Chapter 14 - The Economic Principles

Question 1

“The perception that value is created by the expectation of benefits to be derived in the future.”

is definition of _______________

Answer 1

Anticipation

Simply put, a buyer expects to receive an income stream from the property for a period of time, and is willing to pay now for this income that is expected to be received in the future.

This principle is not limited to income-producing properties. It also applies to residential properties, as well. A buyer might want to buy a house so he or she can enjoy living in it for many years. In this case, the anticipated benefits are not income; they are amenities.

Question 2

Anticipation is defined as

Answer 2

“The perception that value is created by the expectation of benefits to be derived in the future.”

Question 3

• The result of the cause and effect relationship among the forces that influence real property value.”*
• is definition of __________*

Answer 3

The principle of change

Change is constant. Real property values are dynamic and subject to constant and immediate change. It doesn’t mean that values change every day, but that they are capable of dramatic and instant change.

Question 4

The principle of change is defined as:

Answer 4

“The result of the cause and effect relationship among the forces that influence real property value.”

Question 5

• “Between purchasers or tenants, the interactive efforts of two or more potential purchasers or tenants to make a sale or secure a lease.”*
• is definition of _________*

Answer 5

The principle of competition

Question 6

Between sellers or landlords, the interactive efforts of two or more potential sellers or landlords to complete a sale or lease.

Is definition of _____________

Answer 6

The principle of competition

Question 7

• Among competitive properties, the level of productivity and amenities or benefits characteristic of each property considering the advantageous or disadvantageous position of the property relative to the competitors.*
• Is definition of ____________*

Answer 7

The principle of competition

Question 8

The principle of competition is defined as

Answer 8

• 1. Between purchasers or tenants, the interactive efforts of two or more potential purchasers or tenants to make a sale or secure a lease.*
• 2. Between sellers or landlords, the interactive efforts of two or more potential sellers or landlords to complete a sale or lease.*
• 3. Among competitive properties, the level of productivity and amenities or benefits characteristic of each property considering the advantageous or disadvantageous position of the property relative to the competitors.”*

Typical buyers and sellers of residential real property should be aware of the competition in the marketplace when they are making an offer or setting a listing price. The same goes for commercial or industrial properties. One should not act in a vacuum, but consider the competition. That is the only way to make an informed decision.

Question 9

“The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution. ”

Is definition of __________

Answer 9

The principle of substitution

In appraising, the principle basically says, “I won’t pay more than $200,000 for your house, because I can buy another one just as good for $200,000.” This is the primary principle upon which the cost and sales comparison approaches are based.”

Question 10

The principle of substitution is defined as

Answer 10

“The appraisal principle that states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price will attract the greatest demand and widest distribution.”

Question 11

The amount a component of a property adds to the total value of the property. Contribution may or may not be equivalent to the cost to add the component.

Is definition of ____________

Answer 11

The principle of contribution

Question 12

The concept that the value of a particular component is measured in terms of the amount it adds to the value of the whole property or as the amount that its absence would detract from the value of the whole

Is definition of ___________

Answer 12

The principle of contribution

The principle of contribution is used when determining how much to adjust for differences between various components of a property. For example, how much does a fireplace contribute to the overall value of the property? Here’s another example, how much does the lack of a swimming pool penalize a property’s value in an area where almost everyone has a swimming pool?

It is important to note that the value of a particular component of a property is not measured by its cost, as indicated in the first definition above. A tennis court might cost $40,000 to install but the market might only ascribe a contributory value of $10,000, or even zero. This will depend on many factors such as the location of the property, the climate, the price range of properties in the neighborhood and perhaps the age of properties in the neighborhood.

Question 13

The principle of contribution is defined as:

Answer 13

• “1. The amount a component of a property adds to the total value of the property. Contribution may or may not be equivalent to the cost to add the component.*
• 2. The concept that the value of a particular component is measured in terms of the amount it adds to the value of the whole property or as the amount that its absence would detract from the value of the whole.”*

Question 14

The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value.

