The principle of substitution usually comes up with appraisal and property valuation. It’s essential to understand for investors, property owners, and real estate professionals. In this article we cover everything you need to know about the principle of substitution.
What is the Principle of Substitution?
The principle of substitution states that a buyer will not pay more for a property than the cost of an equally desirable property.
In real estate, when comparing identical houses, the buyer theoretically should always choose the cheaper house. The principle simply means buyers usually don’t pay more when they don’t have to.
Principle of Substitution Example
If a house is selling for $500,000 and an equally desirable substitute is selling for $400,000, according to the principle of substitution, the first house will not sell.
What Is an Equally Desirable Alternative Property?
An equally desirable alternative property or equally desirable substitute is just another property that is the same. So when comparing two practically identical properties, they should be equivalent in cost.
This is common in housing developments where each property is basically copied and pasted. If this is the case, according to the Principle of Substitution, each property should be priced the same.
Maximum Value and Market Value
Maximum and market value in reference to substitution are basically the same.
Market value is the actual price paid, while the maximum value is the highest price that can be produced. Typically an appraiser finds a maximum value, and with an excellent real estate agent, the market value ends up being close to the same number.
Who Uses the Principle of Substitution?
The principle of substitution applies to everyone, even investors and leasees.
A wise real estate investor won’t pay more for an income-producing property if it costs less to purchase a similar property or even build a property with the same properties.
Likewise, most leasees or renters would not pay more rent if an equally desirable property exists for cheap.
How Does the Principle of Substitution Benefit a Buyer?
Since a buyer will not pay more for a property than the cost of an equally desirable property, it favors the buyer.
This means buyers ultimately have the final say in the real estate market. If no one buys houses in an area, sellers are forced to lower their prices.
Which Appraisal Method Uses the Principle of Substitution?
The principle of substitution is the basis of the market data approach which primarily focuses on deriving value from other properties sold in the same area.
While the market data approach primarily uses the principle of substitution it is also used in both the income approach and the cost approach.
How Does the Income Approach Use the Principle of Substitution?
Real estate investors and landlords always want to make the most money possible. An investor generally needs to use the principle of substitution to determine a reasonable rental price. If rent is too high, investors will not be successful, and potential tenants will go elsewhere.
How Does the Cost Approach Use the Principle of Substitution?
If a buyer can build a home for less money than purchasing a new property, usually they will. The cost approach looks at the exact price of building a property. Of course, the principle of substitution would apply, as again, most people would rather spend less money than more.
What to Know for the Real Estate Exam
When exam day comes, you need to be familiar with the principle of substitution; remember, the principle of substitution states that a buyer will not pay more for a property than the cost of an equally desirable property. Understand how the principle of substitution applies to real estate valuation and its respective appraisal methods, and you’ll be good to go come exam day.