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Property Valuation: Definition & Principles

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  • 0:03 The Value of DUST
  • 1:25 Property Principles
  • 4:52 The Property Life Cycle
  • 5:33 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Valuing property accurately is very important to sellers, home purchasers, lenders, and real estate investors. In this lesson, you'll learn about property valuation and some of its key principles.

The Value of DUST

Real estate sellers, buyers, and lenders need be able to determine the worth of real estate in order to make good financial decisions. Property valuation is the process which determines the economic value of real estate.

Property valuation typically seeks to determine fair market value, the price at which a knowledgeable seller willingly sells her property and a knowledgeable buyer will willingly purchase it. In other words, it assumes both parties have all the relevant information and neither are forced to buy or sell. Fair market value is not always equal to the sales price. For example, a short sale of real estate may not bring fair market value because the seller is distressed and must sell the property right away. Potential buyers know this so they have a bargaining advantage and usually get the property for less than market value.

Property valuation lies upon four foundational pillars. Demand, the first, is the magnitude of interest and buying power in the market for purchasing property. Utility, the second, is the ability of the real estate to satisfy the use or need of prospective purchasers. Scarcity, the third, recognizes that there's a limited supply of real estate. Transferability, the fourth, refers to the ease at which a parcel of real estate can legally be transferred to a new owner. Many people use the acronym DUST to help remember these four important concepts.

Property Principles

Let's explore principles that are commonly used to help determine property value. The principle of conformity states that real estate whose use and style conforms with property in the immediate area usually has a higher value than property that doesn't. The principle of change recognizes that various forces act upon and change the real estate market and property values. For example, pollution that spills into a residential neighborhood is an environmental change that would lower property values.

The principle of substitution is simply the ability of one piece of real estate to be an acceptable substitution of another. For example, if three-bedroom ranch homes in your neighborhood are selling for $200,000, you're not going to get much more than $200,000 for your own three-bedroom ranch home if you sell it. This is because buyers can substitute your house for another one for that price. The principle of supply and demand states that if supply of real estate exceeds demand, prices will go down, but if demand exceeds supply, prices will go up.

The principle of highest and best use states that property will get the best price when it is being used in a way that produces the highest economic value. For example, a single-family home in an industrial area is not the highest and best use of the real estate because an owner can get a better return by using the property for commercial use. Remember, most people don't want to buy houses in the middle of an industrial park.

The principle of progression dictates that neighboring higher value real estate can pull up the value of lesser value property in the same area. In other words, the worst house on the block is worth more just because it's around the best houses in the neighborhood.

The principle of regression is the inverse of the principle of progression. If a high-valued property is surrounded by lower-valued property, the price of the higher value property tends to be pulled down. The principle of contribution involves determining how each component of the real estate contributes to its overall value. For example, consider a residential lot with a house and pool. We can consider the land, the house, and the pool as separate components that add to the overall value of the real estate.

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