Economic Factors that Affect Value for the Real Estate License Exam
Value doesn’t just happen; people have to create it. Most of these personal actions that will be covered on the Real Estate License Exam, usually called economic influences, are nothing more than normal human behavior.
The test asks two kinds of questions about these economic principles or factors. You’ll see questions about the definitions and questions asking you to identify the principle involved based on an example.
All property value is created by the anticipation of the future benefits the property will provide. You buy your house today so you can enjoy a bigger house for years to come.
You find a balance between land value and building value in any given area. Overall property values and builder’s profits on new homes are maximized when that balance is maintained. For example, in most cases you never want to build a house that costs $100,000 on a piece of vacant land that costs $500,000. In general, the balance needs to be similar to that which exists in the surrounding neighborhood.
Physical, governmental, economic, and social changes all affect property value. Physical factors can include environmental changes such as weather or pollution. Economic issues may be a change in employment levels in an area. Social factors are issues like the aging of the baby boomers. Any or all of these and others can have an impact on the values of properties.
Competition describes the fact that in real estate, the supply side tries to meet the demand side until demand is satisfied. A developer may see a need for a new office building in a particular location. If that building is a success, other builders are likely to follow with more office buildings until the last office building a builder erects remains partially vacant because the suppliers have created a surplus.
Value is created and sustained when real estate characteristics are similar. If you live in a neighborhood of single-family houses, you don’t want an office building to be built across the street from your house. The price of your house probably will be negatively affected by that incompatible land use.
In real estate terms, a building or a faucet is worth the value the market places on it, not its cost. You can spend a million dollars building a house, but if it’s in the wrong location or has an extremely unusual design, it may not be worth a million dollars. On the other hand, a $1,000 paint job may increase the ultimate selling price of the house by $5,000.
Real estate, because it stays in a fixed location, is affected by everything that happens around it. The gas station on the corner, the quality of the schools, the factory that closes in town, mortgage interest rates, and so on all have an impact on the property value.
Highest and best use
The principle of highest and best use states that every property has a single use that results in the highest value for that property. The use must meet four criteria:
Most (maximally) productive
Increasing and decreasing returns
Increasing and decreasing returns relate to adding improvements to a piece of real estate. Increasing returns come in when an improvement adds more value to the real estate than its cost. A dollar spent gives you more than a dollar back. Decreasing returns occur when an improvement gives back less value than its cost.
For every investment opportunity you choose, you lose other investment opportunities. So when Auntie dies and leaves you $100,000, you can invest it in real estate. In doing so, you miss the opportunity to invest the money in certificates of deposit at the bank.
And if you can get a 4 percent return on your money at the bank, you give up that return by investing in real estate. So you better make at least 4 percent and then some in your real estate investment.
The plottage principle states that the whole is sometimes greater than the sum of its parts, particularly with respect to real estate. You can put together four individual 5-acre parcels of land, each worth $50,000, to create a single 20-acre piece of property.
This larger piece may now enable you to do something with it that was impossible with the smaller pieces, such as building a regional-size shopping mall. It turns out the value of the whole property, or the plottage value, is now $300,000 rather than four times $50,000, or $200,000. The act of putting the individual properties together is called assemblage.
Regression and progression
You’ve heard the advice that you should always buy the smallest house in the neighborhood and not the biggest one. If you ever wondered why, it’s because the principle of progression says that the higher values of larger homes tend to have a positive effect on the value of the smaller home. Conversely, lower-priced homes have a negative effect on the value of the higher-priced home.
This economic principle says that a buyer will try to pay as little as possible for the property that meets the buyer’s needs. Given three houses, each of which satisfies the needs of the buyer, that buyer will buy the least expensive house.
Supply and demand
Because only so much land can be found in any particular location, and therefore only so much of anything — houses, stores, office buildings — can be built, the balance between supply and demand affects value. If demand goes up and supply goes down or remains the same, value increases. If demand goes down and supply increases or stays the same, value decreases.
After the builder puts together the land, labor, materials, and coordination necessary to build a building and then sells it, the difference between the costs and the selling price is surplus productivity. Economists use this term to signify profit.