if there is the same physical quantity of land as before.
Scarcity = Value
The scarcity of land that is in high demand makes the selling price rise. However, the inverse is also true.
For example, consider the plight of a small town that has lost its primary job provider. As a result, many people move away due to a lack of job opportunities. Businesses close and homes sit empty because no one wants to live there. Many properties are up for sale and the scarcity is gone. This lack of demand for the area means prices will fall.
Land’s Economic Characteristics
The desirability of a location, known as situs, is an economic preference for a particular location (not a geographic one). The popular real estate phrase, “location, location, location,” is referring to the preferences people have for certain areas.
EXAMPLE
A buyer wants to move from a rural area to a home in a nearby city because the city has a strong local economy with plenty of job opportunities. This buyer is influenced by situs.
Modification Modification (also known as alteration) refers to the fact that the value of land can be affected by human-made changes to the land. Modifications often affect situs. If the city decides to build a park in a particular zip code, then the houses that border that park will probably appreciate in value. This is also true if the city decides to add a train stop near a neighborhood. The economic value of land depends on how heavily it is developed, altered, and modified by buildings and other developments.
EXAMPLE
Consider Orlando, Florida: After the construction of Disney World®, the farmlands that surrounded the theme park suddenly appreciated in value. People desired the land for new hotels and homes for people who worked at the park, and for businesses to serve the amusement park workers, etc.
Put simply: Human-made changes (modifications) can and will affect the value of land.
Situs and Modification
Let’s finish out our discussion on land’s economic characteristics by discussing fixity and illiquidity.
Fixity
Fixity refers to the fact that real estate exists in a fixed location and cannot be moved. (This economic characteristic is very similar to the physical characteristic of immobility.) Fixity describes this truth about land (it can’t be moved) from an economic viewpoint.
Illiquidity
Illiquidity is the relative difficulty of converting an asset to cash without loss of value. This is relevant because it requires investors to think long-term about investing in real estate. You can’t easily get cash out of the investment, and you can’t quickly sell it off if you sense the market turning (like you could with stock, for example).
EXAMPLE
You own a property that appraised at $250,000. Given the right amount of time, you would probably be able to sell it for that amount. However, if I told you that you HAD to sell the property by end of the day tomorrow, you’d have to drop the price significantly to get someone to commit that quickly.
It takes time to convert property into cash, and to rush the process, you would likely have to drop the price (and lose value).
Land’s Economic Characteristics: Wrapping Up
When you think of valuable things, dust is probably the last thing that comes to mind. But DUST is a pretty handy acronym used in the real estate biz to help us remember the four characteristics that make real estate valuable:
Demand
Utility
Scarcity
Transferability
Demand
This is an obvious component of value. If no one wants the property, it’s not valuable. The more demand there is for something, the more value it has.
Utility
Properties need to be useful or serve some kind of purpose in order to have value. Utility is more apparent on some properties than others. An empty lot, for example, may not look like it has much utility, but to a buyer who wants to build a custom home in that area, it’s quite useful!
Scarcity
If you woke up one morning and all the rocks in the world had turned into diamonds, diamonds wouldn’t be quite as valuable, would they? The same thing happens when too much of a certain type of property is available on the market. But when real estate is scarce, it grows in value.
Transferability
How valuable is property that no one is able to buy? Not very. Whether it’s government rules or a title issue, anything that limits the transferability of real estate makes it less valuable.
DUST: The Four Characteristics of Value
Okay, so now you know what makes property valuable. But what do we actually mean when we use the term “value”? Some people use the terms cost, value, and price interchangeably, but they’re not the same in the world of technical real estate terms. This level is mostly focused on value, but before we go any further, I want you to know the subtle differences between these words.
Cost is the amount of money required to buy, build, or develop something. It’s not taking much context into consideration, only the literal cost of acquiring or making something.
Value, specifically market value, is the price for which a property will theoretically sell under typical conditions.
Price is the amount a ready, willing, and able buyer agrees to pay (and a seller agrees to accept) for a property.
Chart showing the differences between cost, value, and price and how they apply to a home.
Image description
Ready to make things a lil’ more complicated? I know you can handle it, Anthony. There are two different kinds of prices:
Market price is the actual open market price paid in a typical transaction that occurs under normal conditions. Think of it as the realistic counterpart to market value. Market value predicts what a probable price would be, and market price reports the actual price paid. These figures shouldn’t be too different from each other.
