Understanding Value, Cost and Price
It Is Not Always Worth What Someone Is Willing to Pay
Let us set the scene: after a long day at work, you’re sitting in the bar talking to a friend, in the ‘know’, about a deal he was involved with. The property being discussed is representative of the market but sold for a premium, leaving everyone involved stunned. Curious you ask, “What was the selling price?” Your friend looks back with a smirk and says it sold for 30% over asking. Just as he goes to take a sip of his drink he looks up and says, “Well you know, the property is worth what someone is willing to pay for it.”
Luckily for you (and your friend), the team at Argianas is here to set the record straight. Friends don’t let friends misunderstand value, cost, and price.
market value: four quarters for a dollar
Ralph Waldo Emerson once said, “Money often costs too much.” In that quote is an important point to be made. We are often guilty of thinking of three very distinct concepts – value, cost and price – as one, when in fact, they all refer to and represent different things. Regardless of the type of service an appraiser provides (business, real estate, or real property) they most likely will immediately be able to explain these differences.
There are many types of value; assessed, business, disposition, insurable, investment, liquidation, and public interest. When we are engaged most often, it is for a Market Value appraisal. What this means is that the appraiser will value the property based on the Market Value definition. Market Value is defined through the Interagency Guidelines (FDIC, NCUA, FNMA, etc.) as:
“The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
1. buyer and seller are typically motivated
2. both parties are well-informed or well-advised and acting in what they consider their own best interests.
3. a reasonable time is allowed for exposure in the open market.
4. payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
Market participants do not always act rationally, and real estate markets are imperfect. Appraisers, therefore, work within the realm and ranges of reasonability through the application of the Cost, Sales, and Income Capitalization Approaches.
Price: not the eye of the beholder
If someone paid $X for the property, isn’t that representative of the market? Not necessarily. Why? Because people sometimes predicate their buy/sell decisions on strategic rather than market conditions. The property that sold for 30% over asking may have done so for any number of reasons; the fact that it did may not be representative of the market. One should ask: Was a business value included with the property? Was favorable financing included (cash equivalency)? Perhaps the property included a sale-leaseback. Or as is sometimes the case, perhaps the buyer purchased the property for emotional reasons. As such, Market Value is not always a buyer’s benchmark.
Context is also greatly important. At the time of writing the real estate markets are experiencing a surge of interest, disruption, and disequilibrium. If we place the Great Recession in context, one need look no further than the 2008 market crash, after which, many purchasers were left with homes worth much less than the mortgage amount owed.
cost: a pile of wood does not a house make
Cost is the amount of money necessary to build a new property. It can be the amount needed to build or replace a property using modern building techniques, replacement or reproduction norms. Put differently, you may love your Frank Lloyd Wright Prairie-style home, however, the cost to build a new like-kind property may not be equal to its market value due to physical, external, and functional obsolescence factors of the original home.
advocating for the data
Despite expectations, all property buyers and sellers do not act based upon informed economics. Part of our job is to educate our clients in an objective and impartial manner. Unlike a lawyer or broker, appraisers are precluded from advocating except for concluding at/near market value. This is implied in our ethics at multiple levels, and we must maintain integrity while advocating for truth.
If our appraisal conclusions are higher or lower than desired by the client, this is what we are obligated to report on.
appraisers and creative writing experts?
While we hope you enjoyed our opening parable, we have to admit that we’re more passionate about real estate than creative writing. Although we do enjoy putting our liberal arts degrees to work!
Do you have a real estate horror story and need someone to help you make sense of it? Call the team at Argianas & Associates, Inc. at 630.390.0113 or email us at [email protected] and we’ll be happy to be a part of your story.