The first part of this series introduces several economic concepts that are used in the appraisal of real estate. Stay tuned to Part II next week for the completion of this discussion!

Economic theory in appraisals, explained

Appraisals are an integral part of the real estate buying and selling process. For many buyers and sellers, it is the final hurdle to be cleared before mortgage-assist financing is obtained and the sale formally closed.

An appraisal is an individual’s opinion or estimate of a property’s value on a given date. This estimate is produced in an appraisal report, including data collected and analyzed by the appraiser to support their opinion.

Multiple economic principles are used in the appraisal of real estate. The economic principles of appraisal covered in Part I of this series include the principles of:

  • supply and demand;
  • change;
  • conformity; and
  • highest and best use.

The principle of supply and demand: For appraisal purposes, the principle of supply and demand holds that once the supply of available homes decreases, the value of homes increase since more people are demanding the decreased supply of available homes.

This principle correlates to the density of the population and its level of income.

The principle of change: The principle of change holds that property is constantly in a state of change. The change a property experiences is seen in its life-cycle. The life-cycle of a property has four stages: development, stability, decline and old age.

  • Development of the property includes the subdivision of lots, improvements constructed and the start of a neighborhood community.
  • The stability stage of a property, such as a home built within a community, occurs when the property reaches a level of completion where changes are only made to it to maintain an appropriate level of condition.
  • The decline stage starts when the oldest buildings begin to deteriorate, lower social or economic groups move into the community and larger homes are converted into multiple family use.
  • The revitalization or gentrification stage occurs when the neighborhood is recognized as suitable for renewal. This most often occurs in more urban areas where high-costs force younger and first-time buyers to create value through the renewal process.

The principle of conformity: The principle of conformity holds that when similarity of improvements is maintained in a neighborhood, the maximum value of a property can be realized on a sale. Zoning regulations and conditions, covenants and restrictions (CC&Rs) tend to protect homeowners by narrowing the uses and excluding nonconforming uses of the property.

The principle of conformity is further categorized under the principle of:

  • regression: The principle of regression holds that the value of the best property in a neighborhood will be adversely affected by the value of other properties in the neighborhood. For example, this principle applies to over-improved homes. When an owner makes extensive renovations, such as adding additional rooms and landscaping, and the other neighbors do not, the house is no longer as similar to the others. On the sale of the over-improved home, the owner will not receive the full value of the cost of over-improvements.
  • progression: The principle of progression is the opposite of the principle of regression, holding that a smaller and lesser maintained property in a well-kept neighborhood will sell for more than if the home were in an area of comparable properties.

The principle of highest and best use: The principle of highest and best use holds that the greatest value of the property is realized when its use is maximized.  The test for highest and best use requires that the use be physically possible, legally permissible, economically feasible, and achieve the maximum productivity (memorized by the acronym PLEM).

The economic principles of appraisal to be illustrated in Part II include the principles of:

  • consistent-use;
  • balance;
  • contribution;
  • substitution;
  • anticipation; and
  • competition.

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