Valuing Real Estate: 10 Key Concepts

By. David Tevlin

At a time such as now when the real estate markets are in ferment, appraising real estate for purchase, sale or financing can be a highly uncertain process.

Each of the three traditional approaches for determining value has its limitations. First, establishing the value of comparable property by recent sales (market data approach) can mislead because of limited market activity. Second, capitalizing net operating income (NOl) from a property (income approach) can be misleading because of the uncertain outlook for NOI. Finally, determining replacement or reproduction cost of a property and accrued depreciation (cost approach) is difficult because future costs may vary widely. Instead, an investor, developer or lender should consider the underlying economic concepts that affect value for any parcel of property. Understanding these economic concepts offers insight into the rationale underlying the various appraisal methods. To the extent these concepts are better understood, they will become more valuable tools for investment analysis.

Substitution

When two parcels of property have the same utility (usefulness), the property available at the lower price will sell first. This common-sense statement has important implications. For example, in the cost approach, the concept of substitution explains why a buyer will not pay more for improved real estate than the cost to the buyer to acquire a site and construct an improvement of equal utility.

Anticipation

This concept again embodies a self-evident point of view - an estimate of value always should be based upon future anticipation rather than past performance. Past financial history may be important evidence of future trends, but can never be a substitute for a judgment about the future. This concept is especially applicable with the income approach to value, since here value is estimated by capitalizing future income.

Change

In one sense, change is merely a specific application of the concept of anticipation. The emphasis here is on the inevitability of change and the need to identify trends that will affect the property in question. For example, the concept of regression says that the value of a superior property in a neighborhood will be adversely affected by surrounding inferior properties. The concept of progression states the reverse, i.e., an inferior property will benefit by its location in the superior neighborhood. An investor who can identify an early trend toward neighborhood improvement, and so make bargain purchases of property, is successfully using the concept of change.

Competition and Excess Profit

This concept expresses the idea that in a relatively unregulated market, abnormal profits cannot be expected to continue indefinitely. Put another way, unless monopoly profit is protected by unique location, government regulation or some other factor, competition will be generated that, in time, will reduce the abnormal profit to a normal range. When the purchaser of a shopping center capitalizes overage rentals at a rate lower than that for fixed rentals because of anticipation that competition from another center will reduce the percentage rents, he is applying the concept of competition.

Increasing and Diminishing Returns

This concept says that in any given case, a certain optimum combination exists of land, labor, capital and entrepreneurship. If any one of the four factors of production is increasingly applied, diminishing returns eventually will be experienced. For example, an outlying site may be capable of returning some positive cash flow if improved with a retail store. If the owner were to invest additional capital and construct a 10-story office building, the result likely would be negative cash flow. In other words, diminishing returns would result from increased capital investment. The determination of just the right combination of factors to produce maximum income from a parcel of property is one of the most difficult jobs of the real estate appraiser or analyst.

Contribution

Contribution is an application of the concept just discussed. Contribution says that changes in an existing improvement can only be justified in a financial sense if the increase in cash flow represents a fair return on the additional investment. For example, an office-building investor must decide whether to replace manned elevators with automatic ones. Offsetting the initial capital investment will be lower operating expenses due to a smaller payroll. The question is whether the additional cash flow represents a satisfactory return on the new investment. If higher rents can be charged because the automatic elevators are quicker and more efficient, this factor also must be considered.

Surplus Productivity

Of the four factors of production, land is the last to be paid. It plays a passive role and a return must first be paid to the other three factors (capital, labor and entrepreneurship) in order to bring about utilization of the land. Consequently, the return to land is surplus productivity in the sense that it is the residual return. This concept is often important in analyzing many small business operations. Consider the case of a couple who operate a fast-food restaurant. They purchase the land, construct the

improvement, and work seven days a week. At the end of the year, they realize a good profit. But what is earning a return? First, they must pay themselves salaries for their labor, as well as some return for the entrepreneurial risk assumed. Second, a portion of the profit represents a return of investment (equivalent to depreciation of improvements) and an additional portion represents a return on the investment in improvements. The balance, if anything is left, represents a return on the capital invested in the land. It may turn out that there is no surplus productivity so that the land is earning no return at all.

Conformity

Experience has shown that maximum value accrues to a parcel of land when a reasonable degree of physical and economic homogeneity is present in the location. The concept of conformity reflects the fact that economic and psychological benefits arise from the grouping of similar activities. Zoning laws are a partial recognition of this concept.

Supply and Demand

Supply and demand is the basic economic logic that lies behind pricing. In a wholly free economy, the interaction of supply and demand would be the sole determinant of price and, hence, of value. In our partially free and partially regulated economy, the law of supply and demand is only one factor, although a crucial one, in setting prices.

Highest and Best Use

This most quoted concept in real estate valuation is that vacant land is to be valued based on the use likely to produce the highest return in the foreseeable future, bearing in mind that such use is likely to change over time. An outlying site suitable for a one-story retail store today may be able to support increasingly larger structures as urban expansion takes place. The highest-and-best-use concept also applies to developed land, but here an additional factor applies, i.e., the cost of demolishing the existing improvement. The highest and best use of vacant land might be a 20-story office-building, but if the land already is improved with a 10-story structure, the cost of demolishing it must be added to the investment equation. The result may be that the highest and best use (from the point of view of return on investment) is the present use.

David Tevlin is a partner in the Real Estate Industry practice in BDO New York office. This article originally appeared in BDO USA, LLP Real Estate Monitor newsletter (Winter 2013). Copyright © 2013 BDO USA, LLP. All rights reserved. www.bdo.com