Basic Principles of Value

Many economic principles influence the value of real property. They are interrelated, and their relative importance varies, depending on local conditions. The following principles are important:

Substitution

Substitution is probably the most important factor in pricing residential property in a neighborhood with an active market. The value of a given parcel of real property is determined using the principles of substitution. The maximum worth of the real estate is influenced by the cost of acquiring a substitute or comparable property.

Highest and Best Use

Of all the factors that influence market value, the primary consideration is the highest and best use of the real estate. A property’s highest and best use is its most legally profitable and physically permitted use – that is, the use that provides the highest present value.

Law of Supply and Demand

As it does with any marketable commodity, the law of supply and demand affects real estate. Property value rises as demand increases or supply decreases. For example, when interest rates decline, demand for residential property increase significantly, resulting in dramatic increases in prices.

Conformity

In neighborhoods of single-family houses, buildings normally should follow the principle of conformity, that is, they should be similar in design, construction, and age to other buildings in the neighborhood to realize their maximum value. An elaborate mansion on a large lot with a spacious lawn is worth more in a neighborhood of similar homes than it would be in a neighborhood of more modest homes on smaller lots. Subdivision restrictive covenants are designed to promote the principle of conformity to maintain and enhance values.

Contribution

Any improvements to a property, whether to vacant land or a building, is worth only what it adds to the property’s market value. An improvement’s contribution to the value of the entire property may be greater or smaller than its cost.

Law of Increasing and Diminishing Returns

Improvements to land and structures reach a point at which they have no positive effect on property values. As long as money spent on such improvements produces a proportionate increase in income or value, the law of increasing returns is in effect. When additional improvements bring no corresponding increase in income or value, one can observe the law of diminishing returns.

Competition

All residential properties are susceptible to competition, some more than others. The only house for sale in a nice, well-maintained neighborhood has a better chance of selling at or near market value than if several houses on the same street are for sale.

Change

All property is influenced by the principle of change. No physical or economic condition remains constant. Market forces are taken into consideration when preparing the opinion of value.

Anticipation

Most buyers purchase real estate with the expectation that its value will increase and they have been rewarded when the anticipation proves correct. In inflationary times, the anticipation of higher prices creates a multitude of buyers, driving prices higher than can be supported for longer periods. In Colorado, the prices for mountain properties have increased dramatically, especially if they are in or near a ski resort area.

But when the market began to opt-out, the anticipation of a price recession can cause investors to put the property on the market, forcing prices lower. Anticipation also is important to prices of property in times of decreasing interest rates, when builders rush to fill the expected demand.

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