1. Micro- economics Valuation & Appraisal

2. 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.”

3. 3 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?

4. 1. Short-run supply of and demand 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 4

5. 1. Short-run supply of and demand for property 5 Supply (S) Demand (D) Q* P* Quantity of land Payment for use of land (rent) Figure 1

6. 2. The real estate market and price determination a)Rent for land b)Land use rent c)Land use intensity 6

7. a) Rent for land Real estate comprises land and buildings Heterogeneity (geographically, physically, legally) Lumpy (financing) Long-lasting (second-hand market) Split occupation and ownership –market in former drives market in latter (relationship between them) –Which means we can focus on rental market 7

8. a) Rent for land Classical economists regarded rent as a payment for the use of land in its ‘unimproved’ state Ricardo’s agricultural land rent theory implied rent was entirely demand-determined because the supply of land as a whole was fixed and had a single use (to grow corn) The most fertile (productive) land is used first and less productive land is used as the demand for the agricultural product increases Rent on most the productive land is based on its advantage over the least productive and competition between farmers ensures the value of the ‘difference in productivity of land’ is paid as rent Rent is therefore dependent on the demand (and hence the price paid) for the output from the land – a derived demand 8

9. a) Land rent 9 D1D1 S (supply of all land) Quantity of land Rent D P O E Figure 2 Q P1P1 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 constant Increase in price of commodity produced from land or increase in land’s productivity

10. b) Land use rents 10 S D Q* P* Economic rent Transfer earnings (opportunity cost) Quantity of land Price or rent Figure 3

11. b) Land use rents (over space) 11 Quantity of land D1D1 S (inelastic) O Rent D2D2 Large increase in rent Economic rent Transfer earnings Figure 4 City centre

12. b) Land use rents (over space) 12 Quantity of land D1D1 S (elastic) O Rent D2D2 Small increase in rent Transfer earnings Economic rent Figure 5 City fringe

13. b) Land use rents (over time) 13 Rent (£) Office floor-space (m 2 ) O S r* D D1D1 S1S1 r1r1 r2r2 Figure 6

14. b) Land use rents Nowadays we think of rent as payment for ‘improved’ land, i.e. buildings too Land & buildings are a fixed factor of production (except in long- run) which users can combine with variable amounts of other factors (labour and capital) to undertake business activity Supply of all land is completely inelastic and supply of land for all commercial uses is very inelastic Supply of land & buildings for specific commercial uses is relatively inelastic in the short-run but less so in the long-run (change of use, development, increased intensity) Nevertheless, compared to the other factors of production, supply of property is the least flexible. So, because of the negligible influence on price of new supply, demand is the major determinant of rental value 14

15. 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 15

16. c) Land use intensity 16 Cost of capital / value of output (unit) Marginal revenue product (MRP) Marginal cost of capital (MC) O X P Q Y Total cost of capital Rent X1X1 X2X2 Units of capital Figure 7

17. Replacement cost rent level Rent at which, when capitalised, equates to the MC of replacement –E.g. Build cost = £200/ft2, yield 8%, so replacement cost rent is 200 x 0.08 = £15/ft2

18. c) Land use intensity 18 MRP Units of capital Rent Capital (a) Intensive use of land MC Revenue & cost per unit of output Figure 8 Units of capital Rent Capital (b) Extensive use of land MC MRP Revenue & cost per unit of output

19. 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 19

20. 3. Location and land use 20 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

21. 3. Location and land use 21 Distance from market Total cost for use B Revenue from both uses 0 R Y Total cost for use A A B X Revenue / costs (£) Figure 10

22. 3. Location and land use 22 A A Rent-earning capacity Distance from market B B C C D D X Y Z M N Figure 11

23. 3. Location and land use 23 Rent Distance from CBD Bid-rent curves Increasing profit XO (CBD) Market rent Figure 12

24. 3. Location and land use 24 Rent Distance from CBD Retail Office Industrial R O O I Figure 13

25. 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 25

26. 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