Is definition of ________

Answer 14

The principle of externalities

This means that good things or bad things can happen to your property’s value based on what is located around it. This isn’t confined to good or bad houses nearby, but could describe the influence of a number of external factors such as exposure to hazards, convenience to work or shopping, adequacy and cost of government services, proximity of recreation, quality of schools, etc.

Real estate is a prisoner of its environment, and its value is affected by factors outside the property’s boundaries.

Question 15

In appraisal, off-site conditions that affect a property’s value.

Is definition of ________

Answer 15

The principle of externalities

Exposure to street noise or proximity to a blighted property may exemplify negative externalities, whereas proximity to attractive and well-maintained properties or easy access to mass transit may exemplify positive externalities.

Question 16

The principle of externalities is defined as

Answer 16

• “1. The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect on its value.*
• 2. In appraisal, off-site conditions that affect a property’s value. Exposure to street noise or proximity to a blighted property may exemplify negative externalities, whereas proximity to attractive and well-maintained properties or easy access to mass transit may exemplify positive externalities.”*

Question 17

“The principle that real property value is created and sustained when contrasting, opposing, or interacting elements are in a state of equilibrium.”

Is definition of _______________

Answer 17

The principle of balance

This can apply to relationships among components of a property, such as the relationship between land and improvements. Once this proper balance is achieved, maximum value is attained. If there is an overbalance, then the principle of increasing and decreasing returns can come into play. Additional expenditures will not produce a commensurate return.

For example, a property owner might build an $800,000 new house on a lot that is only worth $25,000. This would almost certainly result in the house being an overimprovement for its site, and it is highly likely that the value of the property when completed would be worth significantly less than the $825,000 that the owner has invested.

The optimal ratio of land value to improvement value will vary from market to market; there are no standard rules of thumb for this ratio. In some markets, builders regularly construct $400,000 houses on $100,000 lots (4:1 ratio). In other markets, builders might construct $1,000,000 houses on $500,000 lots (2:1 ratio). An appraiser needs to be aware of the principle of balance as it affects local market trends.

Question 18

The principle of balance is defined as:

Answer 18

“The principle that real property value is created and sustained when contrasting, opposing, or interacting elements are in a state of equilibrium.”

Question 19

• “The appraisal principle that real property value is created and sustained when the characteristics of a property conform to the demands of its market.”*
• Is definition of ___________*

Answer 19

The principle of conformity

When properties are unusual or atypical, they may suffer a loss in value. There are more buyers for properties that exhibit characteristics that are commonly in demand. An ultra-contemporary house built in an historic New England village may find very few takers. Whereas, an historical reproduction of a Victorian or American Colonial house may be out of place in Miami Beach and become a hard sell.

Be aware, however, that the demands of the market can and do change over time. They also will vary considerably by area, price range, etc. It will require diligent research by the appraiser to be able to judge pertinent factors accurately.

Question 20

The principle of conformity is defined as

Answer 20

“The appraisal principle that real property value is created and sustained when the characteristics of a property conform to the demands of its market.”

Question 21

Which valuation principle has its strongest application in the valuation of income-producing properties?

• anticipation
• change
• competition
• externalities

Answer 21

anticipation

Question 22

True or False? Basic economic principles apply in the valuation of real property only.

Answer 22

False

Question 23

The principle of supply and demand states that price varies _______ with demand.

• inversely
• directly
• proportionately
• independently

Answer 23

directly

Question 24

The basic economic principles, such as anticipation and substitution, apply in

• business valuation only
• personal property valuation only
• real property valuation only
• any economic endeavor

Answer 24

any economic endeavor

Question 25

Three virtually identical new homes are offered for sale in a subdivision. Two are listed at $350,000, while the third home is listed at $325,000. The home listed at $325,000 is attracting the most interest from potential buyers. What economic principle does this demonstrate?

• substitution
• anticipation
• contribution
• change

Answer 25

substitution

Question 26

When purchasing a home as an owner-occupant, the purchaser’s anticipated benefits are

• income
• amenities
• capitalization rate
• depreciation

Answer 26

amenities

Question 27

A large three-car detached garage is constructed on a homesite at a cost of $65,000. The appraiser researches the market and finds that this garage only adds $30,000 in value to the property. Which valuation principle does this demonstrate?

