Topic 16.3: Principles of Value

Learning Objective

After successfully completing this topic, you will be able to distinguish among the principles of value.

Principle of Substitution 

The principle of substitution establishes that the value of a property is set by the cost to obtain another property that is comparable, either by purchasing it or by building it. The upper limit of value then, is set by the cost to purchase or build a substitute.

Highest and Best Use

“Highest and best use” is the use that produces the greatest return to the land. 

The highest and best use of a parcel of land is NOT necessarily the most profitable use. It is the use which produces the greatest return to the land. The potential uses of a property is what gives the property value. The use must be
legally permissible. For example, zoning or homes association restrictions must not prohibit the use,
physically possible. For example, it may not be possible to build a high-rise office building based on the soil type, and
• financially feasible. The market value of an office building may be lower than the cost to build it if the building is far from a populated area.

Appraisers estimates two types of highest and best use
• highest and best use of the land as if vacant, and
• highest and best use of the property as improved

Highest and best use of the land as if vacant

Assume a parcel of property could be developed as an office building, a convenience store, or a duplex apartment property. After developing an operating statement for each use, an appraiser might determine that the net income of the office building would yield $30,000 annually, the convenience store would earn net income of $52,000, and the duplex would earn net income of $12,000. The highest and best use of the land to an investor would be to develop it as a convenience store. 

Highest and best use of the property as improved

The appraiser must decide how a property that already has improvements can be used most effectively. A small home with water frontage in a large bay may be worth $300,000. By demolishing that home and building a larger home that costs $200,000 to build, the property’s estimated value would be $550,000. The demolition is the best move, because it adds $50,000 to the investor ($550,000 – $200,000 -$300,000).

Increasing and Decreasing Returns 

The principle of increasing returns demonstrates that improving a property may add more value than it costs to improve it. For example, assume a 2-bedroom home is bought for $250,000. The home is in a neighborhood of larger, more expensive homes. The owner adds a new bedroom and bath at a cost of $90,000 and finds that the value of the property is $375,000. The increasing returns gave the owner an extra $35,000 ($375,000 – $250,000 – $90,000).

The principle of decreasing returns is shown below.

Over-Improvement

An over-improvement is an example of decreasing returns that occurs when the improvements of a property cost more than the value added. Assume that a buyer purchased a four-bedroom home for $300,000. The buyer added two more bedrooms and two bathrooms for a cost of $140,000. The value of the property after the improvements were made was $375,000. This was an over-improvement. The cost of the property was $440,000, but the resulting value was $375,000. The buyer lost $65,000. 

Conformity

The principle of conformity says that improvements that are dissimilar to other properties in the area will have less contributory value than the typical house in the area. For example, assume a builder wants to build a traditional home in a neighborhood with mostly contemporary homes. The traditional home would stick out and its value might be less than if it had been built in a neighborhood where the style would conform.

Other Valuation Terminology

Assemblage and Plottage

Assemblage involves combining two or more parcels of land in order to increase the overall value.

Example of Assemblage.
Assume there are five contiguous parcels of land on a street zoned for offices that have 50 feet frontage by 200 feet deep. The value of each is $40,000. A developer purchases all five sites for a total price of $200,000 ($40,000 x 5). The new property has measurements of 250 feet x 200 feet. An appraisal of the new property shows the value is $250,000. Why? Because the larger dimensions allow for a larger building and greater income to the developer.  

Plottage is the increased value of the property after assemblage. In the example above, the plottage is $50,000 ($250,000 – $200,000).

Progression and Regression

Progression says that the value of a modest home in a neighborhood of larger, expensive homes will be higher than if the home were in an area of more modest homes.

Regression is a principle that says, “Don’t build your fancy, large home in a neighborhood of smaller homes.” Its value will be less than if you built it in a more prestigious neighborhood.