Basics of Valuation

The value of real property can be influenced by many factors, such as location and type of use; however, when appraisers make/render an opinion of market value, they must also take into consideration how typical buyers and sellers are responding in the market. Appraisers emulate what informed buyers and sellers will do in an open market. Therefore, we begin by first reviewing some of the basic concepts of real estate economics that affect how typically informed buyers and sellers respond in an open market, and then reviewing some concepts and principles applicable to the income approach.

Based on observation and analysis of real estate markets, appraisers have developed principles to describe how real estate markets operate. These underlying appraisal principles are important in understanding the foundation of the income approach to value and the actions of typical buyers and sellers in the real property market. Although these principles are individually listed, many of the principles are interrelated or affect the other in determining real property value. Here we discusses the following:

  • Concept of Highest and Best Use
  • Principle of Anticipation
  • Principle of Substitution
  • Principle of Supply and Demand
  • Principle of Change
  • Principle of Conformity
  • Principle of Contribution
  • Principle of Increasing and Decreasing Returns
  • Principle of Balance

Concept of Highest and Best Use

The concept of highest and best use requires that each property be appraised as though it were being put to its most profitable use (highest possible present net worth), given probable legal, physical, and financial constraints. This entails identifying the most appropriate market and the most profitable use within that market.

The highest and best use of a property is the reasonable and probable use that will support the highest present value as of the effective date of the appraisal. The use must be:

  1. Legally permissible:

The highest and best use must be a use that is allowed by government. The property tax appraiser must consider the effect that any enforceable government restrictions, such as zoning regulations, have on the value of property.* However, an improved parcel with land uses that are not permitted under current regulations may have been constructed prior to current regulations. These improvements are recognized as legally (grandfathered) nonconforming uses.

* “Unrestricted” ownership of property is actually subject to the necessary powers and rights of government – local real estate taxation, the power of eminent domain (condemnation, at a fair price), police power (such as building codes, health requirements, traffic regulation, and zoning), title by escheat, and control of air space (at a reasonable height).

  1. Physically possible:

The highest and best use depends on physical factors. The proposed or existing use must fit the size, shape, topography, and other specific characteristics associated with the parcel or location. For example, a use that requires a larger site than the subject property, or needs utilities that are not available to the subject property, should be eliminated from consideration.

  1. Financially feasible:

The highest and best use must not be too speculative. There must be a demand for the use in the market that will generate and sustain sufficient income to cover the costs of construction, to have enough money for maintenance during the economic life of the property, and to provide both a return of and a return on the investment. This can include costs to maintain or improve the remaining economic life. All uses that produce a positive return are regarded as financially feasible.

  1. Maximally productive:

The highest and best use must be the most productive use. Of all the financially feasible uses, the one that produces the highest residual land value (yields the highest net return to the investor) is the highest and best use. For example, if it is physically possible, legally permissible, and financially feasible to construct an apartment complex, an office building, and a restaurant on a particular parcel, but the office building would yield the highest value to the real property, then the office building is considered the maximally productive use.

In general, the proposed use that an appraiser determines would yield the highest and best use from a particular real property must pass all four criteria, or the proposed use (either the current use or an alternate use) cannot be considered the highest and best use of the real property. There are exceptions to this general rule. For example, if a parcel is currently improved with a dry cleaner, but zoning would allow an office building that could yield a higher value, the costs associated with cleaning up the property (remediating the property from any potential contaminates) would be cost prohibitive or cost so much as to leave the current or existing use as the highest and best use.

Unless otherwise stipulated in the scope of work, when appraising an improved property, an appraiser will consider the highest and best use as it is improved and the highest and best use as if were vacant. Highest and Best Use as Improved addresses how an already improved property should be utilized. Highest and Best Use as if Vacant considers, among all reasonable, alternative uses, the use that yields the highest present land value. Any existing improvements can be torn down. In fact, demolition is economically appropriate when the market value of the land as if vacant exceeds the market value of the land as if improved.

A consequence of the concept of highest and best use is the

Principle of Consistent Use – that, for an improved property, both the site and improvements must be evaluated as the same use. This principle is violated when the appraiser seeks to assign a value to the land based on one highest and best use, and a value to the improvements based on a different highest and best use. It is permissible, however, to consider time adjusted highest and best uses where neighborhoods are transitioning from one use to another, usually “higher”, use, recognizing the interim and ultimate highest and best uses.

Principle of Anticipation of Future Benefits

Property is valuable because of the future benefits it is expected (anticipated) to provide. A property’s value may be defined as the present worth of the rights to all prospective future benefits, tangible and intangible, accruing to the ownership of real property. Therefore, investors buy income-producing properties today for the future benefits, or income, that is anticipated they will produce in the future.