• substitution
• conformity
• contribution
• change

Answer 27

contribution

Question 28

The concept that a lower-priced property will be worth more in a higher-priced neighborhood than it would in a neighborhood of comparable properties.”

is definition of _____________

Answer 28

The principle of progression

This is a good situation for the owner of the inferior property. You should be happy if you own the cheapest home on the block. Your value will tend to be dragged upward towards the mean. People who can’t afford more may be thrilled with the opportunity to buy into a better neighborhood and be willing to give you a premium.

Question 29

The principle of progression is defined as

Answer 29

The concept that a lower-priced property will be worth more in a higher-priced neighborhood than it would in a neighborhood of comparable properties.

Question 30

“In appraisal, the concept that a higher-priced property will be worth less in a lower-priced neighborhood than it would in a neighborhood of comparable properties.”

is definition of __________

Answer 30

The principle of regression

It is not so good to be the owner of the largest and nicest home in the neighborhood. You may lose value because of the presence of inferior properties around you.

Question 31

The principle of regression is defined as

Answer 31

“In appraisal, the concept that a higher-priced property will be worth less in a lower-priced neighborhood than it would in a neighborhood of comparable properties.”

Question 32

The cost of options forgone or opportunities not chosen.

is definition of ________

Answer 32

The principle of opportunity cost

For example, if an investor purchases an income-producing property, opportunity cost is what he or she gave up (CDs, bonds, etc.) to make the purchase. A prudent investor will choose the investment which seems to offer the highest rate of return at the lowest level of risk.

As an example, let’s say you have $25,000 in cash to invest. You can purchase a 10-year CD which will pay an annually compounded interest rate of 5%. At the end of the holding period, you will have earned $15,722 in interest, plus receiving your initial investment of $25,000 back.

Or, you could use that $25,000 as a down payment on the purchase of a rental house. Assume that if you hold the rental house for 10 years, the total benefits received would equate to an annually compounded rate of return of 12%. At the end of the holding period, you would have “earned” $52,646 in “interest”, plus receiving your initial investment of $25,000 back.

If you chose the CD instead of the rental house, your opportunity cost would be the difference of $36,924. If, however, you selected the rental house over the CD, the opportunity cost would be a negative of $(36,924), which means that your choice was a negative cost (profit). That is not necessarily bad, though. It may be that you preferred lower risk. Or you may have needed to maintain the liquidity of a CD (lower cost to liquidate) compared to owning real estate. Thus, opportunity cost is neither good nor bad. It just is the recognition of the lost potential gain if the lower profit opportunity is selected compared to the higher profit opportunity.

Question 33

The principle of opportunity cost is defined as

Answer 33

“The cost of options forgone or opportunities not chosen.”

Question 34

“Land, labor, capital, and entrepreneurial effort (also known as coordination).”

is definition of __________

Answer 34

The agents of production

The agents of production are based on a production theory. This was introduced in the book “Principles of Economics” by Alfred Marshall in 1890. Production theory presumes that the value of real property is influenced by the cost of producing it.

1. If you were to develop a property, the first step would be to buy some land.
2. Then, in order to construct a building, you would need to pay for the labor (and materials) of construction.
3. The third element is capital. You would probably have to borrow money to pay for the structure.
4. The fourth element is called entrepreneurial effort or coordination. This assumes that besides the capital raised, the developer (entrepreneur) will invest some equity as well as time and expertise. To compensate for that, the entrepreneur expects to make a profit above and beyond all the costs of producing the project.

Question 35

The agents of production are defined as:

Answer 35

“Land, labor, capital, and entrepreneurial effort (also known as coordination).”

Question 36

Based on the book “Principles of Economics” by Alfred Marshall in 1890, each component required a return to make it work:

• The return on land would be _______
• The return on labor would be _______
• The return on capital would be _________
• The return on entrepreneurship would be _____

Answer 36

• The return on land would be rent
• The return on labor would be wages
• The return on capital would be interest
• The return on entrepreneurship would be profit

Question 37

The net income that remains after the costs of various agents of production have been paid.”

is definition of _____________

Answer 37

The principle of surplus productivity

This means that if there is anything at all left after satisfying the four agents of production, the excess profit would be returned to the land. The land was felt to be the most basic component and nothing would be possible without it.

