As with any product on the market, all properties have price and value. In the real estate sector, property prices are not the same as property values. The value of real estate is an estimate of what a house or a plot of land is actually worth. The transaction price may significantly differ from its market value. This difference depends on several factors such as availability of analogs or market stability. It can differ depending on who wants to make the transaction most, who has the best trading skills, and whether any incentives to sweeten the deal have been thrown in. Thus, sellers sometimes agree to reduce the price by 10-20% in order to speed up the sales. The initial price is often deliberately overestimated by 15-20%, in order to then give way to this amount in the bidding process. Sometimes, personal views of transaction parties affect the price and make it unpredictable, while the value of the property stays the same.
Like for other economic products, a price of real estate represents the dollar amount that a seller asks and a buyer offers or actually pays for property. Supply and demand form price of the real estate (Pirounakis).
In the real estate, supply is the amount of property available for sale or lease at any given time (Mettling and Cusic). Government policy and regulations, investment returns, availability of financing, and development costs along with the property value affect its supply. For example, high investment returns will stimulate investors to pour money into construction of new buildings. In future, these building become subjects of the real estate market. Therefore, high return on investment in the construction industry increases the real estate supply. Controversially, if the government abandons construction in a particular area, it reduces the supply by withdrawal of land from the construction market.
Demand is the amount of property that buyers and tenants wish to acquire by lease, purchase, or trade at any given time. Demand for particular types of real estate relates to specific concerns of users. These concerns revolve around components of value: desire, utility, scarcity, and purchasing power. The buyer considers all information he/she has about property. This information includes a desire to buy, in other words, how much one likes the property. Demand can decrease if there are any alternatives available. If there are different houses with similar conditions, then the buyer may choose another one for some reason. The amount of buyers also plays a role here. The more people are willing to buy the property, the higher is the demand. Demand for the real estate increases during economic growth (Manganelli). The increase occurs because people perceive real estate as an opportunity for investments or attempt to protect their savings from inflation.
For example, a person has free money in a period of economic growth. He looks for a way of investing it with high return. He could buy some company shares or just open a deposit in a bank. However, a bank, as well as a company may to go bankrupt one day. Shares purchased may depreciate as a result of market shocks. In the result, the investor may lose all his money. At that time, real estate remains the property of its owner even if it becomes much cheaper due to the demand decrease. In addition, the real estate owner will be able to receive income from it during the entire time of ownership. He can lease it, open his own business on the territory, build a house, and sell it more expensive. The owner can use the land to grow crops for sale. In extreme cases, he can resell the property at a more favorable phase of the economic cycle and earn on the price difference. Many people choose to buy some real estate as investment. Demand for real estate increases in this phase and moves the equilibrium price up.
The equilibrium of demand and supply determines the price of real estate. Due to customers’ competition, the higher is the demand, the higher is the equilibrium price (Pirounakis). Among two buyers who both want to buy the same property, one of them will pay the higher price to make the deal. The actual price of the transaction, in this case, depends not only on the real estate value, but also on personal views of buyers.
Therefore, price is the actual amount of dollars paid for the property by the buyer regardless of its true value.
Valuation of the real estate property is one on the most fundamental activities in the real estate business. Its role is particularly critical in the transfer of real estate property since the value of a parcel establishes the general price range for principal parties to negotiate.
In general, real estate value is the current monetary worth of benefits resulting from the real estate ownership. Primary benefits that contribute to real estate value are the property use, income that it brings, tax benefits, and appreciation (Mettling and Cusic).
Ownership of real estate generates income. Such income is a part of real value of the property because the investor would pay money to buy a revenue stream produced by the property. Actual or projected increase in the market value of real estate is another investment benefit. Forecasted price increase affects real value of a parcel of land.
A method of using the property largely determines its value. Each method of property use has its own benefits.
The cost of real estate is often called fair market value. Fair market value is the estimated price on which a buyer and a seller may agree if both are interested in the conclusion of the transaction. The definition suggests that the two sides have enough information about the market and the property and that asset has been on the market for a reasonable period of time.
