Several years ago, I wrote a course for the continuing education of appraisers regarding the basic economic principles which underlie real estate appraisal.  Though some of the graphics are dated, I believe the discussion holds up and can still be of use. Presented here is an edited down version. 

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A Course on Economics and Real Estate Appraisal

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Chapter 1:    What is Economics?

 

There are as many specific definitions of Economics as there are textbooks devoted to the subject.  But the general agreement is that Economics involves the concept of scarcity.  Human wants are unlimited, but the resources to satisfy those wants are limited indeed.  Economics looks at this interaction primarily through the mechanism of supply and demand.

 

Economic understanding is important for appraisers for the simple fact that appraisal is basically a special case of applied economics.  Applied means less theory and more application to the real world.  The coming together of supply and demand for a good or service creates what is known as a market.  Appraisers deal with markets everyday; appraisal can be viewed as the localized supply and demand of real estate.

 

The broad field of Economics can be broken down into three sub-areas:  microeconomics, macroeconomics, and econometrics.  We give brief explanations of these in the sections that follow, along with how appraisal fits in.

 

Microeconomics

 

“Micro” of course means small.  Microeconomics looks at smaller aspects of the economy.  This includes the behaviors of consumers and producers (or firms) and how pricing comes about.  Microeconomics is commonly known as “theory of the firm.”

 

Microeconomics is what largely underlies real estate appraisal.  For example, an appraiser may be interested in the supply and demand of three-bedroom ranches in a certain geographic location.  Determination of a market-clearing price is the concern of both appraisal and microeconomics.  (Don’t worry if “market-clearing price” is not completely clear to you at this time.  It will be fully explained later in the course).

 

More Microeconomics:  Consumer Choice Theory

 

Consumer Choice Theory deals with how consumers decide what and how much to buy, if anything.  To begin, the economist makes the assumption that consumers are rational.  We know that this is not always literally true.  Sometimes buyers offer more for a home because they “fall in love with it” and/or are afraid it will “get away.”  All appraisers have had the experience of finding a comparable sale that for some reason is far beyond what all the other comparables are selling for.  Often this is attributed to emotion when no other explanation can be located. 

 

Economists refer to the satisfaction a consumer receives from consuming a product as utility.  Total utility is the total satisfaction derived from all the units of that product consumed.  Marginal utility refers to the change in the satisfaction resulting from consuming one more unit of the product.

 

To demonstrate, let’s call the product the living area of a home.  In the local market for three-bedroom ranch homes, 1,500 square feet of gross living area may give a buyer more total utility than 1,499 square feet.  However, foot number 1,500 is worth less than foot number 1,499.  Or to put it more clearly, foot number 1,200 is worth far more than foot 1,500.  This shows the principle of diminishing marginal utility.

 

Let’s further illustrate with an example from appraisal adjustments.  In the adjustment grid on a typical appraisal form, the per foot adjustment for gross living area (GLS) is far smaller than the price per foot it would take to value the home.  For example, a home that is valued at approximately $180 per square foot may only have a GLA adjustment of $25 per square foot or so.  This is because the adjustment is a marginal value.

 

In the next chapter we will advance from consideration of a single individual to groups of consumers, from a single homebuyer to real estate demand.

 

Macroeconomics

 

The theory of the firm, or microeconomics, is well established with little controversy over its general principles over the last fifty years.  This is not the case with macroeconomics.

 

“Macro” of course means large.  Macroeconomics looks at the functioning of the economy as a whole.  Here we have the activities of government, the Federal Reserve, the private sector as a whole, and look at the concepts of recession, depression, inflation, interest rates, GNP, investment, unemployment, etc.

 

Most of these topics are beyond the scope of this course.  However, the appraiser should maintain awareness of the state of the larger economy.  Trends in interest rates and changes in government policy can influence local real estate markets.  But the nuts and bolts of appraisal are microeconomic in orientation.