One of the responsibilities of an appraiser is to interpret attitudes of persons trading in the real estate market. Thus, an appraiser is obligated to consider both the likelihood of future trends and the impact that such trends will have on buyers, sellers, and tenants, as expressed in present market transactions. For example, changes in anticipated demand caused by off-site improvements in the form of highways, freeways, bridges, schools, and parkways have an important impact on value even though such improvements may be in the planning stage and not visible at the time of the appraisal. Because the present value of real estate depends on expected future benefits, the principle of anticipation requires the appraiser to be fully informed of community affairs and economic changes anticipated in the market area in which the subject property is located.

It is the future, and not the past, with which an appraiser must be concerned. The history of operation of the subject, or like properties in a market area, is important only in ascertaining a trend in anticipated earnings over the remaining economic life or holding period of the property being appraised. Past operations and other than typical management practices may hinder or, in the case of accumulated goodwill, accelerate (at least for a time) income production. Such assets or liabilities of a property must be considered in the measure of present value. For property tax purposes, we are required to measure the full value of the property; that includes good management, maintenance, and typical interaction with the market place.

Principle of Substitution

The principle of substitution states that the upper limit of value tends to be set by the cost of acquiring an equally desirable substitute, assuming no untimely delays. A prudent investor would pay no more for an income-producing property than it would cost to build or purchase a similar property. Likewise, a prudent lessee would not pay more rent than they would pay to rent an equally desirable property.

When several commodities or services with substantially the same utility or benefit are available, the one with the lowest price attracts the greatest demand and widest distribution. In the income approach, value tends to be set by the cost necessary to purchase a property offering an equally desirable income stream. This theory provides the basis for using comparable properties in the income approach to value.

From The Appraisal of Real Estate, the prices, rents, and rates of return of a property tend to be set by the prevailing prices, rents, and rates of return for equally desirable substitute properties. The principle of substitution is found in each of the three approaches (income, comparative sales, and cost) to value.

All properties, no matter how diverse their physical attributes or how varied in geographic location, are substitutable economically in terms of service utility or in income productivity, provided such can be fashioned without undue (costly) delay. When there is a significant delay in acquiring the substitute, the cost of the delay must be taken into consideration; a significant delay, in effect, raises the cost. The principle of substitution is closely related to the economic concept of opportunity cost, which holds that the true cost of an economic choice is measured by the opportunity foregone because of the choice.

Principle of Supply and Demand

Interaction between the supply of goods and the demand for goods establishes both the price and the quantity of goods demanded. Demand, the amount of a good or service that would be purchased at various prices during a given period, is created by a product’s utility and the ability and willingness of people to buy it. Buyers and sellers tend to set the price or value of a good based on the supply of a good and the demand for that good. If the supply of a good is stable, and demand for that good increases, sellers of that good tend to increase the price. Supply in the real estate market takes a long time to create; therefore, if the demand for real estate increases, the price of the real estate will also increase, because the supply of real estate will be slow to adjust.

Principle of Changes in Socioeconomic Patterns

Nothing is static; change is constantly occurring. The principle of change recognizes the dynamic nature of real estate markets. In real estate, change affects not only individual properties, but also neighborhoods, communities, and regions. The effects of prospective change are reflected in the market. Change is fundamentally the law of cause and effect. Individual properties, districts, neighborhoods and entire communities often follow a four phase life span:

  1. Growth: a period during which the area gains in public favor or acceptance.
  2. Stability: a period of equilibrium without significant gains or losses.
  3. Decline: a period of diminishing demand and acceptance.
  4. Renewal: a period of rejuvenation and rebirth of market demand.

The principle of change is closely related to the principle of anticipation. Past income experiences may indicate a certain trend, and present income flow may substantiate this trend; nevertheless, the anticipated future income expectancy may radically differ because of important changes in national, regional, and local business activity of which the real estate market is a part.

Principle of Conformity

The principle of conformity states that maximum value is realized when a reasonable degree of architectural homogeneity exists and land uses are compatible. This principle implies reasonable similarity, not monotonous uniformity, tends to create and maintain value. The highest and best land use is generally realized under circumstances of conformity or harmony. The principal purpose of zoning regulations and private deed restrictions is to maintain conformity.

Principle of Contribution, AKA Principle of Marginal Productivity

The principle of contribution, also known as the principle of marginal productivity, applies the principle of increasing and decreasing returns to property components. This principle holds that the value of a property component is measured in terms of its contribution to the value of the total property rather than as a separate component. Note that the cost of an item does not necessarily equal its contributory value. For instance, it may cost Rs.30,000 to build a pool in a 20 unit apartment complex; however, it may only add Rs.20,000 to the overall value of the complex.