Question 38

The principle of surplus productivity is defined as

Answer 38

“The net income that remains after the costs of various agents of production have been paid.”

Question 39

The concept that successive increments of one or more agents of production added to fixed amounts of the other agents will enhance income, in dollars, benefits, or amenities, at an increasing rate until a maximum return is reached. Then, income will decrease until the increment to value becomes increasingly less than the value of the added agent or agents

Is definition of ____________________

Answer 39

The principle of increasing and decreasing returns

An application of this principle in real property might be in how densely you develop a property. This could apply to lots in a subdivision that get increasingly smaller until you reach an optimum size that will lead to the best return and highest utilization of the land.

It could also be utilized in deciding how many garage bays to construct on a residential property. Let’s say the first two garage bays will return $15,000 apiece in value, but a third bay is considered unnecessary by many market participants. Because of that, they would only be willing to pay $10,000 for the third garage bay. A fourth garage bay might only contribute $5,000, and any additional garage bays beyond four might actually contribute nothing to value. (In fact, it might drive potential buyers away from the property.) In this situation, you have increasing returns until two garage bays, and decreasing returns beyond that point. We would then need to consider cost in comparison to value. If a garage bay costs $12,000 to construct, a builder would lose money on the third garage bay. Therefore, a prudent builder would only build two garage bays in this market. If a garage bay cost $8,000 to construct, a prudent builder would probably build three garage bays, but not a fourth.

Question 40

The principle of increasing and decreasing returns is defined as

Answer 40

“The concept that successive increments of one or more agents of production added to fixed amounts of the other agents will enhance income, in dollars, benefits, or amenities, at an increasing rate until a maximum return is reached. Then, income will decrease until the increment to value becomes increasingly less than the value of the added agent or agents. Also called law of increasing returns or law of decreasing returns.”

Question 41

The reasonably probable use of property that results in the highest value.

is definition of ____________

Answer 41

Highest and best use

Question 42

The use of an asset that maximizes its potential and that is possible, legally permissible, and financially feasible

is definition of ___________

Answer 42

Highest and best use

Question 43

The highest and most probable use for which the property is adaptable and needed or likely to be needed in the reasonably near future.

is definition of ________

Answer 43

Highest and best use

Question 44

Highest and best use is defined as

Answer 44

• 1. The reasonably probable use of property that results in the highest value. The four criteria that the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity.*
• 2. The use of an asset that maximizes its potential and that is possible, legally permissible, and financially feasible. The highest and best use may be for continuation of an asset’s existing use or for some alternative use. This is determined by the use that a market participant would have in mind for the asset when formulating the price that it would be willing to bid.*
• 3. The highest and most probable use for which the property is adaptable and needed or likely to be needed in the reasonably near future.*

Question 45

What are the four criteria the Highest and Best Use must meet?

Answer 45

• legal permissibility
• physical possibility
• financial feasibility
• maximum productivity

Question 46

Examples of Highest and Best Use of Land or a Site as Though Vacant

Answer 46

• projected development or a subdivision.
• leave it vacant for agricultural use
• timberland
• nature preserve.

Question 47

Do you need to consider the cost to raze and remove the current improvements when developing an opinion of highest and best use as though vacant?

Answer 47

No

Question 48

Do you need to consider the cost to raze and remove the current improvements when developing an opinion of highest and best use as though improved?

Answer 48

Yes

Question 49

True or False? Each of the four agents of production requires a return to make it work.

Answer 49

True

Question 50

The smallest home in a neighborhood is worth more than it otherwise might be, because it is surrounded by much larger, better quality homes. This is an example of the principle of

• anticipation
• progression
• regression
• surplus productivity

Answer 50

progression

Question 51

True or False? The highest and best use of a property is always to construct some type of building or improvement on it.

Answer 51

False

Question 52

True or False? When developing an opinion of site value of an improved property, an appraiser needs to consider the highest and best use of the property as though vacant.

