The Six Economic Principals of Real Estate Valuation

real estate valuationReal estate valuation is a process used by real estate analysts to estimate a single price one would realistically pay to own a particular property.

The method most familiar to real estate professionals, of course, is the comparative market analysis (or CMA).

In this case, real estate valuation involves an estimate of value based upon the sale prices for similar other properties in the local market area.

Namely, the real estate analyst chooses which sales are best to use to infer price of a particular property, identifies price-affecting characteristics that differ between sales and subject property, then estimates the dollar value of those differences to subsequently value the subject based upon those adjusted sale comparisons.

What is not frequently understood, however, concerns the focus of our discussion. That real estate valuation of residential and commercial real estate (i.e., office buildings, apartment buildings, and plots of land) are ultimately based upon the principals of economics.

So in this article, we’ll look at and summarize six of these applied economic principals to give you an idea of the impact they have on valuation of real estate.

1) Anticipation

This is the expectation of future benefits. In other words, real estate investors measure the value of investment real estate based upon the anticipated future income stream generated by the property. So they are more likely to value a property on the income it generates rather than the market value or upon the construction and land costs to replace the property.

This, of course, should not come as a surprise to you who understand real estate investing. That real estate investors most of all buy the cash flows they expect to collect from the investment property.

2) Conformity

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

For example, an apartment complex located in a primarily residential area will most likely have more value than one located in a highly industrial area.

3) Supply and Demand

This principal surrounds both the scarcity and demand for the property. Although investment real estate with similar physical and economic characteristics typically sell for similar prices, real estate valuation can be greatly impacted in a market that does not have a reasonable balance between supply and demand.

For example, land in a metropolitan area (where undeveloped land is scarce), would command greater value than land in a rural area (which tends to have large amounts of vacant land). Likewise, an apartment complex selling at a time when there was more than enough supply to meet the rental demand would have less value to a real estate investor than at a time when there was less supply to appropriately meet the demand.

4) Highest and Best Use

This is an important concept that encompasses the highest use and the best use of the property rather than its current use. In other words, when legally possible, appropriately compatible, physically possible, and economically and financially feasible, property valuation can be affected when other (greater advantage) uses for the property are available.

An apartment building that can be converted to condominiums, for instance, or a four-unit property consisting of two side-by-side duplexes on two separate tax lots, can dramatically increase its value.

5) Contribution

This essentially means that the value of an income property can be impacted when it is physically, legally, and economically feasible to contribute more space to the property at a cost equal to, or less than, the marginal revenue. In other words, when value added offsets the costs of making the contribution.

For example, when an office building can be enlarged to add additional rentable office space, or an apartment complex can add more (perhaps even larger) units.

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 what the next best substitute with similar levels of risk will yield in benefits.