Wednesday, June 23, 2010

Investor – Do You Know the Seven Basic Principles of Real Estate Valuation?

With knowledge and mastery of the seven principles listed below, you’ll be able to valuate properties with an objective eye and sort out the good deals from the ones that are “money pits.”

Before we get to the principles, be aware that all of them relate to a fundamental maxim of real estate – “the highest and best use” of a property. In a legal sense, “highest and best use” is the use of a property that makes it the most valuable to a buyer or the market.

In a business sense, it means one single use will result in maximum profitability through the best and most efficient use of the property.

Okay, here are the seven principles:

Principle 1: Demand

In plain old English, do buyers want or need to own or possess a property and do they have the money to satisfy that need?

If, for example, you have a home (or rental property) in an upward-trending neighborhood, then you can anticipate a good-to-great demand that will allow you to charge accordingly!

Principle 2: Utility

The term “utility” refers to a property’s intended use; e.g., single-family home, rental property, retail function, industrial use, etc.

The gist of this principle is that you want a property to fulfill its intended purpose. That way, it’s in high demand in the right market.

Here’s an example of unfilled purpose: an upscale boutique stuck in a working-class neighborhood. Since the residents aren’t likely to have the money for luxury goods, this retail store would likely not have a great or profitable future. Clearly, this is not the “highest and best use.”

Principle 3: Scarcity

Put plainly, “scarcity” refers to the fact that the value of a particular property is set by comparing it to similar properties.

In technical real estate language, the “theory of substitution” states the following: “The value of a property replaceable in the market tends to be set by the cost of acquiring an equally desirable "substitute" property.”

Principle 4: Transferability

Transferability” refers to the ease with which ownership rights are transferred from one owner to the next.

As you can imagine, investors love properties that are easily transferable (or relatively so). At the same time, they hate properties encumbered by liens, judgments, etc. because such legal issues eat up time and money and can ruin an otherwise good deal.

Principle 5: Regression

When a property’s value is negatively affected by surrounding properties, then you have a situation of “regression.”

The price of your property deteriorates when the nearby properties are of lower value, have inferior construction, or are just plain in lousy condition. Needless to say, you don’t want to buy the best property in a bad neighborhood. You’d simply be throwing your money away!

Principle 6: Progression

“Progression” is the opposite of regression. In this case, a property’s value rises upward because the surrounding properties have better quality, are in better condition, and possess a higher value.

Another way to spell progression is “opportunity!” In other words, you can purchase a sound but neglected/unmaintained property in a good neighborhood.

Then, by bringing the property up to neighborhood standards through repairs, maintenance and upgrades (“rehabbing”), you have the ability to gain great value at a very low cost.

Principle 7: Conformity

Conformity” refers to the fact that property values are maximized when a property conforms to (is similar to) the properties surrounding it. Of course, the opposite is also true. If a property doesn’t mesh well with surrounding ones, its value decreases.

So, for example, if you buy a neglected property, you should renovate it to conform to neighborhood standards, but not over-improve it. Over-improvement can push that property into a higher cost bracket and limit your opportunities for selling or renting it!

In summary be aware that there many variables that can affect the highest and best use of a property. Zoning, re-zoning, the path of progress, etc. – all these factors can change the value of a property. That means, as an investor, you need to stay on top of the market!

Want to learn more about the fundamentals of the real estate market? If so, contact me right now at to discuss this matter or any other real estate matter of interest to you! I look forward to talking with you!


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