What Is The Principle of Substitution In Real Estate?

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Remember the Payless Shoe Source’s slogan, “You could pay more, but why?” In that question lies a principle that every appraiser has to consider in the appraisal process. In real estate, it is called the principle of substitution. What is it?

The principle of substitution is basically this:

If there are multiple properties that are comparable in terms of desirability and utility and I might add, highest and best use, the property with the lowest price will likely have the greatest demand. Additionally, the maximum value of a property tends to be set by the cost of acquiring a different but comparable home, assuming there are no major difficulties in making the substitution.

This Aldi’s commercial demonstrates this principle to some degree.

 

In this commercial, the value range for a bag of cheddar puffs is $1.49 to $2.63.  The maximum value of the cheddar puffs is potentially $2.63. However, the most probable price that someone will pay for the cheddar puffs, if given the choice between these two, is the one for $1.49.

THE SUBSTITUTION PRINCIPLE IS AT THE HEART OF THE DEFINITION OF MARKET VALUE 

This principle really dovetails nicely with the definition of Market Value that is used for mortgage lending purposes. See my article “It Has To Be Possible & Most Probable!” Here is the definition again:

“The most probable price which a property should bring in a competitive and open market under all conditions requisite to be a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as a specified date and the passing of title from seller to buyer under the conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well-informed or well advised, and each acting in what or she considers his or her own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by someone associated with the sale.”

If a person considering a number of homes that were very comparable, decided to buy the most expensive one, even though it was not really superior to other comparable properties available, one might question whether or not that buyer was really acting prudently and knowledgeably? Is the buyer acting in what they consider to be their own best interest? Possibly. But maybe not.

That’s often why one sale that is an outlier, (which means it sold for considerably higher than other comparable sales), is not usually the best indication of Market Value. Sometimes people may get fixated on that one sale and feel like it reflects the market value of their home.

Usually, that’s not the case. That’s one reason why appraisers use more than one comparable sale in our analysis. In fact, usually, we analyze many sales that may be considered to be relatively comparable, and then narrow down to what we feel are the most comparable sales to use in our report.

A SHORTAGE OF INVENTORY CAN LEAD TO IRRATIONAL PURCHASES

The problem with a continued shortage of inventory is that it may tend to cause some buyers to feel desperate to find a desirable home. This can sometimes lead to their not acting rationally or financially prudently in what they are willing to pay for a home. Based upon the principle of substitution, the highest priced home, among other comparable homes on the market, is the one least likely to sell, when a person can purchase a comparable home for less. While this seems logical, sometimes the market is not logical. This has been seen in some market activity in recent years.

However, irrational market activity doesn’t change the principle of substitution that appraisers have to consider. It’s sometimes difficult for people to get their heads around this principle in a market like many of us are in currently.

It can be difficult to see the distinction between what is reflected by the market vs. an individual buyer. Especially when comparable sales are scarce. But then again, that’s why we use more than one comparable sale. That’s also why appraisers consider what comparable homes are listed for and what pending sales of comparable homes are doing. This can provide a clearer picture of the market. Historical sales of the property being appraised, as well as the comparable sales being considered, can be very helpful at telling the story of where the market is at.

WATCHING THIS PRINCIPLE IN ACTION

Supply levels in many areas are on the increase. Some due to seasonal changes, and others, due to changes in housing affordability, tax law changes and the like. With increased inventory, there are more choices for buyers. This leads to increased competition, which in turn leads to the lowering of prices to make a home more attractive to buyers. We again see the principle of substitution at work. As the pendulum of supply swings from a shortage of inventory to a more balanced inventory, or even an over-supply (hopefully not an over-supply), this principle becomes even more evident. I personally feel that some increase in inventory will be helpful to the housing markets in many areas. I believe that most real estate professionals will agree with me on that.

THE PRINCIPAL SEEN IN OTHER APPROACHES

There are other areas of the appraisal process in which the principle of substitution plays a role. Here are two examples:

Cost Approach – In the Cost Approach to value, if a buyer is able to build a home for less money than an existing home costs, they will not pay more for the existing property.

Income Approach – In the Income Approach to value, if a tenant wants to rent a property, they will likely rent the property that costs less but that delivers the same desirability and utility as other properties that are priced higher.

So to wrap it up, you might say that the principle of substitution really is all about competitive pricing. Hopefully this has been a little helpful at explaining the rationale of appraisers in the appraisal process.  Thanks for reading my post!

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September Washtenaw County Snapshot – Ann Arbor Appraisal Blog

Will It Be a Form or Not a Form? – George Dell’s Analogue Blog

NAA Leadership Round Table – National Association Of Appraisers

Adjustments: What Now? – George Dell’s Analogue Blog