Price, on the other hand, is the amount a ready, willing, and able buyer agrees to pay (and a seller agrees to accept) for a property. The difference between price and market price is that a price doesn’t have to result from normal market conditions. The circumstances of the sale could cause the price to deviate from the expected market price.
Cost
Cost is the amount of money required to buy, build, or develop something. It’s the total dollar expenditure for labor, materials, legal services, architectural design, financing, taxes during construction, interest, the contractor’s overhead and profit, and the entrepreneurial overhead and profit.
The cost of a property may or may not equal the value of that property.
Direct and Indirect
To break it down a little further, costs can be sorted into two different categories:
Direct costs are the costs of labor and materials. You may also hear these referred to as hard costs.
Indirect costs are costs associated with a construction project, NOT including labor or materials. We’re talkin’ architectural and engineering fees, professional fees (such as the ones charged by appraisers), financing costs, lease-up costs, administration, filing fees, etc.
Scenario: The Appraiser
A developer builds a home for a total of $200,000. That is the cost. If material and labor costs were $150,000, those are the direct costs. The other $50,000 were spent on architect fees, financing, permits, etc., which are the indirect costs.
An appraiser comes and appraises the house for $250,000. That is the value. Remember, the appraiser is attempting to determine the home’s current market value.
A buyer then pays $275,000 for the property. That’s the price. Since it was paid under normal conditions, it’s also the market price. Make sense?
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Differences Between Cost, Value, and Price
The appraised value and the assessed value are two different but very important kinds of value. Let’s talk about each one and what differentiates one from the other.
Appraised Value
The appraised value of a property is the value determined by a licensed real estate appraiser. Before most real estate purchases, the buyer (or lender, if financing is involved) will choose a licensed appraiser to appraise the property.
We talked about this a few screens ago, but just to reiterate: only licensed appraisers can give an appraised value, or appraisal.
What the appraiser will seek to estimate is the market value of the property. So the two terms “market value” and “appraised value” can be a bit tricky. Just remember that market value is a theoretical concept, and appraised value will be a number on an actual appraisal report.
Assessed Value
The assessed value is the value placed on a property by a governmental unit for use in calculating property taxes.
Property taxes are ad valorem taxes, which means “according to value.” For this reason, tax authorities must assess properties in order to determine how much owners owe in taxes.
Taxes are based on the assessed value of the property, NOT the price that the homeowner paid for it.
Market vs. Appraised vs. Assessed
You just learned a lot of values, Anthony! Let’s recap:
Market value: This is the price for which a property will theoretically sell under typical conditions. This refers to the economic principle; it’s the price that a buyer and seller would probably accept.
Appraised value: This refers to the value determined by a licensed appraiser, usually during the mortgage origination process.
Assessed value: This refers to the value placed on a property by a governmental unit for use in calculating property taxes.
Types of Value Chart
Here’s a handy image to help you compare these three types of value.
Chart summarizing market, appraised, and assessed value.
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Appraised and Assessed Value
There are even more types of value! Check ‘em out:
Taxable Value
This is the value placed on a property by a governmental unit for use in calculating property taxes, minus any exemptions. Assessed value - Tax exemptions = Taxable value.
Investment Value
Investment value is the highest price an investor would be willing to pay for a property based on how well it will serve their investment goals.
Insurable Value
Insurable value the highest value for which a property can be insured. It’s generally equal to the replacement cost of the structure and NOT the land value.
Insured Value
The insured value is the value of the actual insurance policy on the property.
Mortgage Value
The mortgage value is the value of an asset in the context of securing a mortgage loan.
Actual Cash Value
The actual cash value is the depreciated value of a property — we’ll talk more about depreciation and value in another level.
Value-in-Use
Value-in-use is the current worth of the future benefits of ownership.
Condemnation Value
The condemnation value is the value of a property according to the condemning authority in an eminent domain proceeding.
Salvage Value
Also known as residual value, the salvage value is the value remaining at the end of a piece of property’s useful economic life.
Other Types of Value
There are even more types of value! Check ‘em out:
Taxable Value
This is the value placed on a property by a governmental unit for use in calculating property taxes, minus any exemptions. Assessed value - Tax exemptions = Taxable value.
