Using The Principle of Substitution in Real Estate Appraisal

What Does The “Principle of Substitution” Mean When Appraising Properties?

The principle of “Substitution” is something that every real estate appraiser considers when establishing the value of a property.  So, what exactly does it entail? Basically, the principle of substitution refers to the following: If there are a number of properties that are equivalent based on desirability and use, or highest and best use; it is highly likely that the lowest priced property will have the highest demand.

Also, the maximum price of a property tends to be determined by the cost of buying a different property that is deemed comparable with the assumption being there aren’t any key difficulties when it comes to making the substitution.

The Principal Of Substitution Is At The Center Of The Market Value Definition

The substitution principle blends quite conveniently with the following definition of Market Value:

“The most feasible price that a property should deliver in an open and competitive market under all the conditions needed to be a fair sale in which both the purchaser and seller are acting rationally and prudently.”

The assumption here is that price doesn’t get affected by any undue stimulus.  If an individual chooses to purchase the most expensive home among a number properties that were closely comparable, even though it was not significantly better than the other equivalent homes on sale, one might be prompted to ask whether their decision was prudent and knowledgeable. Did the buyer act in a way that suggests they had their best interest at heart? True…or not true?  This is why in most cases, an outlier sale (a sale considerably greater than that of other similar properties) is normally not the best indicator of Market Value. Some people may base too much on this sale and believe it to be the indicator of their home’s market value.  This is often not the case; a reason behind why appraisers look at more than just one sale. In fact, we consider a number of sales that are deemed to be relatively comparable in our analysis before narrowing down to those sales we see as most comparable. These are what we use in our report.

Inventory Shortage May Lead To Buyers Making Irrational Offers

The challenge that comes with inventory shortage is that buyers tend to get desperate in trying to find a home they desire. The implication here can sometimes mean buyers fail to act rationally or prudently with their finances when it comes to paying for a property. Considering the substitution principle, the home with the highest price tag among a number of comparable properties on the market has the lowest probability of being sold when an individual can buy a comparable property for less. Sometimes, the market makes no sense, and this has been exhibited by some market activities just a few years back.  Nevertheless, this irrational market activity does not change the substitution principle considered by appraisers. In some situations, people find it tricky to understand this principle, especially in a market like the one most of us are presently in.  It can prove daunting to distinguish between what you see in the market and what you see from an individual buyer. This is very true for cases with very few comparable sales. Anyway, this is the reason why we use multiple comparable sales. It’s why appraisers look at the price of listed comparable homes, as well as the pending sales of comparable properties. This may give a more clear state of affairs in the market. Past sales of the home under appraisal and comparable sales under consideration can be instrumental in explaining the current situation in the market.

The Principal Of Substitution As Seen In Other Approaches

There are more areas in the appraisal process where the substitution principle is used. Consider the following examples:  Cost Approach- In this approach, if a buyer can build a home at a lower cost than the price of the existing home, they won’t pay more to acquire the existing property.  Income Approach- For the Income Approach, if a tenant is looking to rent a property, it is possible they will rent the property which costs less but offers the same convenience and desirability as other properties with a higher price tag.   In conclusion, it can be said that the principle of substitution generally revolves around competitive pricing.

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