Real estate valuation is based upon the principals of economics. Whether its residential or commercial real estate, an office building or apartment building, the value of real estate involves the forces of supply and demand in the marketplace.
Sound investment analysis requires the application of these economic principals to correctly determine real estate value, and real estate investors would be wise to understand them. So let’s take a look.
Anticipation is the expectation of future benefits. Value is a function of the anticipated future income stream from a present value standpoint. Investment value is estimated from the future annual cash flows plus the reversion (sale).
Conformity is defined as the need for reasonable similarity and compatibility in a given location. Compatible land uses may generate higher values. It is, however, possible to over-improve a site and not actually recover the cost it took to build because of limitations imposed upon the property due to location.
Change is important as it may establish trends that will be useful in forecasting future change, and the impact these changes may have on value and the feasibility of the real estate investment opportunity.
Supply and Demand forces operate to establish price. Investment properties with similar physical and economic characteristics will sell for similar prices, but many underlying factors may impact transaction price, including the terms and conditions unique to the individual investment and investor. Supply and demand must also be placed in the context of shortrun and long-run considerations. In the short run any given type of investment property is fixed in supply. In the long run, which is defined by all costs being allowed to vary, the supply can change as appropriate to meet the demand.
Highest and Best Use is a concept that encompasses the highest use and the best use of the property. This concept identifies that use that will exploit the land to its greatest advantage. Highest and best use is usually identified through its legally possible, appropriately compatible, physically possible, and economically and financially feasible characteristics.
Increasing and Decreasing Returns apply to value, as the law of diminishing returns in economic theory suggests that as more variable factors are added to fixed factors, the benefits will first increase at an increasing rate, then increase at a decreasing rate, and finally decline.
Contribution is defined as the change in the total amount of product as the result of adding additional units of input. In this case, of course, the cost of adding units must be equal to or less than marginal revenue to be economically advantageous.
Substitution is an opportunity cost concept. Given alternatives, with similar levels of risk, the investor should pick the least costly alternative to provide any given level or rate of return. Alternatively, a rational real estate investor will not pay more for an investment property than what the next best substitute will yield in benefits.
