Valuation and Financial Analysis >> Principles of Valuation
Principles of Real Estate Value
What is Valuation
Valuation is the process of estimating market value. A property's market value is the most probable price a property will bring on the open market in an arm's length transaction between knowledgeable buyers and sellers.
Valuation principles are the forces and characteristics that affect the value of real estate. External market forces drive property values as well as an individual property's characteristics. The more a property complements its environment and surrounding land uses, the greater will be its value. However, these factors are ever changing and must be continually reassessed to estimate a property's price at any given point in time.
Supply and Demand
As with any market, the forces of supply and demand are the determinants of property values in a given market place. Factors that influence property owners to list real estate for sale affect supply. Forces that encourage investors to buy real estate or drive businesses to look for commercial properties for lease affect demand.
Markets give rise to competition. Competition among property owners, real estate buyers, or tenants affect property values and leasing rates. Greater competition among suppliers works to discipline real estate values. Greater competition among buyers or tenants drives real estate prices up.
The availability of substitutes affect real estate values. If a buyer or tenant has two equally suitable properties to choose from, the property with the lower price will be more attractive. Therefore the availability of substitutes puts downward pressure on property values.
Real Estate Markets are dynamic and cyclical. Sellers, buyers and tenants continually enter and exit the market. The factors that drive them continually change. For this reason, a real estate value is only good at a certain point in time when all factors are considered to remain the same. This condition of all factors remaining the same is also known as ceteris paribus, that you may recall from studying supply and demand curves.
Highest and Best Use
The principle of highest and best use is the idea that the use of a property that produces the greatest net return over time will generate the greatest value for that property. A property may have many different possible uses that range from a dental office to a fast food restaurant, but the use that yields the greatest return will justify the highest price.
For example, a fast food restaurant may generate greater revenue and profits from a highly visible and accessible corner location than other businesses. With a high traffic count, the restaurant could be justified in paying a higher price for the location. The location might be great for the neighborhood dentist, but the location would yield a smaller return. The dentist couldn't justify paying the higher price than the fast food restaurant would pay, especially since dentists don't have very many impulse buyers.
What characteristic or amenities a property has should depend on how each contributes to the overall value of the property. A property's feature should be evaluated by its ability to address a need or preference that increases the entire property's value and appeal to the market. As an example, imagine an office in Las Vegas with no air conditioning. Adding an air conditioning system would greatly increase the office's appeal, rental price, and overall property value.
Diminishing Marginal Returns
Diminishing marginal returns is the principle that initial improvements on a property greatly improve the property's value. However, at a certain point, additional improvements on a property increase its value less and less. At a certain threshold, continued investment in a property will increase property value very little, and may not be justifiable.
Returning to our office in Las Vegas. We may continue to invest by adding better insulation to save on energy costs and stay cooler. This may increase the property's value a little more, but not as much. However continued investment by adding a second or third air conditioning system and more and more insulation to the same office would probably not do much to increase the property's value.
The better a property fits in its environment, the greater will be its value. The principle of conformity states that a property's value increases the more it conforms to its surroundings and complements the needs and values of the surrounding area.