Saturday, December 24, 2005
Price, Value and Worth
The importance of intelligent pricing in real estate is underscored by the relation between Value and Worth. Excess inventories combined with the everyday low-pricing mindset that exists in most sectors of the economy including, of course, real estate has created buyers who are more price-sensitive than ever before. In this environment sellers typically can no longer justify the notion that the properties they are about to sell are a value-added inventory item. Unless sellers can prove, in terms of dollars and cents, the economic value of their properties, buyers have no choice but to view sellers’ products as just another commodity.
In order to motivate buyers, sellers must apply leverage on the perceived value of the interest in land they are offering. In Economics the ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition is termed ‘worth’. Clearly the lower the risk, the higher the worth. It follows, therefore, that the perceived value – or simply ‘value’ - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability. Put in elementary terms, ‘value’ is the total net benefit a buyer expects to receive from a purchase, measured in currency. The measure of the ‘value in exchange’ of the real estate transaction is the sales price.
In an economically efficient market, defined as a market where there are large numbers of rational, profit-maximizers actively-competing participants, with each trying to predict future market values of individual investments and where important current information is almost freely available to all participants, competition leads to a situation where, at any point in time, actual sales prices will be a good estimate of value. It follows, therefore, that sales prices of transactions past are the best measure of value of transactions to come.
Real Estate, however, is possibly the quintessential economically inefficient market because different participants may have varying amounts, degree and quality of information. This offers an advantage to sellers and helps explain the reason why properties offered for sale are typically overpriced. Furthermore, the uniqueness of each property compounds such inefficiency even further. A problem, therefore, arises as it relates to the determination of value, and the solution is in function of the real capital asset taken into consideration. There are three primary approaches used in valuing interests in land:
[ ] the Cost Approach, which generally works well for estimating the value of new buildings, involves estimating the cost to build an identical property taking into account land prices, labor, construction materials and developers profit;
[ ] the Comparative Sales Approach involves estimating the value of a property by comparing it to similar properties recently sold. The problem with this approach is that all properties are unique and adjustments must be made to account for differences in the properties being compared;
[ ] the Income Approach involves estimating the value of a property by calculating the present value of future income. The formula for market value equals annual net operating income (NOI) divided by a market capitalization rate that must be estimated and is determined by market factors.
As it relates to non-revenue producing residential assets, which account for the vast majority of transaction in the real estate market, the equilibrium between value and worth is obtained by setting a price based upon the sales price of recent transactions using the Comparative Sales Approach with due adjustments for correction, because this best defines how much a certain real inventory product is worth to a buyer relative to similar (but not equal) inventory products already consumed (sold).
Luigi Frascati
Real Estate Chronicle