Principle of Increasing and Decreasing Returns

The principle of increasing and decreasing returns recognizes that increments of the agents of production produce greater net income (increasing returns) up to a point (surplus productivity). The point of maximum contribution of the agents in production (point of decreasing returns) attests to the proper combination of agents, resulting in the highest and best use. Any further increase in the amount of the agents of production will decrease the margin between the cost of agents and the gross income they will produce, resulting in a decrease in the proportionate net income returns.

Increasing and decreasing returns applies to the maximum size apartment building that should be placed on a parcel of land. Adding stories to an apartment building may result in property value exceeding costs until the point is reached that the structures must be framed with steel on top of foundation piles driven down to the bedrock. At this point, the added cost, over wood framing on top of a concrete podium, may not result in added value commensurate with the cost – this would be the point of decreasing returns.

A decreasing, or diminishing, return is the proportional decrease in the amount of return as a single element of production is increased, all other factors remaining constant. This Law of Decreasing Returns is also known as the Law of Variable Proportions.

Principle of Balance in Land Use and Development

The principle of balance is closely related to the principle of increasing and decreasing returns; it holds that maximum value is achieved and maintained when all elements in the agents of production are in economic balance. The value of a property depends on the balance of:

  1. Land
  2. Labor
  3. Capital
  4. Entrepreneurship

Land includes the ground, the airspace, and the natural resources found on the surface or in the sub-surface of the earth. Labor includes human work directed toward production—that is, all wages and other operating expenses involving human work. Capital is composed of goods (e.g., equipment and buildings) and intangible assets and rights (e.g., working capital and franchises) used in the production process. Unlike other factors of production, capital must be produced before it can be utilized in the production process. Human capital is the productive power of individuals developed through education and training. Entrepreneurship is the act of visualizing needs and taking the necessary action and risk to produce products that fulfill such needs. In real estate development, entrepreneurship is synonymous with the development function.

Elements both internal and external to a property must be in balance for maximum value to be attained. Internally, the proper combination of land and building is critical to economic balance. Externally, a property should be in balance with surrounding properties. For example, an expensive home built on a low-value lot in a modest neighborhood may not sell for its full cost of production.

Here, we will discuss those assumptions. There are three basic assumptions that are associated with income-producing properties. These assumptions are:

  • Value is a Function of Income
  • Investors will Estimate the Duration, Quantity, and Quality of the Future Income
  • Future Income is Less Valuable than Present Income

If any one of these three assumptions cannot be made about the property being appraised, then the income approach to value should not be used.

Value is a Function of Income

People purchase income-producing property for the income it will return on their investment. It follows then that the value estimate of a property is based on the potential income that the property can produce. To apply the income approach, the property being appraised must be of a type that is commonly bought and sold based on its income stream.

The income a property generates may come from many sources, such as property rents, royalties, amenities, roof rents from billboards, and ground rents from cell towers. The estimate of future income may be based on either an actual or a hypothetical income stream. Rents are, in effect, sales prices for short-term rights to use property. Appraisers apply these short-term sales prices in the income approach to obtain value indicators, which are estimates of the present worth of the sum of all these expected future short-term sales prices. This sum of income may involve a terminating period or go on into perpetuity.

The benefits a property will provide over time must be expressed in terms of money, so the income approach to value is best when used with a type of property that is bought and sold based on its expected income stream such as commercial, industrial, and multi-family properties. These types of properties are typically developed and purchased for the income they provide and are frequently leased to tenants in competitive markets. Although single-family residential properties may also be leased, they are generally purchased to provide their owners with amenity benefits (a place to live) rather than monetary benefits. Consequently, it is often difficult to apply the income approach to single-family residences.

If the income approach is used to value property that provides both monetary and amenity benefits, care should be exercised in converting amenity benefits into value. If the capitalization rate reflects the amenity benefit, a question arises whether the amount of the amenity benefit reflected in the rate equals the amenity benefit in the subject property. For example, a farm may be both a production unit returning monetary benefits and a living unit returning amenity benefits. Because the appraiser is often unable to impute an income to the amenities from the living unit, the capitalization rate is derived from market data that is based only upon the income derived from the farm as a production unit. The capitalization rate will consequently be lower than it would have been had it been possible to impute an income to the amenities and sum the income from both benefits (i.e., monetary and amenity) to obtain a more accurate measure of the true monetary return. Capitalization rates that include both monetary and amenity elements should be used for properties that have amenities similar to those of the properties from which the respective rates were derived.

