Chapter 2
THE NATURE OF VALUE
The Nature of Value 15
The concept of value pervades every segment of the real estate industry. Value considerations are of central importance in a broad and diverse range of real estate activities. The term value is often used imprecisely in common speech, but in economics it has a specific meaning which distinguishes it from the related concepts of price, market, and cost.
DISTINCTIONS AMONG PRICE, MARKET, COST, AND VALUE
Appraisers make careful distinctions among the terms price, market, cost, and value. The term price usually refers to a sale or transaction price and applies to an exchange; a price is an accomplished fact. A price represents the amount a particular purchaser agrees to pay and a particular seller agrees to accept under the circumstances surrounding their transaction.
Generally, the circumstances of a transaction reflect conditions within one or several markets. A market is a set of arrangements in which buyers and sellers are brought together through the price mechanism. A market may be defined in terms of geography, products or product features, the number of available buyers and sellers, or some other arrangement of circumstance.
A real estate market is the interaction of individuals who exchange real property rights for other assets, such as money. Specific real estate markets are defined on the basis of property type, location, incomeproducing potential, typical investor characteristics, typical tenant characteristics, or other attributes recognized by those participating in the exchange of real property. The market for new, singlefamily residences selling for $100,000 and the market for older apartment buildings located near the central business district and available for renovation are examples of specific real estate markets.
The term cost is used by appraisers in relation to production, not exchange; cost may be either an accomplished fact or a current estimate. Appraisers distinguish among several types of costs: direct costs, indirect costs, construction costs, and development costs.
Direct costs are expenditures for the labour and materials necessary to construct a new improvement. Direct costs are also called hard costs. A contractor's overhead and profit are generally considered direct costs.
Indirect costs incurred in construction refer to expenditures for items other than labour and materials. Indirect costs include administrative costs; expenses incurred by the owner for professional fees, financing, taxes, and interest and insurance during construction; and leaseup costs, which are the net expenses of operating the project until it reaches a stable occupancy level. Indirect costs are sometimes referred to as soft costs.
Construction cost, or contractor's bid price, normally includes the direct costs of labour and materials plus the contractor's indirect costs.
Development cost is the cost to create a property, including the land, and bring it to an efficient operating state, as distinguished from the cost to construct the improvements. Development cost includes the profit to the developer or entrepreneur who brings the project into being.
These real estaterelated expenditures are directly linked to the price of goods and services in competitive markets. For example, the costs of roofing materials, masonry, architectural plans, and rented scaffolding are determined by the interaction of supply and demand in specific areas and are subject to the influence of social, economic, governmental, and environmental forces.
16 The Appraisal of Real Estate
Price, market, and cost relationships also incorporate concepts of value. Value can have many meanings in real estate appraisal; the applicable definition depends on the context and usage.' In the marketplace, value is commonly perceived as the anticipation of benefits to be obtained in the future. Because value exists at a given moment, an appraisal reflects value at a particular point in time. Value as of a given time represents the monetary worth of property, goods, or services to buyers and sellers. To avoid confusion, appraisers do not use the word value alone; instead they refer to "market value," "use value," "investment value," "assessed value," or other specific kinds of value. Market value is the focus of most real property appraisal assignments and its estimation is the purpose of most appraisals.
MARKET VALUE, USE VALUE, AND OTHER VALUES Market Value
The concept of market value is of paramount importance to business and real estate communities. Vast sums of debt and equity capital are committed annually to real estate investments and mortgage loans, which are based on market value estimations. Real estate taxation, litigation, and legislation also reflect an ongoing, active concern with market value issues. In virtually every aspect of the real estate industry and its regulation at local, provincial, and federal levels, market value considerations are of vital importance and essential to economic stability.
The definition of market value used by appraisers and the clients they serve must be clearly understood and communicated. However, in real estate appraisal, definitions of market value can and do represent different beliefs and assumptions about the marketplace and the nature of value. Market value is inherently a simple concept it is an objective value created by the collective patterns of the market but the definition of market value is controversial. Debate on the subject continues and often centres on rather fine distinctions.
Current definitions of market value reflect different schools of thought on five key points.
