Six economic principles of real estate valuation

Real estate valuation is the process of estimating a single price that would realistically be paid for owning a particular property. The method for valuing residential properties that is most familiar to brokers and agents, of course, is Comparative Market Analysis (or CMA). This property valuation process involves an estimate of the value based on the sales prices of other similar (or comparable) properties within the local market area and / or other similar markets.

When preparing a CMA, a minimum of three recently sold comparable properties and three currently for sale comparable properties are typically chosen to infer the price of the property in question. Differences between comparable properties and the property in question are evaluated to add or reduce value in the analysis and to estimate a fair market value of the property in question using a comparison approach.

The valuation of commercial properties (i.e., office buildings, apartment buildings, single-family communities, and land) is largely influenced by various economic principles. These principles are generally not included in the typical CMA report for residential properties. The goal of this article is to shed some light on these principles because they can be applied to any property valuation effort. They are the foundation of our focus in this discussion as we analyze and summarize six applied economic principles that can help give you an idea of ​​the impact they can have on a property’s value.

1) Anticipation

This is the expectation of future profits. In other words, real estate investors measure the value of the real estate investment based on the anticipated future income stream generated by the property. They are more likely to value a property based on the income it generates rather than the perceived market value inferred by comparative analysis, or the construction and land costs required to replace the property. The expected or anticipated earning capacity of the asset is the primary focus.

This approach comes as no surprise to those who have some knowledge of commercial real estate investing; However, it is not common knowledge to the average homeowner or buyer. Focusing on buying anticipated cash flows can also help broaden understanding of value in residential properties. For example, instead of thinking “how much the property is worth now,” also think, “how much return would you buy the property and rent later.” In a competitive environment, this approach and knowledge can make a difference.

2) Compliance

This is defined as the need for reasonable similarity and compatibility in a given location. Compatible land uses, for example, can generate higher values ​​than those with limitations imposed on property due to location.

For example, an apartment complex located in a primarily residential area will likely be worth more than one located in a highly industrial area. Savvy commercial real estate investors are interested in this concept, while many residential home buyers may not pay much attention to adjacent or nearby land uses. Taking a broader view of the surrounding uses can provide a deeper understanding of value, or perceived value, from an investment perspective.

3) Supply and demand

This principle encompasses both scarcity and demand for the property in question. Although investment real estate with similar physical and economic characteristics can be sold at similar prices, the valuation of real estate can be greatly affected (higher or lower) within a market that lacks a reasonable balance between supply and demand.

For example, land in a metropolitan area where undeveloped land is scarce would demand more value than land in a rural area with large parcels of vacant land. Likewise, an apartment complex that is sold at a time when there is more than enough supply to meet the rental demand, would have less value to a real estate investor than the same complex during a time when the supply of apartments in the area is smaller and it does not. they do not adequately satisfy the demand.

4) Better and higher usage

This is an important concept that relates to the highest possible use and the best possible use of a property, as opposed to its current use. In other words, when it is legally possible, appropriately compatible, physically possible, and financially feasible to modify the use of a property, the value of the property itself can increase significantly.

For example, an office building can be expanded to add a more profitable office space or a store on the first floor; Or, an apartment complex can add more units or add mixed-use features to the community while enhancing its value.

Commercial real estate investors and developers use this principle to create value and improve cash flow. The principle can also be used in residential real estate when a buyer or owner of a residential property assesses the highest and best use of the land under municipal zoning and building codes, and considers adding or expanding the property’s features and characteristics. to enhance its value. .

5) Contribution

This essentially means that the value of an income property can be affected when it is physically, legally and economically feasible to bring more space to the property at a cost equal to or less than the marginal revenue it generates. That is, when the added value offsets the cost of making the contribution or investment. In contrast to the principle of Maximum and Best Use, this principle compares the income or value with the benefits that the investment or contribution can produce. The question to ask yourself after you have identified the highest and best use of your property is whether the investment or contribution required to achieve the highest and best use of the property makes financial sense or is justifiable. You can add features to a home, such as a pool and deck, and you can add units to a multi-family building; The contribution question is, “Will you be able to sell the house for the added value you perceive you are creating, or will the new apartments be rented?”

6) Substitution

This is an opportunity cost concept. In other words, a rational real estate investor will not pay more for an investment property than the next best substitute with similar levels of risk will yield in financial gain. For the home buyer, homeowner, or investor, this means looking carefully at all other options. Residential home buyers often fall in love with the first or second home they see and can easily miss out on better opportunities as a result. This principle suggests evaluating and comparing numerous opportunities in the market before making a decision.

The six principles mentioned in this article are intended to be an overview, to give you an idea of ​​how other economic factors can affect property valuation. While these principles are demonstrated in commercial real estate valuation, they also affect residential properties and should be considered when analyzing the value of any real estate property.

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