Principles relating to the requirements to real estate objects
This group includes the principles of residual productivity of land, marginal productivity (the principle of contribution), the principle of increasing and decreasing profitability, the principle of balance (proportionality).
The principle of residual productivity lies in the fact that land value is based on its residual productivity. To understand this situation, it is necessary to recognize that any kind of activity usually requires four components of production: capital, labor, management, and land. Each component of production (capital, labor, management, and land) should be covered by revenues from business activity. However, since the land is physically immovable, and other components are attributed to it for business purposes, labor, capital and management are paid for first, and the rest of income is paid to the landowner as rent. Such reasoning is consistent with the basic provisions of economic theory: the land has a “residual cost”¯ and a certain value only when there is a surplus of income after covering the other three components of production. Thus, the residual productivity is expressed in income falling to the land after paying the expenses for labor, capital and management (Jacobus, 2009).
The principle of marginal productivity or the principle of the contribution means that as a result of investments an income must be received remaining after covering the costs. For instance, often the costs for the repair of an apartment can increase its value in amounts far exceeding the cost of the repair itself. The amount of the contribution corresponds to the difference between the price received as a result of the repair of an apartment, and the cost of such a repair (Oprea, 2010).
The principle of increasing and decreasing profitability. The essence of this principle is that the increase of investment in basic components of production causes an increase in the rate of profit growth only to a certain limit, after which the increase in profits becomes less than the increase in investment. This limit corresponds to the maximum value of the real estate object. Any subsequent additional investments in real estate will not give a proportional increase in profits, hence, the proportional increase in the value of the object (Cebi & Kahraman, 2010).
Principle of balance (or the principle of proportionality) is formulated as follows: the components of production (or real estate object) must be combined with each other in certain proportions. If the amount of investments exceeds the amount of work in a given period of time, for instance at the construction of an object, the freezing of capital occurs and the reduction of the overall effectiveness of the project (Cebi & Kahraman, 2010). A similar situation can occur when at a given time there is not enough money for the construction of the object, which is well known to investors of new constructions. In this regard, regulatory documents in the project documentation for the construction of the object provide for the development of calendar schedules of the object construction to get the maximum possible effect from the implementation of the project.
The above reflections about the need to combine all the components of production in certain proportions are valid in relation to the existing real estate object. For example, the effective functioning of a sore requires enough working capital to provide a wide range of goods, a large plot of land enough for the driveways and parking lots, optimal salaries for store managers, the salaries of shop assistants to correspond to (dependent on) the intensity of their work. Only with the optimum combination of all four components of the production the real estate object will bring the maximum profit and, consequently, the value of object in case of assessment will be higher.
The principle of the best and most efficient usage of property
The principle of the best and most efficient usage of property is formulated as reasonable and possible usage of a real estate object which provides the highest present value of an object on the effective date of evaluation. In other words, it is such a variant of usage of property, selected from the reasonable and possible variants, which leads to the highest cost of land. This principle is the basic one in implementing all the approaches to evaluation of real estate objects, and its interpretation is of particular importance in each case, as it directly effects on the choice of the cost.
The analysis of the best and most efficient use of property is carried out in two stages: 1) examination of the best and most efficient use of land, as if it was free; 2) defining the best and most efficient use of building (construction), which is factually on the site (Oprea, 2010).
In practice, the following investment situations may occur: a) it is planned to purchase a free land; b) a user searches for a certain kind of land; c) an investor searches for an optimal combination of user and land; d) an entrepreneur tries to find land with significant potential for increasing its value, in order to resell it later. The solution of the first two situations can be achieved by applying market-based approach to assessment. However, the decision on the last two investment situations can only be possible by determining the best and most efficient usage of land.
In this case, it is necessary to examine various options for exploration of land and real estate development, in order to choose one option which will ensure the highest residual current value. For this analysis, the principle of the best and most efficient usage of land is formulated as the usage selected among reasonable, probable and legal alternatives, which is physically possible, well grounded, financially feasible and leads to the highest cost of land.
The selection of the optimal variant of the land usage depends on the potential of the land location; market opportunities to adopt this option of using the land and implement this option from the legal point of view; physical, soil and landscape features of the land, as well as technological and financial soundness. Still, the potential of the land location is the main factor affecting the value of the real estate object. For instance, if the investor is planning to build a cafe, the object should be located on busy streets; if a warehouse – near highway and railway entrances, etc. In the analysis of the selected option of using the object, various inconveniences and/or negative factors should also be taken into account.
The theory of real estate market functioning and value formation has produced the four major factors affecting the cost of real estate objects: need, utility, deficiency, and real purchasing power. These factors are manifested through the main principles of market which determine their impact on the value of real estate during its functioning. The basic principles of real estate are organized into four groups: 1) user-based principles, 2) principles relating to real estate objects (land, buildings), 3) principles relating to the market environment, and 4) the principle of the best and most efficient usage of property.
Having discussed the major principles, we have come to the conclusion that in the process of interaction, the critical factors affecting the cost (need, utility, deficiency, and real purchasing power) form the economic principle of supply and demand. In the aggregate, consumer properties of real estate objects, the volume of their supply, and the opportunities and needs of buyers in acquiring them shape demand and supply of real estate in a particular market situation.
Ownership and successful management of real estate objects provide investors with the opportunity for gaining economic profit; and though real estate markets are characterized by great instability, the real estate is the core object of evaluation and real estate markets are a significant driving force for economic development of the society.
Investing in real estate, investors are basing on their needs and abilities. The variety of choices of investment instruments, and real estate objects in particular, reflects the diversity of forms available for national economies. Each participant of the market tends to get one’s own economic goals and results, while in the process of interaction between all the participants, a complex formation of the real estate market occurs. The variety of unstable and interrelated factors affecting real estate is factually manifested in the basic principles of market expectations and market changes discussed above.