Answer 52

True

Question 53

A lot owner constructs a new 4,000 square foot home in a neighborhood of mostly 800 to 1,200 square foot homes. The value of the new 4,000 square foot home is diminished by the smaller homes surrounding it. This is an example of which valuation principle?

• opportunity cost
• competition
• progression
• regression

Answer 53

regression

Question 54

The net income that is left over after the four agents of production are paid is returned to the

• seller
• land
• lender
• borrower

Answer 54

land

Question 55

Unfortunately, with real estate, the ______ side of the equation is relatively fixed and slow to change whereas the ______ side of the equation can change quickly.

• supply, anticipation
• demand, supply
• supply, demand
• demand, distribution

Answer 55

supply, demand

Question 56

Which statement is FALSE concerning the highest and best use of land as though vacant?

• It could be to leave it vacant
• It could be for projected development
• This analysis can only be applied if there are no existing improvements
• It could be the existing use

Answer 56

This analysis can only be applied if there are no existing improvements

Question 57

Good things or bad things can happen to the value of your property according to what is located around it. This illustrates the principle of

• balance
• substitution
• anticipation
• externalities

Answer 57

externalities

Question 58

Value is the present worth of future benefits. This is an illustration of the principle of

• change
• externalities
• substitution
• anticipation

Answer 58

anticipation

Question 59

“The principle that real property value is created and sustained when contrasting, opposing, or interacting elements are in a state of equilibrium” is the definition of the principle of

• supply and demand
• balance
• increasing and decreasing returns
• substitution

Answer 59

balance

Question 60

If there is anything at all left after satisfying the four agents of production, the excess profit would be returned to the land. This is the principle of

• surplus productivity
• increasing and decreasing returns
• opportunity cost
• regression

Answer 60

surplus productivity

Question 61

“The concept that successive increments of one or more agents of production added to fixed amounts of the other agents will enhance income, in dollars, benefits, or amenities, at an increasing rate until a maximum return is reached. Then, income will decrease until the increment to value becomes increasingly less than the value of the added agent or agents” is the definition of the principle of

• surplus productivity
• increasing and decreasing returns
• opportunity cost
• regression

Answer 61

increasing and decreasing return

Question 62

The principle of ____________is the basic principle that underlies all three of the appraisal approaches.

• contribution
• substitution
• change
• conformity

Answer 62

substitution

Question 63

“In appraisal, the concept that the value of a superior property is adversely affected by its association with an inferior property of the same type” is the definition of the principle of

• progression
• balance
• regression
• substitution

Answer 63

regression

Question 64

“The perception that value is created by the expectation of benefits to be derived in the future” is the definition of the principle of

• amenities
• anticipation
• substitution
• discounting

Answer 64

anticipation

Question 65

In the agents of production theory, the return on land would be __________ and the return on labor would be ________.

• profit, wages
• rent, interest
• rent, wages
• interest, profit

Answer 65

rent, wages

Question 66

A recession caused by a factory closing illustrates the principle of

• anticipation
• change
• balance
• highest and best use

Answer 66

change

Question 67

When estimating the value of a swimming pool to a residential property, the most important principle is the principle of

• contribution
• competition
• supply and demand
• anticipation

Answer 67

contribution

Question 68

Supply and price move in a(n) ____________ relationship.

• inverse
• converse
• direct
• parallel

Answer 68

inverse

Question 69

“The appraisal principle that real property value is created and sustained when the characteristics of a property conform to the demands of its market” is the definition of the principle of

• balance
• substitution
• conformity
• externalities

Answer 69

conformity

Question 70

How many criteria are used in highest and best use analysis?

• 2
• 3
• 4
• 7

Answer 70

4

Question 71

Normally the first step in highest and best use determination is to investigate the uses that are

• physically possible
• financially possible
• legally permissible
• maximally productive

Answer 71

legally permissible

Question 72

The concept of highest and best use applies to

• vacant land only
• improved property only
• both vacant land and improved property
• neither vacant land nor improved property

Answer 72

both vacant land and improved property

Question 73

The principle that studies the relationships between participants in the marketplace, such as buyers and sellers or landlords and tenants, is the principle of

• competition
• substitution
• surplus productivity
• anticipation

Answer 73

competition