Chapter 11

The Value of Real Estate

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 11: The Value of Real Estate

Important Definitions and Concepts
• Seven characteristics of real estate include: – 4 value characteristics (demand, utility, scarcity, transferability) that all items must have – 3 physical characteristics (uniqueness, immobility, indestructibility) • Factors that can affect real property value: – Broad market factors – Property-specific

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 11: The Value of Real Estate

Important Definitions and Concepts
• Difference between: – Value – Price – Cost • Market value • Arm’s length transaction • Assemblage, plottage, subdividing, and frontage as they relate to increasing the value of land

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Chapter 11: The Value of Real Estate

Key Terms
• Arm's Length Transaction • Assemblage • Buyer's Market • Conformity • Contribution • • • • Demand Depreciation Effective Demand External Obsolescence • Frontage

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Chapter 11: The Value of Real Estate

Key Terms
• Functional Obsolescence • Highest and Best Use • Immobility • Indestructibility • Law of Decreasing Returns • Law of Increasing Returns • Market Value • Plottage • Price

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Chapter 11: The Value of Real Estate

DUST
The seven characteristics of real estate include the four value characteristics (remember: D U S T):
1. 2. 3. 4. Demand Utility Scarcity Transferability

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Chapter 11: The Value of Real Estate

Physical Characteristics
Three physical characteristics unique to real estate: 1. Uniqueness 2. Immobility 3. Indestructibility

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Chapter 11: The Value of Real Estate

Value
• The amount of goods or services offered in marketplace in exchange for something else • To have value, certain value characteristics must be present and perceived by the user and other potential users • All four characteristics must be present and in harmony for item to achieve maximum value
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Chapter 11: The Value of Real Estate

Demand
• The need or desire for a specific good or service, and an essential ingredient in creating value • Without demand, any amount of supply is meaningless • Effective demand or purchase ability means a prospective buyer has enough disposable income available to satisfy needs or desires

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Chapter 11: The Value of Real Estate

Utility
• The ability of a good or service to satisfy human wants, needs, or desires • Utility is the degree of usefulness to prospective users
– No perceived use for something  no perceived value

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Chapter 11: The Value of Real Estate

Scarcity
• The perceived supply of a good or service relative to the demand for it: Unlimited supply of something Perceived to have little value

• Scarcity and utility must both be present for the item to have value • Value also derived from scarcity

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Chapter 11: The Value of Real Estate

Transferability
• The ability to freely buy, sell, encumber, dispose of property in any way the owner sees fit
– Property value derived from freedom to transfer title readily from one person to another

• The fewer restrictions on property, the more perceived value in the marketplace
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Chapter 11: The Value of Real Estate

Added Requirement
• Effective demand or purchase ability (effective purchasing power)
– Person receiving property must have ability to pay

• Without this, desires and demands go unfulfilled because property can’t be transferred to the person who desires it

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Chapter 11: The Value of Real Estate

Uniqueness
• A physical characteristic of real estate referring to each piece of land, each building, and each house being different
– Non-homogeneity: No two properties are exactly the same

• More land cannot be created in a given location
– Value is derived from this perceived scarcity due to uniqueness
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Chapter 11: The Value of Real Estate

Immobility
• The physical characteristic of real estate referring to the fact that it can't be moved • Immobility helps value in a good market
– Other land can't be moved in to take away potential customers

• Immobility can hurt land value in a bad market

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Chapter 11: The Value of Real Estate

Indestructibility
• A physical characteristic of real estate referring to the fact that it can't be destroyed
– Real estate will always have some minimum value by virtue of its existence

• Land’s usefulness, and hence its value, can change over time

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Chapter 11: The Value of Real Estate

Additional Factors in Valuing Property

(more or less in order of importance):
• • • • • • Highest and best use Location Substitution Conformity Contribution Depreciation
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Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

Chapter 11: The Value of Real Estate

Highest and Best Use
• The use that is the most physically possible, legally permissible, economically feasible, and maximally profitable or productive. • Vital consideration when examining vacant land or land that has changed zoning

