Lesson 2 Exercises - Basic Economic Principles of Real Property Value (The Income Approach to Value) (2024)

FAQs

What is the principle of supply and demand in appraisal? ›

Principle of Supply and Demand

Buyers and sellers tend to set the price or value of a good based on the supply of a good and the demand for that good. If the supply of a good is stable, and demand for that good increases, sellers of that good tend to increase the price.

Although several appraisal principles are relevant to the income approach, the principle of anticipation is fundamental. The principle of anticipation states that value is created by the anticipation of future benefits, which leads in fact to one definition of value as the present worth of future benefits.

The Principle of Anticipation of Future Benefits states that property is valuable because of the future benefits, such as income, that it is expected (anticipated) to provide (earn).

The income approach is a real estate valuation method that uses the income the property generates to estimate fair value. It's calculated by dividing the net operating income by the capitalization rate.

For example, if there is a rising trend to own ripped jeans, suppliers of ripped jeans would be able to sell these jeans for a higher price. This also illustrates the role of demand in market trends. When there is a growing demand for a certain good, its price will naturally rise.

If supply increases and demand stays the same, prices will fall. If supply remains constant and demand decreases, prices will fall. If supply decreases and demand stays the same, prices will rise. If supply remains constant and demand increases, prices will rise.

An example of someone who would use the income approach is a rental real estate investor to calculate the income generated by the property and consider the cost of the property in comparison to the rental income. Flippers and retail buyers are not primarily concerned with the home's income-producing potential.

In the income approach, the method used to convert a single year's income into an estimate of property value. This can be accomplished by dividing the net operating income by a market-derived overall capitalization rate or by multiplying the income by a market-derived income multiplier.

An appraisal principle of value based on the concept that the more a property or its components are in harmony with the surrounding properties or components, the greater the contributory value. (The more the properties are alike, the more they retain value.)

The principle of supply and demand states that property values will be impacted by the laws of supply and demand. Increased supply compared to demand will decrease property values, whereas a lacking supply compared to demand will increase property values.

What are the three approaches to value? ›

There are three internationally accepted methods of measuring the value of property: the cost approach, the sales comparison approach and the income approach. Depending on the nature of the property being valued, one or more of the approaches may be used by the assessor.

Highest and best use may be defined as "the reasonably probable and legal use of vacant land or improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value."

The formula for the income approach is simple: the property value equals the net operating income divided by the capitalization rate, also known as the cap rate. To calculate property value using the income approach, assume a property has an expected rental income of $20,000, with operating expenses of $7,000.

The GRM method determines the market value of a property by multiplying the gross rent multiplier (GRM) by the property's annual gross rental income. The formula to compute the GRM divides the sale price of a property by its annual gross rental income, which can be rearranged to isolate the price variable.

NDP_FC = Compensation of Employees + Profit + Rent & Royalty + Interest + Mixed income. The last step of calculating National Income through the Income Method is the estimation of Net Factor Income from Abroad(NFIA). NFIA is added to domestic income (NDP_FC) to get the National Income(NNP_FC). NNP_FC = NDP_FC + NFIA.

In real estate, as with other businesses, when demand is higher than supply, prices rise, and if supply outpaces demand, prices fall. Factors that impact real estate supply include labor and materials supplies, government policies, and local sentiment about development.

To sum up, effective demand determines the equilibrium level of employment (or output or income) in a capitalist economy. At this level, aggregate demand is equal to aggregate supply. The entrepreneurs earn maximum profits and have no incentive to offer more or less employment.

The housing market is a good example of how supply and demand works within an industry. When the demand for housing is high, but supply is low, home prices often rise. When there is a glut of housing available in a market, homeowners may lower their prices due to less demand in the market.

Key Takeaways

The law of demand holds that the demand level for a product or a resource will decline as its price rises and rise as the price drops. The law of supply says that higher prices boost the supply of an economic good and lower ones tend to diminish it.