12.1 Economic Principles of Real Estate Value

Distinguish an estimate from a price or cost

Market value is an opinion about the most probable price for specified property rights as of a given date. It assumes reasonable exposure in a competitive market, knowledgeable and prudent parties and a transaction free of undue duress. Identify the payment terms and unusual concessions when they affect comparability. The assumptions describe the value question being asked. They do not guarantee what one purchaser will offer.

A sale price can be strong market evidence when its terms and circumstances are comparable. A related-party transfer, unusual concession or distress can change how much it tells you. Cost is useful evidence for some questions and does not measure the price contribution by itself. For example, a family may pay more for a layout that meets an unusual accessibility need. A seller can value an improvement personally even when comparable evidence supports a smaller price contribution. Utility, scarcity, demand and the ability to transfer the rights all help explain why properties with similar construction costs can sell for different amounts.

Test highest and best use

Highest and best use asks which reasonably probable use produces the highest value once the feasible alternatives have been considered. Test the land as if vacant and the property as improved when relevant. The existing structure may contribute enough value to keep, or evidence may support changing its use, renovating or redeveloping. Analyze timing and costs before assuming that a future opportunity is already available.

For example, a clinic could earn more than residential use on paper. If the applicable district excludes the clinic and there is no reasonably probable approval or change, the proposal fails the legal test. Verify the current municipal mapping and use definitions for the parcel. A listing label or a nearby project cannot establish the permissions on this lot.

Explain why buyers pay different amounts

Substitution describes how buyers compare available alternatives with similar utility, risk and timing. If two homes meet the same needs, a buyer may choose the less costly one. Financing terms, condition and availability can make two apparently similar alternatives unequal. An investor similarly considers competing properties with comparable income and risks.

Contribution describes the change in the whole property’s value that the market attributes to a feature. Suppose reliable evidence supports a $15,000 increase for a specialized improvement that cost $75,000. Its indicated contribution is $15,000. A renovation can contribute less than its cost, and a comparable adjustment should use evidence of buyer response rather than an invoice as the amount.

Anticipation links current value to expected future benefits. A planned station or future rent may influence today’s market if participants expect those benefits and price in the chance, timing and cost of realizing them. Check what has actually been approved and what remains contingent.

Conformity and balance describe how an improvement fits its market and site. A modest home can benefit from more desirable surroundings, sometimes called progression. A large, high-specification house can receive less market support in a lower-priced area, sometimes called regression. These are tendencies to test against comparable evidence. Check other differences, especially redevelopment potential, before attributing a price gap to surrounding homes. Balance also concerns whether a feature or improvement has enough utility for its cost and site.

Supply and demand explain how the number of competing listings and capable buyers can influence negotiating conditions. Construction and approvals take time, while changes in borrowing costs can affect demand quickly. Compare active inventory, sales pace and days on market for the relevant segment and period. For example, 60 active listings and 20 sales per month imply three months of supply at that pace, before new listings or changes in sales. The number helps describe the market. Its meaning depends on local and historical comparisons.

At a given price, a shortage means the quantity buyers seek exceeds what sellers offer. A surplus means the quantity offered exceeds what buyers seek. At equilibrium, the quantities balance at the prevailing price. Compare inventory, sales pace, price changes and days on market together. If listings and days on market rise while sales slow, investigate whether demand weakened or supply grew before attributing the change to one cause. A planned development can affect expectations before it adds completed homes. Check what has been approved and when supply is likely to arrive.

A price bubble is a distinct concern. Expectations of further gains can themselves raise demand and push prices away from levels supported by fundamentals such as income, financing costs and population. Rapid price growth can also reflect strong underlying demand and constrained supply. A short inventory period or one price statistic cannot establish a bubble.

Bank of Canada on housing demand and supply · Bank of Canada on price exuberance