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Chapter 11: The Value of Real Estate

Location
• The exact position of a piece of real estate • Consider neighborhood’s growth, popularity, prosperity, etc. • An individual home’s location within a neighborhood also affects its value

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Chapter 11: The Value of Real Estate

Substitution
• Theory that an informed buyer will not pay more for a home than a comparable substitute – The value of the “worst” home in a given area is increased by the other homes in the area – The value of the “best home in a given area is decreased by the other homes in the area • This theory can also be applied to items within a home
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Chapter 11: The Value of Real Estate

Conformity
• The theory that a particular home achieves its maximum value when surrounded by homes of similar style and function • Applies to neighborhoods as well

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Chapter 11: The Value of Real Estate

Contribution
• The theory that a particular item or feature of a home is worth only what it actually contributes in value to that piece of property • An item or improvement is worth only what a prospective buyer is willing to pay, not what it actually cost the owner

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Chapter 11: The Value of Real Estate

Law of Decreasing/Increasing Returns • Law of decreasing returns: Beyond a certain point, added value of additional feature, addition, repair, is less than the actual cost of it
– Also called law of diminishing returns

• Law of increasing returns: Added value of an additional feature, repair, is more than the actual cost of that item
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Chapter 11: The Value of Real Estate

Depreciation
• The loss in value to property for any reason • Factors contributing to depreciation can be classified as curable or incurable • Depreciation is usually attributed to one of three causes:
1. Physical Deterioration 2. Functional Obsolescence 3. External Obsolescence
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Chapter 11: The Value of Real Estate

Law of Supply and Demand
• For all products, goods, and services, when supply exceeds demand, prices will fall and when demand exceeds supply, prices will rise • Lag time for market forces to respond to supply and demand situations lead to buyer’s and seller’s markets

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Chapter 11: The Value of Real Estate

Buyer’s vs. Seller’s Market
• Buyer's market: buyers have a large selection of properties from which to choose • Seller's market: sellers can choose from a large number of buyers looking for houses in a particular area • The real estate market is in balance when there are slightly more homes available than buyers.

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Chapter 11: The Value of Real Estate

Value, Price, Cost
• Value: What a typical person would pay for something • Price: What one person actually paid – Price is a fact. • Cost: Dollars needed to develop, produce, or build something – The value of a piece of real estate should never be confused with its price

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Chapter 11: The Value of Real Estate

Market Value
• The most probable price a property should bring in competitive, open market under all conditions requisite to a fair sale
– The final value entered on the Uniform Residential Appraisal Report (URAR) should represent the appraiser's opinion of market value

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Chapter 11: The Value of Real Estate

Arm’s Length Transaction
• One that occurred under typical conditions in the marketplace with each party acting in his or her own best interest

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Chapter 11: The Value of Real Estate

Making Land More Valuable
• Assemblage: Combining two or more parcels of land into one larger parcel; typically done to increase usefulness of the land • Plottage: Increase in value (over cost of acquiring the parcels) by successful assemblage, usually due to a change in use • There are times when subdividing and splitting property into multiple smaller parcels can increase value

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Chapter 11: The Value of Real Estate

Frontage
• Dimension across access side of property • Adding it makes land more valuable than adding depth, even if total amount of land added is the same
– This is especially true for commercial property

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Chapter 11: The Value of Real Estate

Summary
1. Value is the amount of goods or services offered in the marketplace in exchange for something. There are seven characteristics of real estate. Maximizing value requires all four value characteristics—demand, utility, scarcity, transferability (DUST)—plus the three physical characteristics – immobility, indestructibility, uniqueness. Buyers must want a site, feel it’s useful to satisfy needs, perceive limited supply, and be free to transfer the site later. To have value, scarcity must be coupled with utility. Without demand, supply is meaningless, but a person must also have an ability to purchase (effective demand).
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Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