Investment Value
Investment value is the highest price an investor would be willing to pay for a property based on how well it will serve their investment goals.
Insurable Value
Insurable value the highest value for which a property can be insured. It’s generally equal to the replacement cost of the structure and NOT the land value.
Insured Value
The insured value is the value of the actual insurance policy on the property.
Mortgage Value
The mortgage value is the value of an asset in the context of securing a mortgage loan.
Actual Cash Value
The actual cash value is the depreciated value of a property — we’ll talk more about depreciation and value in another level.
Value-in-Use
Value-in-use is the current worth of the future benefits of ownership.
Condemnation Value
The condemnation value is the value of a property according to the condemning authority in an eminent domain proceeding.
Salvage Value
Also known as residual value, the salvage value is the value remaining at the end of a piece of property’s useful economic life.
Let’s move on to economic principles that affect the value of land, but aren’t exclusively related to land.
These next few screens will cover principles that affect how real estate is valued. These are important concepts to know if you want to have a solid understanding of how and why property is valued the way that it is.
They’re called the economic principles of value, and they are:
Principle of anticipation
Principle of contribution
Principle of substitution
Principle of change
Principle of conformity
Principles of regression and progression
Principle of competition
Let’s look at each of these, one at a time.
Principle of Anticipation
The principle of anticipation is the idea that the present value of a property is affected by the anticipated income or utility that property will give its property owner.
EXAMPLE
An investor buys a house for a little more than its current market price because they believe the house will increase in value due to the new corporate headquarters opening in the neighborhood. The investor’s anticipation of the future price affected the property’s current market value.
Principle of Contribution
A property’s overall value is made up of the combined value of each of its parts. The value of each component contributes to the total value. This is the principle of contribution.
One important thing to know about this (especially if you are a seller’s agent) is that the contributory value of an item is not always equal to the cost of that item. So for example, spending $20,000 on a pool won’t necessarily add $20,000 to your home’s value. It could be that in your area, a pool only adds $10,000 in value. That’s why it’s important for homeowners to think about the value they’re adding (or not) before undertaking costly renovation projects.
Principles of Value
The principle of substitution is present in practically all markets, not just real estate. This principle states that the value of something is affected by the cost of getting a similar (substitute) item elsewhere. If there are two restaurants in your neighborhood that sell equally amazing pizza, the principle of substitution suggests that Wise Pies should not charge more than Nice Slice for the same quality pizza. 🍕
A lot of factors make the appraisal or valuation process more complicated than following this simple principle, but it still informs us that similar properties should have fairly similar values.
Principle of Change
The principle of change reminds us that the condition of a property, the desirability of its location, and the market in which it exists can always change. Any change could affect the value of the property, which is why appraisals are only good (acceptable to lenders) for a few months. An outdated appraisal may not reflect important zoning changes, damage to the building, or changes in the housing market.
Principle of Conformity
Ever wonder why houses in any given neighborhood all tend to look alike? Sure, they probably match whatever architectural style was popular when they were built, and they were probably built by the same company. But aside from that, you’ll learn that there is a principle of conformity that says values are highest when the houses in a neighborhood look roughly the same. Value suffers when a house is much nicer, much worse, or just plain weirder than the other houses on the block.
Note: Another way of stating the principle of conformity is that maximum value is realized when land use is in harmony with surrounding standards.
Principles of Regression and Progression
The tendency is for houses in a neighborhood to be fairly close in value, but the presence of higher or lower value homes can change the value of a nearby subject property.
Principle of Regression: When lower-value properties surround a subject property, they can drag down the value of that property via the principle of regression.
Principle of Progression: If a subject property is located among properties that have a higher value, that can bump up the subject property’s value because of the principle of progression.
Principle of Competition
The basic economic concept of supply and demand has an effect on the value of real estate.
When supply is low (not many available houses) and demand is high (lots of people who want to buy houses), prices increase.
When supply is plentiful (lots of houses for sale) and demand is low (few potential buyers), prices drop.
The supply and demand, or level of competition in the market, helps determine the value of a property.
