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Chapter 11

The Value of
Real Estate

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 1


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 2


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

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


Chapter 11: The Value of Real Estate

Key Terms

• Arm's Length • Demand


Transaction • Depreciation
• Assemblage • Effective Demand
• Buyer's Market • External
• Conformity Obsolescence
• Contribution • Frontage

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 4


Chapter 11: The Value of Real Estate

Key Terms

• Functional • Law of Decreasing


Obsolescence Returns
• Highest and Best • Law of Increasing
Use Returns
• Market Value
• Immobility
• Plottage
• Indestructibility
• 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. Demand
2. Utility
3. Scarcity
4. Transferability

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


Chapter 11: The Value of Real Estate

Physical Characteristics

Three physical characteristics unique to real


estate:

1. Uniqueness
2. Immobility
3. Indestructibility

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 7


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
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 8
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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 9


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 10


Chapter 11: The Value of Real Estate

Scarcity

• The perceived supply of a good or service relative


to the demand for it:
Unlimited supply Perceived to have
of something little value
• Scarcity and utility must both be present for the
item to have value
• Value also derived from scarcity

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 11


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 13


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 14


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 15


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 16


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 17


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 18


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 19


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
Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 20
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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 21


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 22


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 23


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 24


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 25


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.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 26


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 27


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 28


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 29


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 30


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 31


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).

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 32


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 33


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.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 34


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.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 35


Chapter 11: The Value of Real Estate

Quiz

1. The amount one particular person paid


for property is its
a. cost.
b. market value.
c. price.
d. value.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 36


Chapter 11: The Value of Real Estate

Quiz

2. What are the value characteristics


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 37


Chapter 11: The Value of Real Estate

Quiz

3. Land has inherent value because of


a. immobility.
b. indestructibility.
c. uniqueness.
d. all of the above.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 38


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

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 39


Chapter 11: The Value of Real Estate

Quiz

5. Which house will hold its value best?


a. "best" house in the "worst" neighborhood
b. "worst" house in the "best" neighborhood
c. $50,000 house overlooking a huge landfill
d. $500,000 house in an area of apartment
complexes

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 40


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.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 41


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. assemblage
b. frontage
c. plottage
d. subdividing

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 42


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. assemblage
b. frontage
c. plottage
d. subdividing

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 43


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. assemblage.
b. frontage.
c. plottage.
d. subdividing.

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 44


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’

Mortgage Lending P&P 3rd Edition/Updated Nov. 6, 2009 45