What is Substitution in Real Estate?

When valuing a property, lots of different factors need to be considered. How can two homes which are perhaps next door to each other and seem so very similar, vary widely in the price? One way to determine this is using substitution in Real Estate appraisals.

The principle of substitution is that the value of one property is equal to another, equally desirable property. Essentially you can substitute one for another and is the basis for the market data approach to appraisal.

In this article, you will learn about what substitution in real estate is, as well as the different methods Realtors, and Appraisers use to value a property. There are a lot of real estate terms here, but the principles of value all apply. Real estate buyers are very savvy and don’t want to overpay, at least not in the short term on the open market.

Related topic: What is Plottage in Real Estate

Why a house needs to have a value assigned to it.

The first thing we should talk about is why a house or property needs value. There are at least four reasons a house needs to have a value assigned to it. Each of these is slightly different, and as a result, might have a different valuation associated. I’ll share my thoughts about each below.

  1. Taxes
  2. Mortgage or Refinance
  3. Insurance
  4. To Sell

Valuation for Taxes

One way municipalities pay for services like police and schools is through property taxes. In some areas, they are linked to market prices. In other non-disclosure states like Texas, each county independently values homes.

It’s important to remember that the market value of a property is not the same as the Tax value. Often homeowners want a very high market value, but a very low tax value. For property tax purposes, a modified sales comparison approach is usually used.

Mortgage or Refinance Value

In my mind, this is one of the most accurate ways to value a house. This is because it’s done by a licensed, 3rd party appraiser. They have guidelines and rules to follow to make sure the valuation is fair.

However, appraisers don’t always value a house at the highest value which can sometimes cause issues in getting a mortgage.

Valuation for Insurance

Your insurance agent needs a value for your property, but not the whole thing. They only need the replacement value of the dwelling in case of some natural disaster or whatever. If a forest fire destroys the house, the land is still there. It wasn’t destroyed. And the land can be a significant part of the value. But all that needs to be rebuilt is the house. This is why the insurance value is usually lower. Only the new home replacement value needs to be considered.

Market Value of a House

When it comes to selling a house, obviously you want as much money as possible. This is the job of a real estate agent. They will provide a value based on comps (similar home) upgrades, and assign a value to it. If the homeowner decides to sell, then ultimately the price it sells for is the true market value of the house. What a ready, willing, and able buyer is willing to pay.

How an Appraiser Values a House

But in any real estate market, there are differences that complicate what the maximum value of a property may be. Appraisers have developed different methods to create equality among properties:

  • Sales Comparison Approach
  • Cost Approach
  • Income Capitalization Approach

Note that these are the terms for residential real estate, and used by appraisers. Not for commercial use.

The Sales Comparison Approach

The Sales Comparison to valuing homes is one of the most commonly used by the residential appraiser. It compares one property to another recently sold similar property in the area. It takes into account all the different features of a home, and how they might affect the overall value.

Sometimes it is impossible to find a similar property. This is where it gets challenging, and appraisers use mathematical models to provide value. They will add in value for extra features, and take away for lacking items. For instance, let’s say there are two similar two-bedroom homes next door to each other. The only difference is a pool. An appraiser might add or subtract the value of the pool to create the value of the property.

The value of an improvement is hard to judge. What if the floor has brand new floors, and they are high quality but very ugly?

Also called the SCA, this is the basis of the CMA method that Real Estate agents used to determine the value of the property. They look at specific characteristics to determine the value of your property in conjunction with other nearby residential property that has sold in the recent past. Too far away and it doesn’t count, and too long ago and it doesn’t work, either. The similar properties need to be in the general vicinity or at least a very similar area. A desirable substitute property must be in the same area, not different neighborhoods.

The Cost Approach

This method of determining the value of the subject property is a method that uses the price to completely rebuild a property from scratch. Lumber, materials, labor, all the things that would be required to build a place. It does take into account the value of the land and includes that in the value, but does reduce the value for depreciation.

The Income Capitalization Approach

Of the three different ways to value a property, this is the least commonly used in residential real estate. It is primarily for investors and estimates the value of a property based on the income it generates. Rarely used for residential real estate, it is more common for commercial spaces like an office buildings, or an apartment complex. The net income of the property is calculated, as well as future profitable use to come up with a sales price. This method does not use comparable properties.

How a Realtor or Broker Values a House

Real Estate agents and brokers often use a different method called the market data approach. This is similar but differs from an appraiser’s methods. This method compares one property to comparables or other recently sold properties in the area with similar characteristics

Seller’s Market vs Buyer’s Market.

Depending on how many people are looking vs how many people are buying each area can either be balanced, a seller’s market, or a buyer’s market. The simple principle of economics (supply vs demand) applies very clearly here.

In a balanced market, there are enough homes for all the people looking. This is where the principle of balance can apply ( maximum value is achieved and maintained when all elements in the agents of production are in economic balance).

In a seller’s market, more people are looking for homes than others are for sale. The sellers have the upper hand. This typically results in higher home prices and sets the upper limit of value.

In a buyer’s market, there are more homes for sale than people looking, resulting in the buyers having an advantage. This generally results in the lowest home prices.

Final Thoughts

The term substitution in Real Estate is one used for valuation. It is where an equivalent substitute property determines by the maximum value of a house. A prudent buyer will pay what they think a house is worth, taking into account all the different data points they get during the process.

One last note – there are so many different ways to do an appraisal of real estate. In the appraisal world even if you get multiple experienced experts to each independently use these methods, the price won’t be the same. Instead, you will get a range. There are just too many various mathematical rules that can be applied.

Each transaction is always a negotiation to what the highest a buyer will pay, and the lowest a seller will take. That’s how you get a fair price.

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