Principle of Substitution
Principle of Substitution
The principle of substitution is present in practically all markets, not just real estate. This principle states that the value of something is affected by the cost of getting a similar (substitute) item elsewhere. If there are two restaurants in your neighborhood that sell equally amazing pizza, the principle of substitution suggests that Wise Pies should not charge more than Nice Slice for the same quality pizza. 🍕
A lot of factors make the appraisal or valuation process more complicated than following this simple principle, but it still informs us that similar properties should have fairly similar values.
Principle of Change
The principle of change reminds us that the condition of a property, the desirability of its location, and the market in which it exists can always change. Any change could affect the value of the property, which is why appraisals are only good (acceptable to lenders) for a few months. An outdated appraisal may not reflect important zoning changes, damage to the building, or changes in the housing market.
Principle of Conformity
Ever wonder why houses in any given neighborhood all tend to look alike? Sure, they probably match whatever architectural style was popular when they were built, and they were probably built by the same company. But aside from that, you’ll learn that there is a principle of conformity that says values are highest when the houses in a neighborhood look roughly the same. Value suffers when a house is much nicer, much worse, or just plain weirder than the other houses on the block.
Note: Another way of stating the principle of conformity is that maximum value is realized when land use is in harmony with surrounding standards.
Principles of Regression and Progression
The tendency is for houses in a neighborhood to be fairly close in value, but the presence of higher or lower value homes can change the value of a nearby subject property.
Principle of Regression: When lower-value properties surround a subject property, they can drag down the value of that property via the principle of regression.
Principle of Progression: If a subject property is located among properties that have a higher value, that can bump up the subject property’s value because of the principle of progression.
Principle of Competition
The basic economic concept of supply and demand has an effect on the value of real estate.
When supply is low (not many available houses) and demand is high (lots of people who want to buy houses), prices increase.
When supply is plentiful (lots of houses for sale) and demand is low (few potential buyers), prices drop.
The supply and demand, or level of competition in the market, helps determine the value of a property.
More Principles
All good things must come to an end, Anthony. So it is with life, and so it is with this chapter. But before you go, let’s review some of the important terms, concepts, and principles you’ve learned along the way.
Key Terms
Here are the key terms you learned in this chapter:
appraisal
an official valuation given to a property by a licensed appraiser
appraiser
an individual who is trained and licensed to perform appraisals, which estimate the value of real property
appreciation
the increase in value of a property
assemblage
the combining of multiple contiguous pieces of real property into a single tract of land, resulting in an increase in value
assessed value
the value placed on a property by a governmental unit for use in calculating property taxes
contribution
the amount of market value added to a property by an addition or improvement to the property; not necessarily the same as the cost of the improvement
market value
the price for which a property will theoretically sell under typical conditions
plottage
the increase in overall value resulting from the successful assemblage of multiple plots
substitution
an economic principle stating that the value of a good or service is affected by the cost of getting a similar (substitute) item elsewhere
taxable value
the value placed on a property by a governmental unit for use in calculating property taxes, minus any exemptions
value
the price for which a property will theoretically sell under typical conditions
Key Concepts & Principles
Here are the concepts and principles you’ll want to master from this chapter.
Physical Characteristics of Real Estate
Immobility: can’t be moved
Durability (indestructibility): can’t be destroyed
Uniqueness (non-homogeneity): no two parcels are the same
Assemblage and Plottage
Plottage is the increase in value by successful assemblage.
Assemblage 👉 the act of combining parcels
Plottage 👉 the resulting increase in value
Economic Characteristics of Real Estate
Chart summarizing the economic characteristics of land, which include, scarcity, situs, modification, fixity, and illiquidity.
Image description
Characteristics of Value (DUST)
Demand: people want the property
Utility: the property can be used
Scarcity: less available property means it’s worth more
Transferability: property must be able to be sold to be of value
Value, Price, and Cost
Value, specifically market value, is the price for which a property will theoretically sell under typical conditions.
Price is the amount a ready, willing, and able buyer agrees to pay (and a seller agrees to accept) for a property.
Cost is the amount of money required to buy, build, or develop something. It’s not taking much context into consideration, only the literal cost of acquiring or making something.
Types of Value
The types of value, who determines them, and what they’re used for:
Chart summarizing market, appraised, and assessed value.
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The Economic Principles of Value
Chart summarizing the economic principles of value.
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Chapter Summary
