SCHOOL OF EDUCATION, SOCIAL SCIENCE AND TECHNOLOGY
PRINCIPLES OF VALUATION LECTURE NOTES 1
Introduction
Property valuation is an art and a science of assessing the value of properties for different purposes. Some of the reasons that one might need to know the value of property is the need to get a loan from a bank or other financial institution and if one wants to sell property. In other parts of the world, it is known as property appraisal and is defined as the act or process of developing an opinion of value.
Purposes of Valuation
The basic purpose of valuation is to estimate a particular value for support of sales price, loan value, investment value etc. Some of the uses for requiring the estimate of value are:
1. Transfer of Ownership of Property
a. A valuation assists buyers and sellers in arriving at a fair and equitable sales price. A valuation of physical property may also include an opinion of its age, remaining life, quality or authenticity.
b. A listing agent (that is, an agent who is hired to let or sell property on behalf of an owner) needs an estimate of value of the property before accepting a listing from the owner. An agent or a real estate practitioner should therefore, be able to demonstrate a knowledge of both comparative and economic values of property.
c. Where a trade is involved, valuations tend to assist in clarifying the opinions of value formed by both parties to the trade.
d. Valuations are also necessary for the distribution of estate properties among heirs.
2. Financing and credit
a. The lender (such as a bank and any financial institution) has a valuation made of the value of the property to be pledged as security for a mortgage loan.
b. Measuring economic soundness of real estate projects involves feasibility studies in relation to financing and credit.
3. Valuation for taxation purposes
a. Valuations are needed by governmental bodies to establish the proper relationship between land and improvements for real estate taxes. In Zambia, the local authorities, in conjunction with the Government Valuation Department (GVD), carry out valuations for rating purposes in order to determine property rates and ground rents payable.
b. Income-producing properties also need to be valued for the purposes of depreciation. Only improvements on land depreciate and not land itself.
4. Condemnation actions
a. With the right of eminent domain being vested in governmental agencies, it is important that properties under condemnation be evaluated at market value to properly estimate the purchase price, benefits and damages to the property being affected. (You should have learned about this is Real Estate Law, what does it state? The power or authority of the state to compulsorily acquire property. 3 conditions must be fulfilled, that the use for which property is being acquired is for public purposes, just compensation as arrived at by the courts should be given and that the rights of the owner will be protected by the due process of the law).
5. Insurance purposes
a. Valuations in this case are principally upon the cost of replacement. This is important for the purpose of insuring properties against fire.
b. Valuations are also important in settling claims arising from insurance contracts after a property has been destroyed.
6. Miscellaneous reasons for valuation
a. Estimating market rents for the negotiation of leases;
b. Establishing the value of property before and after it is damaged;
c. For inheritance and gift purposes;
Concepts of Value
Price, market, cost and value are important concepts that valuers make careful distinctions of. Let’s take a look at the meanings of each of these concepts:
Price – this refers to a sale or transaction price and applies to an exchange, price is therefore, an accomplished fact. It represents the amount a particular purchaser agrees to pay and a particular seller agrees to accept under the circumstances surrounding their transaction.
Market – this is a set of arrangements in which buyers and sellers are brought together through the price mechanism. A property market therefore, is the interaction of individuals who exchange real property rights for other assets, such as money.
Cost – this is used by valuers in relation to production, not exchange. Cost may either be an accomplished fact or a current estimate, e.g. building costs or construction costs. Cost is therefore, the expenditure to produce a commodity having a value. In the construction industry, cost means the original cost of the construction including the costs of material and labour.
Value – this is an opinion or an estimate which will be determined by many factors such as the purpose, supply, demand, depreciation, obsolescence etc. Value is a function of place, date and purpose.
Price, market and cost relationships also incorporate the concepts of value. Although the term value has varied meanings, the applicable definition will depend 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, a valuation/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. A prefix is usually used before the word value in order to adequately indicate what the value the valuer is referring to.
Types of Value
There are various types of value which include open market value, existing value, alternative use value, historical cost, depreciated replacement cost (reinstatement value), going concern value, forced sale value, social value and many more.
A valuation surveyor is mostly concerned with the Open Market Value and although there are such varied types of value, value generally refers to a sum of money, which is usually taken as the price. Price and worth are also two different concepts which will be discussed in more detail below.
Market Value
In Zambia, market value is defined using the Royal Institute of Chartered Surveyors’ (RICS) definition, which defines Open Market Value as the “best price at which the sale of an interest in property might reasonably be expected to have been completed unconditionally for cash consideration on the date of valuation, assuming:
- A willing seller
- That prior to the date of valuation, there had been a reasonable period (having regard to the nature of the property and the state of the market), for the proper marketing of the interest, for the agreement of price and terms and for the completion of the sale.
- That the state of the market, level of values and other circumstances were on any earlier assumed date of exchange of contracts, the same as on the date of valuation.
- That no account is taken of an additional bid by a purchaser with a special interest..