1. Allcash and terms equivalent to cash versus noncashequivalent financing terms
2. Specified property rights versus the real estate
3. Price versus the highest price
4. Most probable price versus the highest price
5. Equilibrium value versus market value
One school subscribes to the belief that market value is best measured in terms of allcash. This opinion originated in the first half of the twentieth century when economic conditions were remarkably stable. During this period, mortgage rates remained nearly level and were characteristically fixed over the 25year life of the mortgage, real estate prices rose slowly, and the fee simple interest was the subject of most appraisals. Because of these static conditions, financial terms were not of great importance and market value in appraisals most frequently implied allcash transactions.
The Nature of Value
A second school of thought emerged in the latter part of the twentieth century when changes in real estate markets and financing created increasingly complex real property interests. Interest rates are now seldom fixed in a mortgage for longer than five years, and have fluctuated dramatically in periods of high inflationary pressures. Traditional longterm, fixedrate loans have largely been replaced by shortterm or more complicated financing instruments. Many clients now request estimates of the market value of a property subject to leases, easements, or mortgages. Therefore, real estate analysts have focused their attention on the interrelationships of debt and equity interests and fee simple, leased fee, and leasehold interests.
Financing terms, which may or may not be equivalent to cash, affect value. Value affected by financing or leases can be market value, because it is created by the activity of the collective market. However, the sale price of a comparable property that sold with atypical financing terms must be adjusted to reflect typical market terms before it can be used to derive a value indication for the subject property. This adjustment produces a cash equivalent price.
A market value appraisal is always a valuation of specified rights in the subject property, not the physical real estate. The specified property rights can be the fee simple estate, the estate subject to a lease or mortgage, or some other interest in the real estate.
General dictionaries define market value as "value as a saleable thing"', "a price at which both buyers and sellers are willing to do business'3 and "what a property can be sold for on the open market."' Professional appraisers recognize, however, that in general commerce the amount of this price depends on custom, encumbrances, and conditions; in legal use, price may depend on regulations, statutes, or a court or tribunal decision. These differences are not necessarily inadvertent.
Although there is considerable logic and simplicity in the concept of market value as the most probable selling price, this definition does not exclude duress. If duress is present, it will be reflected in a transaction price and this price may not be market value.
The concept of market value as the highest price under a set of specific conditions, as opposed to market value as a central tendency under the same conditions, is also controversial. For a market to exist, there must be enough buyers, sellers, and product to provide competition; out of this competition a central tendency and a highest tendency will develop. The notion of the highest price was originally rooted in the idea that market value should be the highest possible price represented by the central tendency; it was not thought to be the highest possible price obtainable. However, any definition that includes the word highest may be subject to misinterpretation.
Equilibrium value is the price that would be available in the market if supply and demand were in balance. When the forces of supply and demand are out of equilibrium, market value can and does differ significantly from market value in a more balanced situation. During the Depression, for example, values fell dramatically, and many people believed or wanted to believe that property had intrinsic value although it was not then obtainable in the market. When the market is extremely active, prices rise above the level some people believe to be normal or intrinsic. In all cases, however, market value is the price that is available in the market. Intrinsic value is regarded by some practitioners and theorists as meaningless in relation to market value.
18 The Appraisal of Real Estate
Despite differing opinions on individual aspects of the market value definition, it is generally agreed that market value results from collective value judgements rather than isolated judgements. A market value estimate must be based on objective observation of the collective actions of the market. Because the standard measure of these activities is cash, the increments or diminutions in market value caused by financing and other terms are measured against an allcash value. The definition that follows, developed by the U.S. Appraisal Institute from which this text has been adapted incorporates the concepts that are most widely accepted, such as willing, able, and knowledgeable buyers and sellers who act prudently, and gives the appraiser a choice among three bases: allcash, terms equivalent to cash, or other precisely revealed terms. It also requires increments or diminutions from the allcash market value to be quantified in terms of cash.
The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to fair sale, with the buyer and seller each acting prudently, knowledgeably, and for selfinterest, and assuming that neither is under undue duress.
