Shawn has a masters of public administration, JD, and a BA in political science.
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.
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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The principle of anticipation involves assessment of the parcel's future potential. For example, vacant land that's right next to a growing part of a vibrant city has more value than land next to a desolate part of the same city. The principle of competition relates to supply and demand; the more competition there is for a particular type of property, such as residences or retail spaces, the higher the price will be.
The principle of balance relates to the best use of land. Land that's either under-improved or over-improved may create problems. For example, building a 4,000-square-foot ranch house on a 4,500-square-foot lot is an over-improvement that may actually diminish the value of the property. On the other hand, placing a two-bedroom, 900-square-foot house with a single stall garage on a four-acre estate is an under improvement. Balance is making the highest and best use of the land.
The principle of increasing and diminishing returns is related to the principle of balance. Improving real estate increases its value up to a point, but eventually improvements may offer diminishing returns on the investment. For example, if you over-improve a house in a low-income neighborhood, your improvements may not increase the house's sale price because buyers for homes in the area may not be able to afford a more expensive property.
The Property Life Cycle
Other factors which determine property value are dictated by the principle of four-stage life cycle. The four stages are:
Growth: a period of new construction
Stability: a phase when the real property undergoes little improvement, or even deterioration
Decline: a time when maintenance increases to prevent deterioration of the property
Revitalization: an interval when a piece of real estate may be renovated and updated
If a property is not maintained, its effective age, which is based on the physical condition of the property, may be greater than its chronological age, which is based on the date it was acquired or built. Revitalization can make the property's effective age less than its chronological age.
Property valuation is the process of estimating the economic value of real estate. Four foundations of valuation include demand, utility, scarcity, and transferability. Many principles are applied to help guide valuation, all of them related to attributes, use of, and changes to the real property and its neighborhood as well as fluctuations in the real estate market. The four-stage life cycle of property includes growth, stability, decline, and revitalization.
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