Knowledge of basic assumptions, postulates or premises that underlie appraisal methods is essential to an understanding of the purpose, methods and procedures of valuation. Principles of valuation influence the general understanding of the appraisal process. these principles include the following:
- Principle of conformity: Holds that maximum value is realized when land uses are compatible and a reasonable degree of architectural harmony is present. Zoning ordinances help set conformity standards.
- Principle of change: Real property is in a constant state of flux and change, affecting individual properties, neighbourhoods and cities. The appraiser follows trends and influences and is sensitive to changes in conditions that affect the value of real estate. Economic, environmental, government, and social forces affect all markets, especially real estate.
- Principle of substitution: This principle is the basis of the appraisal process. Simply stated, value will tend to be set by the cost of acquiring an equally desirable substitute. The value of a property to its owner cannot ordinarily exceed the value in the market to persons generally, when it can be substituted without undue expense or serious delay. In a free market, the buyer can be expected to pay no more, and a seller can expect to receive no less, than the price of an equivalent substitute.
- Principle of supply and demand: Holds that price varies directly, but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately, with supply. Increasing supply or decreasing demand tends to reduce price in the market. The opposite is also true.
- Principle of highest and best use. The book by the Appraisal Institute titled, “The Appraisal of Real Estate” (10th edition, p.244) gave the definition of highest and best use as:
“The reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.”
The best use of a parcel of land, known as its highest, best and most profitable use, is that which will most likely produce the greatest net return to the land over a given period of time. This net return is realised in terms of money or other amenities. The application of this principle is flexible. It reflects the Valuer’s opinion of the best use for the property as of the date of his appraisal. At one period of time, the highest and best use of a parcel of land in a downtown business district might be for the development of an office building; at another time, a parking lot may be the highest and best use. It is also useful to understand that highest and best use may not be only economic or profit-making in character. Environmental, aesthetic, and historical considerations are increasingly important in governmental views of highest and best use.
Determining highest and best use includes assessing potential buyers’ motives, the existing use of the property, potential benefits of ownership, the market’s behaviour, community or environmental factors, and special conditions or situations which come to bear on appraisal conclusions of value.
- Principle of progression. The worth of a lesser-valued object tends to be enhanced by association with many similar objects of greater value (inadequacy or under-improvement).
- Principle of regression. The worth of a greater-valued object is reduced by association with many lesser-valued objects of the same type (super adequacy or over-improvement).
- Principle of contribution. A component part of a property is valued in proportion to its contribution to the value of the whole property or by how much that part’s absence detracts from the value of the whole. Maximum values are achieved when the improvements on a site produce the highest (net) return, commensurate with the investment.
- Principle of anticipation. Value is created by anticipated future benefits to be derived from the property. In the Fair Market Value Analysis, appraisers estimate the present worth of future benefits. This is the basis for the income approach to value. Simply stated, the income approach is the analysis of the present worth of projected future net income and anticipated future resale value. Historical data are relevant because they aid in the interpretation of future benefits.
- Principle of competition. Competition is created where substantial profits are being made. If there is a profitable demand for residential construction, competition among builders will become very apparent. This could lead to an increase in supply in relation to the demand, resulting in lower selling prices and unprofitable competition, leading to renewed decline in supply.
- Principle of balance. Value is created and sustained when contrasting, opposing, or interacting elements are in equilibrium, or balance. Proper mix of varying land uses creates value. Imbalance is created by an over-improvement or an under-improvement. Balance is created by developing the site to its highest and best use.
- Principle of four-stage life cycle. In due course, all material things go through the process of wearing or wasting away and eventually disintegrating. All property is characterised by four distinct stages: growth, stability, decline, and revitalisation.