Forced Sale Value
This is defined as the price at which the property or an interest in property might reasonably be sold, assuming an arm’s length transaction between a willing, able and informed seller and buyer and that the time allowed for the marketing and disposal of the property is more restricted and limited than in the case of the Open Market Value. Such reasonableness of the marketing period will vary depending on market conditions.
Replacement Value
The Replacement Value or the Reinstatement Cost of a building is the estimated cost of erecting the building or modern substitute building having the same gross external areas as that existing, and the ancillary site works together with the relevant professional fees and other associated expenses directly related to the construction of the building and the site work excluding the value of the site itself. In Zambia, this value is usually used for insurance purposes.
Valuation is referred to as a science and an art because, in addition to establishing the value of property based established facts such as the total floor area and building finishes, the valuer is also using his or her opinion in determining the value of the property based on location and the perceptions of the market. In this way, when assessing the value of property, the valuer is imitating how the market is interpreting information in assessing sale prices. Since value is the opinion of the valuer, it should be expected that there will be difference between the valuer’s opinion and the market value and also differences between the values arrived at by two different valuers valuing the same property.
This does not mean that huge discrepancies are allowed. Differences should be within a reasonable range. For example, a one wishes to obtain a loan from a bank and obtains the services of a valuer to determine the value of his or her house, and the valuer estimates the value at K300,000.00. if the bank also hires their own valuer to determine the value of the property, there should not be huge discrepancies between the estimates of the two valuers (e.g. K300,000.00 vs. K200,000.00).
Other definitions of value include:
Use Value – this is the value a specific property has for a specific use, which is different from market value. This value is especially used for limited-market properties. Limited-use properties are those with relatively few potential buyers at a particular time (can we think of types of properties that have a limited use).
Investment value – this represents the value of a specific investment to a particular investor based on his or her investment requirements. It contrasts with market value in that investment value is value to an individual only, not the marketplace.
Going Concern – this is the value of a proven property operation. It includes incremental value associated with the business concern, which is distinct from the value of the property only. It includes both real property and intangible personal property attributed to business value, e.g. goodwill.
Object of Valuation
Object of Economics
An economist studies issues of scarcity and choice. Resources are allocated through markets, which coordinate the activities of producers and buyers by setting a price which determines how much of a good is produced and sold. Therefore, an economist is concerned with why prices rise, their magnitude and the effects of the price mechanism. It follows, therefore, that the character of economics is that which makes prices manifest, which is the value of the sense of productivity. The object of economics is wealth as priced under the light of productivity or value.
Object of Land Economics
The material object of land economics is landed wealth. The characters and object follow from the consideration of economics and for land economics, its object is landed wealth as priced under the light of productivity. The allocation of landed wealth is not the result of centrally planned or political directive, rather it is responses made by individuals who shape their actions according to the signals conveyed by the market that determines prices. Can we say that the allocation of landed wealth in Zambia is not politically motivated? For example, in the allocation of land, can we say that there is no political influence? Land is vested in the President on behalf of the people of Zambia, therefore, is there a purely market-based determination of prices of land and landed wealth?
Objects of Valuation
Having looked at the object of economics and of land economics, let us now discuss what the object of valuation is. The material object of valuation is landed wealth. The character is estimated price and the character is based on productivity. This is what gives rise to price, in short the object of valuation is estimated price of landed wealth under the light of productivity. The difference between a land economist and a valuer is that a land economist takes a much broader view of the land economics, the valuer is property-specific. The valuer wants to estimate the price that this particular item is likely to fetch on the market.
Aspects of Value
Value is extrinsic to the commodity, good or service to which it is ascribed. What does this mean? It means that value is created in the minds of the individuals who constitute the market. The relationships that create value are complex, and values change when the factors that influence value change. It is difficult to ascribe ‘value’ to any particular item. It is the forces of demand and supply that determine the price at which a price will be sold therefore, it is the individuals who make up the market who ascribe value to a particular item.
There are four independent economic factors that create value; utility, scarcity, desire and effective purchasing power. All 4 factors are essential for a property to have value.
Utility – this is the ability of a product to satisfy a human want, need or desire.
You learned about diminishing marginal utility in Principles of Economics, What does this law state?
It states that as a person increases consumption of a product, while keeping the consumption of other products as a constant, there is a decline in the marginal utility that person derives from consuming each additional unit of that product.
Therefore, if a product is a consumer good, utility is the item’s ability to satisfy desires; if it is a factor of production, its utility is its productivity, its ability to create goods and services.
All properties must have utility to tenants, owner-investors, or owner-occupants. The benefits of owner ownership are derived from the bundle of rights that an owner possesses.
Scarcity – this is the present or anticipated supply of an item relative to the demand for it. We say that the supply of land is scarce, however, when you look around, there are vast amounts of land that is still undeveloped. How then can we say that land is scarce? Well, land is scarce in the sense that land of a particular type and in a given geographic location is scarce. This makes desirable land scarce therefore, giving it greater value.
Desire – this is the purchaser’s wish for an item to satisfy human needs (e.g. shelter, clothing, food and companionship) or for individual wants beyond essential life support needs.