Some American appraisers cite this definition verbatim in their appraisal reports and state separately that the value is stated in cash, in terms equivalent to cash, or in other terms. Others simply change one phrase in the value definition, i.e., they may substitute "in cash," with "in terms arithmetically equivalent to cash" or "in terms precisely revealed below" as appropriate. The Standards of Professional Appraisal Practice of the U.S Appraisal Institute require that the following items directly related to the market value definition be included in every appraisal report:
1.Identification of the specific property rights to be appraised.
2.Statement of the effective date of the value opinion.
3.Specification as to whether cash, terms equivalent to cash, or other precisely described financing terms are assumed as the basis of the appraisal.
4.If the appraisal is conditioned upon financing or other terms, specification of whether the financing or terms are at, below, or above market interest rates and/or contain unusual conditions or incentives. The terms of above or belowmarket interest rates and/or other special incentives must be clearly set forth; their contribution to, or negative influence on, value must be described and estimated; and the market data supporting the valuation estimate must be described and explained.
Although this definition includes noncashequivalent financing terms within the scope of the market value of appraised property rights, these rights are valued in relation to cash. Increments or diminutions in market value attributable to financing terms are measured against an allcash standard, and the dollar amount of variance from the cash standard must be reported. Market value definitions can be found in a variety of sources, including appraisal texts, real estate dictionaries, various federal and provincial statutes that deal with expropriation, assessment and other related matters, and court decisions. In many commercial agreements, market value may be defined in terms having slight differences from those definitions given above.
The Nature of Value 19
In litigation matters, appraisers must use the exact definition of market value that applies in the jurisdiction in which the services are being performed or in the act from which the matter arises. Moreover, government and regulatory agencies redefine or reinterpret market value from time to time so individuals performing appraisal services for these agencies or institutions under their control are cautioned to use the applicable definition. (Real estate law textbooks and the relevant acts may be referenced for the applicable definitions of various federal and provincial statutes.) Two recent definitions have been put forth in attempt to capture the essence of the market value concept. The first is as follows:
The price in cash and/or other identified terms for which the specified real property interest is expected to sell in the real estate marketplace under all conditions requisite to a fair sale.5
This definition does not include any reference to a specified date. The second definition is as follows:
The value or distribution of values inferred by a competent observer from sufficient patterns of clearly understood, correctly reported, representative, and uncompelled transactions found in an adequate market which is either identical or sufficiently congruent to the market in which the property will be traded.6
This definition does not refer to the date of value or to property rights, but assumes that these are understood. Whichever definition of market value is employed, or its precise wording, the following conditions are always assumed:
(i)No undue pressure on either party. This assumption is often not met in actual market conditions. This is one important reason why the appraiser must investigate the conditions of sale for each comparable property utilised in the direct comparison analysis, as well as in gross rent multiplier analysis.
(ii)An informed buyer and seller. This includes an awareness of the alternatives available to each. The presumption is that they have "reasonable or normal" market information, rather than absolute knowledge. Buyer and seller are assumed to be acting in a prudent economic manner.
(iii) A reasonable turnover period. A quick or forced sale is not assumed. In addition, a seller could receive "a desired price" if willing to wait an unduly long time to find a buyer. Neither of these cases meets the condition of market value. As of the date of appraisal, the appraiser must ascertain the typical turnover period for properties of the type being appraised.
(iv) Payment consistent with the standards of behaviour of the market. Typical or normal financing and payment arrangements are assumed. Usually, this will not involve an allcash payment by the purchaser, and it does not mean especially favourable financing to attract a buyer to the seller's price. Appraisers must pay particular attention to the terms of financing, since "creative financing" schemes can greatly affect prices paid for property.
20 The Appraisal of Real Estate
Use Value
The realities of current real estate and mortgage practices not only place new emphasis on market value, but also require more frequent consideration of other kinds of value. One of these, use value, is a concept based on the productivity of an economic good. Use value is the value a specific property has for a specific use. Use value focuses on the value the real estate contributes to the enterprise of which it is a part, without regard to the property's highest and best use or the monetary amount that might be realized upon its sale. Use value may vary depending on the management of the property and external conditions such as changes in the business. For example, a manufacturing plant designed around a particular assembly process may have one use value before a major change in assembly technology and another use value afterward.