Real estate fair value measurements assume the “highest and best use” of the property by independent market participants. The highest and best use of the real estate is measured by market participants that would maximize value and use of the property, which may not be the same as the intended use by reporting company. For example, a company may intend to keep a wooded area for conservation when the highest and best use is additional housing.
The most widespread method for determining the value of property is a comparison of similar sales, for example, homes of the same size and similar facilities in comparable areas. Assessors and experts will use a year or six months in sales as the basis for the value of similar houses.
It might be necessary to understand the value of real estate for several reasons. The value of property is the basis for estimation of taxes and for calculation of whether the sale of an investment asset is an income or a tax write-off. Lenders want to know estimated value of the property to make sure it is good for the size of mortgage or home equity loan.
In addition to the method of comparable property in the assessment of value, appraisers can also assess value using analysis of costs or incomes. The cost method calculates value of a building and finds out what it would cost to build a similar structure at current prices. They use an income analysis to determine value of the investment property by calculating how much money it brings.
Theory of income is typically used to assess investment and commercial real estate. It is designed to simulate typical expected behavior of market participants. Application of this theory requires sufficient market information. Such approach capitalizes an income stream into a property value in the commercial income-generating real estate.
Future incomes determine true value of the property for the investor. They show what an expedient price of this property is. This theory converts future expected incomes from the property by capitalizing net operating incomes with a market capitalization rate. In fact, the capitalization rate is profitability of the investment, as well as the dividend earned on the stock. Investors use this rate as a guide to determine how much they should pay for the property. In the valuation practice, capitalization rates are determined by analyzing sales of similar property and applied to the net income of the subject property in order to determine its value (Goddard).
A real estate investor would use the desirable rate of return from a cash investment and then capitalize that rate by the net operating income produced by the property.
For example, one can assume that the investor desires a 10.0% rate of return on his real estate investment and estimates that the subject rental will produce an annual net operating income of $40,000. To calculate market value of a rental property based on its income stream and the desired return on investment, he would divide the property’s net operating income by the rate of return. Net operating income / Desired rate of return = Market value:
$40,000 / .10 = $400,000
Market value is the lowest price the owner wants to sell the property at and the highest price that a buyer is ready to pay for it. The market price, conversely, is the amount of money for what a real estate actually sells for.
In the example mentioned above, according to the income theory, the value of the house is $400,000 (Goddard). The transaction price of a building might be $400,000, but its value could be noticeably higher or lower. For example, if the new owner finds a serious drawback in the house such as defective foundation, its value can be lower than the price. The house will require additional investments to receive the income cash flow planned when purchasing. If the house is put up for sale at $500,000, the buyer might not want to purchase it (Eldred).
Another example is as follows. For instance, the investor wants to build some housing complex that will bring him $100,000 a year. He desires 8.5% return on his investments. The investor made some researches and found a good place for construction. The calculated market value of the land was $100,000 / .085 = $1,176,470. He decided that it was an extremely high price and offered only $1,000,000 as a price for the property. The owner knows that his property can be sold for a higher price and does not want to sell it for $1,000,000.
Sometimes, price can be different than the value even when both participants know the real estate market value. The owner gets in troubles and needs money in a short period of time. He wants to sell the house as soon as possible. He knows that its value is $150,000. However, it will take much time until someone is interested in purchasing. Therefore, he offers the house for $135,000 to sell it fast. It appears that the value of the house is $150,000, while the price is $135,000.
The market price of property does not always match the property value. If the property has been on the market for a short time, the seller may set up an extremely low price to move it quickly. Even if the price is accurate at the time of sale, changes in the local real estate market may change the property’s value. The difference between price and value depends on specific circumstances of each transaction. Motives of the transaction participants may affect its price, as well as completeness of available information and time available to complete the transaction. Depending on these factors, one of the transaction participants wins, while the second one carries some losses.