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Real Estate Finance for Texans: Value and the Four Simple Questions

Posted on September 5, 2018 by texasfirstrealty in Real Estate Finance

Understanding Value

In this Real Estate Finance for Texans post we take a closer look at the fundamental concept of value.

It seems obvious, but when you look at what value really means it can help you make an initial assessment of a potential property purchase. And in the end, I will teach you how to form four simple questions that can help you grasp value.

What is value?

In real estate terms, we can look at value as having four parts: Scarcity, Utility, Demand and Effective Purchasing Power.

Scarcity

This one can be a little difficult to wrap your mind around at first. But without scarcity, land isn’t valuable.

Here is an example. How much would you pay for an acre of land on the Moon? Probably, you wouldn’t pay anything for it. Why? Because it isn’t scarce. There aren’t other investors trying to purchase land on the Moon (yet) and making the price rise.

So how can we re-form the idea of scarcity into a useful question for investors?

Are there a lot of similar properties available in the market area?

It’s as simple as this. If over the last decade, ranches around Pilot Point are not coming onto the market as much as ranches in Gainesville, then ranches in Pilot Point are relatively more scarce compared to ranches in Gainesville. So there is more scarcity for this type of property in Pilot Point and more potential value.

Now, remember this is only one component of value and can’t tell you everything about comparing two properties. But if the above is true, we might assume that comparable ranches in Pilot Point will often be priced higher than comparable ranches in Gainesville. And this is generally true.

On the other hand, you might want to buy in the Gainesville area because you believe the market will ultimately make ranches there more scarce in the future. And of course, it is better to invest just before a market area becomes more scarce, so you can profit from increased future prices.

Utitlity

The idea of utility in real estate is the ability for that property to satisfy a need or want. Remember our example of land on the Moon? Since a lot of people don’t want to go live on the Moon, it doesn’t have a lot of utility.

Now just because something has utility doesn’t mean it has value. Oxygen has utility. We need it to breathe. But since oxygen isn’t scarce, it doesn’t have much value.

How does this translate to real estate? And what question can you as an investor in accessing property?

Does this property have more utility than comparable properties in the market area?

Here is an example on how to use this question.

Let’s say you are comparing two properties. They are both 10 acre pieces of land. The topography is good for building a subdivision on. You want to find a good piece of land to build a small subdivision.

Property A is already platted and there are utilities running along the frontage. Property B is not platted and utility lines will have to be brought up to the frontage of the property.

Which has more utility?

Property A. Because if the price is equal, the ultimate demand from customers who want to buy a home in a subdivision can be satisfied less expensively. You don’t have to pay as the investor to have the property platted, or deal with the utility companies. Now, one would expect there to be a price difference in the two properties, but if there isn’t, then we can use the concept of utility to answer this basic question about investing.

Demand

There has to be demand for a type of property for it to have value. Almost all property has more than 0 percent demand. But…remember our example of acreage on the Moon. Is there really any demand for land on the Moon? Not really. So land on the moon won’t have much value.

I use these extreme examples of land on the moon to illustrate the idea. But let’s use a real world example and get to a target question we can use.

Does this type of property have or will have in the future strong demand?

Let’s go back to the example of the 10 acre investment property for building a subdivision. So, you’ve acquired the property and you have your builder lined up. You decide there are two choices.

You can build 5 modest, 3/2 homes on the land. The price range will be in line with average sold prices in the market area. You have checked past sales and it seems houses like this are selling in under 45 days in the market area. You will make a great return on investment if you follow this plan.

Or

You can build 2, multimillion dollar homes in the style of medieval castles, complete with their own private motes and drawbridges. If you sell these two homes, you will actually make MORE money from your investment. You tell your builder this idea. They stop returning your calls. You wonder why.

Well why? Again, I use funny and extreme examples to illustrate the point. IF you could sell those two castles you build on the investment property, you would make more money. But how much demand is there in the market for castles with moats and drawbridges? Probably close to none. Without demand, even if the investment technically works out mathematically on paper, it won’t work out in real life.

Now you wouldn’t likely even make this choice. But you do have to think about what is in demand. Are duplexes a better investment at the moment than the 3/2 houses? Are rentals stronger than small hobby ranches? What is in demand in the area? And more importantly, do you think you can see six months or a year into the future and know what will be in demand then?

Effective Purchasing Power

This is the concept of making sure there is a large enough pool of potential buyers for your investment property. Here is an easy example and a simple question to ask yourself.

Let’s pretend you own 200 acres of potentially good development property outside of Tioga, Texas. You can put these 200 acres up for sale with a great real estate company, called Texas First Realty. You decide to give them a call after reading an informative blog post about real estate finance on their website.

But when you discuss the listing with the broker, he suggests you consider also listing the property as multiple listings. Making separate listings for the property so that you can sell them in increments of 20 acres.

At first that seems like more trouble than its worth. You won’t get all the money for the sales back at once. You will have to deal with multiple closings and multiple transactions. But…

The broker points out that there is a much larger pool of buyers who can afford a 20 acre piece of land than buying 200 acres of undeveloped land. And if you sell them that way, you can actually sell them for more individually. So after they are all sold off, you will make more money.

Effective Purchasing Power is really simple. While a 200 acre property is probably more scarce, has more potential utility, there are going to be a lot less people who can actually afford to buy that property. But if you simply change the way in which you sell the property, you open it up to a lot more potential buyers.

So ask yourself this question when thinking about buying or selling a property?

Is there a way I can make this property accessible to more potential buyers?

Reviewing Value and the Four Simple Questions

Let’s review the four questions we can ask ourselves as investors when considering selling or buying real estate.

Are there a lot of similar properties available in the market area? (Scarcity)

Does this property have more utility than comparable properties in the market area? (Utility)

Does this type of property have or will have in the future strong demand? (Demand)

Is there a way I can make this property accessible to more potential buyers? (Effective Purchasing Power)

We hope you enjoyed this Real Estate Finance for Texans post. If you are considering investing or buying real estate in North Texas, feel free to contact us with any questions. And if you like this type of content, make sure to subscribe to the newsletter.


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