Chapter 11: The Value of Real Estate

Summary
2. Factors that affect the value of a particular piece of real estate include many of the same economic, governmental, and social factors that influence the broad real estate market. Some of the most relevant broad market factors that influence the value of a particular piece of real estate include supply and demand, and uniqueness and scarcity. Property-specific factors include highest and best use, location, substitution, conformity, and contribution.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 11: The Value of Real Estate

Summary
3. Market value is the theoretical price that a piece of real estate is most likely to bring in a typical transaction, not to be confused with market price, which is the actual price paid for a piece of real estate. A typical real estate transaction is often referred to as an arm’s length transaction, meaning the transaction occurred under typical conditions in the marketplace with each party acting in his or her own best interests. Typical conditions are buyer paying cash, seller not offering financing or unusual terms, buyer and seller are not related, buyer and seller acting in their own best interests, buyer and seller not acting out of undue haste or duress, both are reasonably informed about the property, and the property has been on the market for a reasonable period of time.
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Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

Chapter 11: The Value of Real Estate

Summary
4. Inherent value of land can be increased through assemblage or subdivision. Assemblage is combining two or more parcels of land into one larger parcel, increasing the usefulness of the site. If the larger parcel is worth more than the sum total of the smaller parcels, this is called plottage. Subdividing a larger parcel of land can also result in more utility and more value. Frontage is the dimension across the access side of a parcel of land. With commercial property, frontage is usually more valuable than depth. The first number in a lot size is always the frontage. With residential land, usually, only total size is compared. In both cases, a market study must be done to determine any amount of value difference.

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Chapter 11: The Value of Real Estate

Quiz
1. The amount one particular person paid for property is its
a. b. c. d. cost. market value. price. value.

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Chapter 11: The Value of Real Estate

Quiz
2. What are the value characteristics properties must have in harmony to maximize value?
a. b. c. d. demand, utility, scarcity, transferability supply and demand uniqueness, immobility, indestructibility utility and scarcity, coupled with a lack of purchasing power

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Chapter 11: The Value of Real Estate

Quiz
3. Land has inherent value because of
a. b. c. d. immobility. indestructibility. uniqueness. all of the above.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009

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Chapter 11: The Value of Real Estate

Quiz
4. Which is an example of real estate put to its highest and best use?
a. flat, paved parking lot in downtown Boston b. house in a residential subdivision c. old house on a major highway surrounded by commercial buildings d. vacant lot

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Chapter 11: The Value of Real Estate

Quiz
5. Which house will hold its value best?
a. b. c. d. "best" house in the "worst" neighborhood "worst" house in the "best" neighborhood $50,000 house overlooking a huge landfill $500,000 house in an area of apartment complexes

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Chapter 11: The Value of Real Estate

Quiz
6. Typical conditions in the marketplace include all EXCEPT
a. buyer pays cash for real estate. b. buyer and seller are not related. c. buyer and seller are reasonably informed about the property. d. property has been on the market for seven years.

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Chapter 11: The Value of Real Estate

Quiz
7. Someone buys two adjacent parcels of land for $20,000 each. An appraisal shows the combined larger parcel is now worth $40,000. What has occurred?
a. b. c. d. assemblage frontage plottage subdividing

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Chapter 11: The Value of Real Estate

Quiz
8. Someone buys two adjacent parcels of land for $20,000 each. An appraisal shows the combined larger parcel is now worth $50,000. What has occurred?
a. b. c. d. assemblage frontage plottage subdividing

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Chapter 11: The Value of Real Estate

Quiz
9. Someone buys one large parcel of land for $200,000. An appraisal shows it could become 10 lots worth $25,000 each. This is an example of
a. b. c. d. assemblage. frontage. plottage. subdividing.

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Chapter 11: The Value of Real Estate

Quiz
10. A fast food chain is looking for a new location. Assuming the cost of the lot is of less concern than customer convenience entering and exiting the property, which lot would the restaurant likely choose? a. 100’ x 200’ b. 125’ x 150’ c. 150’ x 125’ d. 200’ x 100’

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