Most people believe that if you spend money on improvements to your property, the market value of your property will go up by the cost of the improvement they add, but that is not always the case. Today, we are talking about the principle of contribution, how it works, and what you need to know for the real estate exam.
What Is the Principle of Contribution?
The principle of contribution states that the actual worth of an improvement is what contributes to the property’s market value, not the cost of the improvement.
Worth and cost are not always the same thing when it comes to real estate. For example, a pool could add $5000 to the value of a home but cost $10,000 to build.
There are also times when an improvement can add more value than the cost. For example, adding an additional room can be an easy simple job to complete for handy people. So maybe the cost to build is $1000 but the value it adds is $2000.
Contribution is most commonly applied to determine how renovation and property changes may affect the property’s overall cost. The principle contribution is one of the many appraisal principles appraisers use to determine fair market value for a property. Appraisers can accurately determine a fair price for properties using the contribution principle, economic principles, contributory value, real estate market trends, and more.
In some of your areas, the principle of contribution is also called the principle of marginal contribution.
Contribution Principle Example
Appraiser Jack was hired to prepare a feasibility study for a 12-unit apartment complex in which the owner is considering putting in a swimming pool. Which basic principle of appraising should Jack use?
Jack should use contribution. Contribution is most commonly applied to determine how renovation and property changes may affect the property’s overall cost. In this case, since the owner wants a feasibility study, contribution would need to be used. Swimming pools are a typical contribution example.
There are factors that affect the principle of contribution and how much weight it has in the appraisal process, for example, labor costs, land costs, insurance, demand, and many other circumstances. An excellent example of how this is applied is to compare a pool in Florida vs. somewhere like North Dakota. The pools may cost the same to be installed, but the value derived from the pool in Florida would be much larger than in some places like North Dakota.
Contribution and Prospective Future Benefits
The principle of contribution does not have to be taken literally in most circumstances. Now obviously, adding something like a pool to a property has its benefits. If your family really wants to stay cool in the summer in the heat, and you’re adding some value to your home, why not?
Generally speaking, if you want to add something to your property that increases the property’s worth, then usually, it’s a good idea. But you have to keep in mind that cost does not always equal the return on investment.
Contribution and the Real Estate Industry
The principle of contribution is used in real estate investing as the whole purpose of investing is to make the most money possible. Remember, as an investor, it’s your job to maximize income, benefits, and capital, so it’s essential to consider the contribution principle whenever possible.
Contribution relates to other areas of real estate as well. A large portion of real estate appraisal includes using different aspects of contribution. Primarily the three approaches to value consider the principle of contribution as one of the main factors, which is more than likely why you’re reading this today!
What to Know for the Real Estate Exam
When exam day comes, you must be familiar with what we discussed today. Remember, the principle of contribution states that the actual worth of an improvement is what contributes to the property’s market value, not the cost of the improvement. Understand how contribution relates to the three approaches to value, real estate investing, and the real estate industry, and you’ll be good to go come exam day.