Again, investors purchase income-producing properties for the income (future benefits) the properties will yield (produce); it is the income the real estate generates, not income that the business generates that appraisers consider. For example, a retail store operated by the property owner involves at least two activities. One is the ownership of the real and tangible personal property, and the other is the business of selling merchandise at the property. It is necessary to determine what portion of the operation’s expected future earnings is attributable to the ownership of the taxable property. If the earnings of the business (after deductions for operating expenses) are capitalized into an indicator of value, the appraiser should be aware that the indicator might contain the value of nontaxable intangible assets and rights. The value of such assets and rights must not be reflected in the value of the taxable property. However, taxable property may be assessed and valued by assuming the presence of intangible assets, or rights necessary to put the taxable property to beneficial and productive use.

Lastly, when valuing a property, appraisers consider not only the Highest and Best Use of the parcel As if Improved (with the existing structure and use), but appraisers also consider the Highest and Best Use of a property As if Vacant. Consideration of As if Vacant assists the appraiser in determining whether the existing improvement or use of a parcel is yielding the highest income the property has the potential to generate. For example, if a single-story automotive repair shop has been operating in the heart of a downtown financial district for decades, the Highest and Best Use As if Vacant for that parcel may be an office building, a multi-story parking garage, a retail/restaurant business, or a combination of businesses.

This concept – that the value of a property is directly related to the income it will generate during the period of ownership, which may be the economic lifetime of the property or may be a lesser period – cannot be stressed enough. If there is no relationship between income and value, the income approach is of no use in the valuation of that property.

Investors will Estimate the Duration, Quantity, and Quality of the Future Income

This second assumption is related to the first, that value is a function of income. Investors recognize that value is a function of income, and, in determining a price for a property, will need to know how much income they will receive, how long they will receive that income (the timing of the income flows), and the risk involved that they will (or will not) received that income.

Potential buyers (investors) of an income-producing property will generally make several determinations before investing a sum of money into a property. They will estimate the quantity, quality, and duration of the future income.

The income approach assumes that the investor in real property will estimate the duration of the income stream and its risk, or likelihood of receipt, when selecting a capitalization rate to value the property.

  1. Duration

Duration refers to the probable period over which the property can be expected to produce the estimated income. For land, the estimated duration of the income stream is usually in perpetuity, but improvements have limited lives. The estimate of the remaining economic life of an improvement (that period of time over which the property will earn a net income above the rent imputable to the land alone) is an important consideration in the income approach. Average life tables have been developed as general guides to estimating remaining economic life. However, a careful study of the structural soundness of the improvements, the degree of functional obsolescence, and the economic and social trends in the neighborhood and community should serve as the primary basis for this estimate.

  1. Quantity

Quantity of income refers to the amount of income (rent) per year the investors can receive.

  1. Quality

Quality of income is the amount of risk that is associated with the investment. The risk of an income stream refers to its certainty; that is, how likely it is that the investor will receive the income. The greater the uncertainty of the income, the greater the risk; consequently, the income should be capitalized using a higher capitalization rate. Not all investments are subject to the same level of risk, and as such, not all income streams should be capitalized at the same rate.

Future Income is Less Valuable than Present Income

The third assumption of the income approach is that future income is less valuable than present income. The concept of present value is essential to understanding the income approach to value; it provides that the sum of the present worth of the future income payments is always less than the undiscounted sum of these future payments.

This concept is one of the most important in valuation. Because investors prefer immediate returns to future returns, they “discount” future returns, or reduce their value, when analyzing investments. Because of the time value of money, this is true even if no risk is involved. A rational investor would not pay Rs.1,000 today for the certain right to receive Rs.1,000 one year from now because they could earn interest on the Rs.1,000 during the year, with the result that the total value would accumulate (at the risk-free rate of interest) to an amount greater than Rs.1,000 at the end of the year. To the rational investor, a certain payment of Rs.1,000 a year from today is worth something less than Rs.1,000 today, with the amount of the discount determined by the risk-free rate of interest.

An illustration of this concept is can be found in any lottery – how many winners take payment in graduated installments, and how many, instead, chose the cash value of their jackpot prize – how many would rather have the money now. An old English proverb goes, “A bird in the hand is worth two in the bush.”

The present value is the amount which, when compounded periodically (usually annually) at a given rate, will accumulate to the future amount. For example, Rs.1,000 due one year from today has a present value of Rs.909.09 if the annual interest rate is 10 percent (Rs.909.09 x 1.10 = Rs.1,000).

The process of discounting a series of annuity payments, or any future payment, in order to obtain the present value of this income, is the basic theoretical underpinning of income capitalization. This concept and the use of factors to convert annuities into value by using the compound interest tables was discussed in the mandatory Time Value of Money – Six Functions of a Dollar Self-Paced Online Learning Session the participant was required to successfully complete prior to starting this learning session.

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