Micro-economicsValuation & Appraisal

Adam Smith

“A dwelling house, as such, contributes nothing to the revenue of its inhabitant. If it is lett (sic) to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue ... The revenue of the whole body of people can never be in the smallest degree increased by it.”

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Valuing property developments

1. Why does land have value?

2. Development valuations differ markedly from other areas of valuation, why?

3. What does the value of a piece of land depend on?

4. Why is it difficult to rely solely on the comparison method to value development land?

1. Short-run supply of anddemand for real estate

• A property has value because it has utility and is scarce

• Economics; the science of choice, the allocation of scarce resources amongst welfare maximising consumers

• Demand, measured by opportunity cost, is limited by budget constraint - a reflection of the distribution of resource-buying capacity throughout an economy

• The market is the distribution mechanism

• So value will be determined by utility, scarcity, opportunity cost and budget constraint and is reflected in the basic economic principle of supply and demand

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1. Short-run supply of anddemand for property

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Supply (S)

Demand (D)

Q*

P*

Quantity of land

Paym

en

t fo

r u

se o

f la

nd

(re

nt)

Figure 1

a) Land rent

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D1

S (supply of all land)

Quantity of land

Rent

D

P

O

E

Figure 2Q

P1

Economic rent

More economic rent...

Price is determined solely by demand

MRP (downward-

sloping because the

law of diminishing

returns means MP decreases as quantity of

land increases, assume MR is

constantIncrease in price of commodity produced from land or increase in land’s productivity

b) Land use rents

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S

D

Q*

P*Economic rent

Transfer earnings

(opportunity cost)

Quantity of land

Price or rent

Figure 3

b) Land use rents (over space)

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Quantity of land

D1

S (inelastic)

O

Rent

D2

Large increase in

rentEconomic rent

Transfer earnings

Figure 4

City City centrecentre

b) Land use rents (over space)

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Quantity of land

D1

S (elastic)

O

Rent

D2

Small increas

e in rent

Transfer earnings

Economic rent

Figure 5

City City fringefringe

b) Land use rents (over time)

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Rent

(£)

Officefloor-space (m2)

O

S

r*

D

D1

S1

r1r2

Figure 6

c) Land use intensity• The quantity of land that a user demands depends not only

on its price and the price of the final product but also on its productivity

• Productivity of land can usually be increased by using it more intensively through the addition of capital (e.g. more floor-space)

• If land is cheap it will not take much building before it will pay to acquire more land to provide more accommodation whereas, if land is expensive, a large amount of building may take place before building costs increase to a level where it pays to acquire more land to provide extra accommodation

• The process is subject to the principle of diminishing returns

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3. Location and land use• To understand commercial rent we are not only

concerned about supply and demand of land as a whole, of land for particular uses and the intensity of use but also where the land is

• Land close to a market or a supply of labour will yield the same output as land that is further away but would incur lower labour and capital costs due to accessibility advantages

• Assuming the price of the output remains the same regardless of where it was produced, the utility value of the prime site is greater and this value is reflected in the rent

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3. Location and land use

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Distance from market

Total cost (including transport)

Total revenue

Difference between revenue and cost (surplus profit)

Cost

s

0 (market location)

R

Y

Costs (exclg

transport)

Figure 9

3. Location and land use

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Distance from market

Total cost for use B

Revenue from both uses

0

R

Y

Total cost for use A

A

B

X

Revenue /

cost

s (£

)

Figure 10

3. Location and land use

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A

A

Rent-

earn

ing

capaci

ty

Distancefrommarket

B

B

C

C

D

DX Y Z

M

N

Figure 11

3. Location and land use

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Ren

t

Distance from CBD

Bid-rent curves

Increasing profit

XO (CBD)

Market rent

Figure 12

3. Location and land use

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Ren

t

Distance from CBD

Reta

ilO

ffice

IndustrialRO

O

I

Figure 13

Summary• Supply, demand and markets

– Scarcity, choice, opportunity cost, budget constraint– Allocation of scarce resources to satisfy the competing needs– Demand for real estate largely a derived demand

• Competitive market with distinguishing characteristics– Competitive: profit-maximising behaviour, supply allocated to most

profitable demand (in terms of use and intensity, subject to regulation)– Characteristics: decentralised, fewer transactions, heterogeneous,

physically immobile, durable product , in finite supply

• Price mechanism– Real estate rent is a surplus from the MRP generated after having

deducted the unit costs of optimally employed factors of production involved in using land in its most profitable manner

– Paid to landowner by user

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Summary

1. Ricardian land rent theory– MRP theory and law of diminishing returns– Elastic demand and inelastic supply

2. Neo-classical land use rent theory– Elastic demand and elastic supply– Optimum land use allocation due to competition– Transfer earnings and economic rent

3. Marshallian land use intensity and rent theory– Margin of building– Land use intensity: to maximise revenue from a site capital

must be added to point where MRP=MC– Land use rent: When MRP=MC surplus revenue (rent) is also

maximised, the highest bidder is therefore also the most intensive user of the land

4. Urban location theory– Bid-rent theory– accessibility