The Principles Of Property Valuation

  • 1. Supply and Demand - Physical, Economic, Government, and Social are the four forces that influence demand. The abbreviation makes it easier to remember as PEGS.
  • P = Physical

  • E = Economic

  • G = Government

  • S  = Social

Physical refers to the actual physical property for sale and how appealing it is to potential buyers.   The more appealing, the more potential buyers there are. Economic refers to the economic conditions in the area where the property is located. Government refers to the Federal, State and local government situation in that area. For example, perhaps the city politicians are planning to build an airport, or a huge garbage dump or waste disposal facility near the subject property. Obviously this will have a negative affect on the demand to buy that real estate. If the property is located in an excellent school district, this will increase demand from potential buyers. Social refers to the social conditions of the area around the subject property. For example, is the house located in a desirable community that typical buyers would want to live in?

Effective Demand is the desire for new housing plus he income potential to buy the new housing. For example, there are millions of people who would like to buy a large house overlooking the ocean. You could therefore conclude that the demand for large houses overlooking the ocean is extremely high. However, this doesn't mean that the market value of these houses suddenly shoots sky high because it is not an effective demand. Meaning that even though there are millions of people who have the desire to buy these houses, effective demand is measured only by the people who actually can afford these houses and who want to live in that particular area where the subject property is located.

The supply and demand are very important principles in estimating the market value of real estate. You relate it to the supply of houses for sale that the subject property is competing with. If there are many houses for sale in the area, then the market values will drop because there is too much supply. Supply is also called standing stock and is inelastic. This phrase "inelastic" is used because you can't build houses very quickly to meet a sudden increase in demand for them. Demand analysis can refer to whether people are moving into or out of the area. If an area has become undesirable, then the market values and sales prices of the homes will decrease due to a lack of buyers. Also, is it Effective Demand where the potential buyers have enough money and the desire to purchase the houses in the area.

  • 2. Highest and Best Use - there are four forces that influence H&B Use, which in turn have an affect on the market value of real estate. These four are discussed in more detail in the Highest and Best Use section.
  • Physically Permissible

  • Legally Permissible

  • Appropriately Supported(access to it)

  • Economically Feasible

See section The Highest And Best Use for more details and explanations of these factors.

  • 3. Substitution - the opportunity cost of making one investment decision over another has an affect on the market value of real estate. It's the choice someone has to make between different investment options.      The Principle of Substitution is an alternative course of action open to a purchaser. The purchaser's alternative is to buy another property or investment with the same utility and depreciation as the subject property. This is the basis for the Direct Sales and Cost Approaches to estimate market value. It can also apply to the Income Approach to estimate market value. For example, let's say there's an area that has very similar designs of houses that are relatively all the same age. What if all of the houses in the area are on the market for sale at $200,000 and one house is on the market for $250,000. Then the chances of that seller getting the higher price of $250,000 is unrealistic. The reason for this is that the typical buyer would purchase a similar and competitive house in the area for the $200,000 sales price.
  • 4. Marginal Productivity - the different contributions made to an investment by its aspects. In terms of real estate, adjustment amounts are made for the pluses and minuses of a property to account for the marginal productivity. For example, there may be something about the subject property that is more appealing to buyers than other properties for sale in the area, such as a swimming pool. The appraiser will need to make a plus adjustment in their report for this to increase the estimated market value of the house.
  • 5. Variable Proportions - the increasing and decreasing rate of returns. This refers to the law of diminishing returns for any improvements made to a property. For example, let's say you have to spend $15,000 to make repairs to a house. Then how much will the value of the house increase when the work is finished? From an appraisal standpoint the normal rate of return for repairs should be at least one-to-one. This means that for each $1.00 you spend in repairs and improvements; you should increase the value of the property by at least $1.00. So using our example, if you spent the $15,000 then the market value of the property should increase by at least $15,000. If it doesn't, then your rate of return on your invested money will diminish or decrease. This will lower the estimated market value of the property.
  • 6. Change - the real estate market is always fluctuating due to the physical, economic, government, and social conditions (PEGS). This change is reflected in the four stages which make up the lifecycle of a neighborhood.
  • Growth

  • Stability

  • Decline

  • Renewal

The Principle of Change is reflected in the lifecycle of a neighborhood. This means neighborhoods can change over time. The area may go through a period of growth during good economic times. Then the area will be stable for several or many years. Then the conditions could change and the area may start to decline. When the conditions change again, the area may begin a renewal process to complete the cycle.

The neighborhood where a property is located is crucial to the appraisal report. This is important because of the affect the external aspects have on the market value of a property. Every property takes on the characteristics of its neighborhood. As a result, if the neighborhood is in decline, then the property values will decline as well.

  • 7. Anticipation - the value of an investment at the end of a certain period of time is what an investor is interested in. This is also known as appreciation which is the gradual increase in market value of a house or asset. This is mainly more important for income producing properties. However, all homeowners want their properties to appreciate in value over time. The Principle of Anticipation is the basis for the Income Approach to estimate market value. It's the present value of future benefits for an investment. For example, if an investor is purchasing an income producing property, he's going to determine his purchase price based upon anticipated future profits in the deal.
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