 

Macroeconomic theory was thrown into the spotlight with the financial and housing crisis at the end of 2008.  What was striking was that so few economists saw it coming.  In an interview with the New York Times (11/2/2008), noted economist James K. Galbraith estimated that out of some 15,000 professional economists in the country only 10 or 12 foresaw the crisis. 

 

For those of you who would like more detail, an interesting source is the writing of Nobel laureate Paul Krugman, particularly “How Did Economists Get It So Wrong?” in the New York Times (9/6/2009).  For a more conservative viewpoint, see Thomas Sowell’s The Housing Boom and Bust (Basic Books, 2009).

 

Useful Definitions for Macroeconomic Understanding

 

Before we leave this topic, here are a few definitions that will help you follow economic debates in the media.

 

• Federal Reserve System:  This is the central bank of the United States.  It regulates the flow of credit and money in the country.  It is a bank for banks.  Mortgage rates are closely tied to the lending practices of the Fed.

 

• Fiscal policy:  This refers to government spending and tax policies.  The idea that government spending is necessary in times of recession and depression in order to stimulate the economy is based on the work of John Maynard Keynes from the 1930’s.  Thus, the policy is called “Keynesian.” 

 

• Monetary policy:  This is usually brought up in opposition to Keynesian policy.  This holds that the economy responds to activities of the central bank (the Federal Reserve System in the U.S.) in its control of the money supply primarily through the manipulation of interest rates.  “Monetarists” see little role for government spending.

 

Common Economic Indicators:

 

• GNP:  This is gross national product, the output of a nation’s goods and services for a particular year.  A healthy economy seeks growth in its GNP.

 

• Unemployment rate:  For appraisers, local unemployment is far more important than the national rate.  For example, the closing of a local auto parts plant would have an impact on the local housing market despite a low national unemployment rate.  In appraisal this is considered external obsolescence from adverse market conditions.

 

• Inflation:  This is the general rise in the price of goods and services in an economy.  It is typically measured by the consumer price index and reflects a decline in the purchasing power of money, e.g. a dollar today will not buy as much as it did last year.

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Econometrics

 

Literally interpreted, econometrics means “economic measurement.”  Basically it is the use of statistical methods to tease out relationships among economic factors or forces.  A primary tool in econometrics is regression analysis.

 

What is Regression Analysis?

 

A regression is a statistical procedure that attempts to determine the strength of the relationship between one dependent variable (so called because it depends on the values of the other variables) and a series of other variables called independent variables.

 

A special type of regression is of concern to appraisers.  It is called Hedonic pricing and is commonly used in the housing market.  The dependent variable is the price of the house and the independent variables are potential explanatory factors such as size, features, view, location, etc.  This makes it possible to determine how much each independent variable affects the price.

 

Hedonic pricing essentially does a series of appraisers’ “paired data” analysis all at the same time.  Recall that paired data analysis is based on the premise that when two properties are in all other respects equivalent, a single difference can be valued by looking at the difference in price between them.  For example, if one home sells for $250,000 with a one-car garage and another, otherwise identical home, sells for $255,000 with a two-car garage, paired data analysis tells us the value of a second garage stall is $5,000.

 

Paired data is difficult to find in the real world, and appraisers will be tempted to turn to regression.  Computer programs that do the analysis are increasingly common, even spreadsheet programs such as Microsoft Excel have the capability.  However, appraisers should be cautious because it is one thing to run the program and quite another to correctly interpret the results.  One should hesitate about making regression results part of a final report without first having a solid mathematical and statistical background. 

 

Summary

 

Economics is the art and science of trying to meet unlimited needs with limited resources.  We have looked briefly at the three main sub-areas of Economics:  microeconomics, macroeconomics, and econometrics.  We have seen that real estate appraisal is rooted in microeconomics and the interaction of supply and demand. 

 

Chapter 2:    Real Estate Demand and the Demand Curve

Chapter 3:    Real Estate Supply and the Supply Curve

Chapter 4:    Markets:  The Intersection of Supply and Demand

Chapter 5:    The Languages of Economics and Appraisal

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