Measuring what an asset is worth

Intrinsic value

Intrinsic value is defined as a measure of what an asset is worth. In simple terms, the intrinsic value of a property is its replacement cost. Intrinsic value can be estimated by determining the cost of building an equivalent structure on an equivalent block of land. Unlike shares, houses and blocks of land are not identical, but you can generally find ones that are sufficiently alike and allow for comparison, particularly at the lower end of the market.

There are several ways to value a property. The first and most obvious is market value; this is what most people talk about when they refer to value. Market value, very simply defined, is the price an informed buyer is willing to pay, and an informed seller is willing to accept at any given time, where neither party is forced into the deal.

When a home sells for $25 million does the cost of the land, cost of construction (including cost of time and financing) and finish out equal the selling price? Hardly. I have seen homes sell for half their replacement cost and triple their replacement cost.

You’re never going to be perfectly accurate in working out a property’s intrinsic value. There are factors in the cost of replacement that are difficult to measure, such as the value of good design, or in the case of townhouses or condominiums, the cost of getting a project approved (which will be divided across all the units). Nonetheless, it should give you a good baseline of what a similar property would cost to construct.

Whether we like it or agree with it or not, most of today’s pricing - especially in the luxury sphere - is in the form of an auction or 'delayed' auction. Some sales result in multiple bidding - not unlike an auction - that ultimately determines what someone is willing to pay. That highest bidder is not calculating cost, just the way an art bidder is not adding up the cost of paint and canvas. Other real estate pricing is often based on a delayed auction philosophy: a home sells for one price, so the next similar home is priced based on what that sold for, up or down.

Replacement cost can be useful in determining value. Unfortunately, while prices can soar upwards, they can also do the reverse based on supply and demand. In the luxury sector though - not unlike the auctioning of a fine masterpiece - often the sellers are wealthy enough that many withdraw their sale item and wait for a better market.

Understanding a property’s intrinsic value can help us avoid major mistakes and gives us the opportunity to profit from mismatches between market value and intrinsic value. It is not, however, a long-term predictive tool. If we want to maximize our future profits, we’ll first need to select the right kinds of property in the right locations.

As the market shifts and you have questions, we are here for you. Offering the highest level of expertise and customer service in the residential real estate market and a proven record of excellence throughout Los Angeles and Ventura Counties. 

 

 


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