Nobody can deny that there are a lot of issues plaguing the appraisal industry at the moment. I want to talk about one issue that I sometimes see: the incorrect usage of extremely important terms.
Many real estate professionals use certain terms interchangeably, even when they have significantly different definitions. Appraisers, unfortunately, are not immune in this crime against clarity. Today, I want to get back to basics and look at the actual definitions of three absolutely crucial terms in our industry: price, cost and value.
I think you’ll agree these are words that you use on a more-or-less daily basis in your work… but are you using them correctly? Based on my own experiences – and for the good of appraisers everywhere – I want to make the differences between these terms crystal clear.
Let’s look at “price” first. Price is simply the amount of money that’s asked for a good or service. The key word in that definition – hence the italics – is “asked”. The price may or may not reflect reality; it may or may not represent the invisible hand of the market.
Let me give you an example, from the not-too-distant past. I was looking to sell the family SUV. We’d had it for a good ten years and it was time for a change. I looked on the Kelley Blue Book website, entered the details for my car and actually advertised it – in local Facebook groups – at below the amount they had listed there. The amount I listed it for – which I thought was fair – was my price. Did I end up actually getting that amount of money? Unfortunately not! The amounts of money on Kelley Blue Book and in my head were not reality. Reality was how much someone in my area would actually pay for the car.
We see this in real estate all the time. In appraisal specifically, we will often put a list-to-sale ratio. That’s because we realize there may be a difference between the price that’s asked and what something actually sells for. Price is the amount of money that’s asked for something, but is not the amount it actually sells for.
Next, we’ll go over “cost”. Cost is what the buyer will actually pay for a product or service. Now, that’s similar to value, but it’s definitely not the same; these kinds of differences are subtle, but important. The price is how much the seller asks for; the cost is how much the buyer will buy for. The product or service may be worth more or less than what the buyer actually pays, but the price is the amount they actually end up forking over.
It’s worth clarifying something at this point: the buyer never actually pays what something is worth. Cost is not the same as value (which we’ll look at soon). Let’s say you have a candy bar and I buy it off you for a dollar. How much was that candy bar worth? To me, it was worth more than the actual dollar, because buying the candy bar involved going to you or your shop, reaching into my pocket for my wallet and handing over the money. To you, it was worth less than the dollar… otherwise you wouldn’t have made the exchange in the first place.
Let me give you a real world example, just to cap off this point. I was in Vegas recently (not my favorite place in the world), with my wife (it’s perhaps her least favorite place in the world). We were walking down the Strip and it was hot; close to 100 degrees. What I wanted more than anything else right then was a nice, refreshing bottle of water. What did I happen to see at that moment? A vendor, with a big ice box full of lovely, cold bottles of water. I could not get the money out of my pocket quickly enough. How much did I actually pay for the bottles of water for my wife and me? Two dollars. How much were those waters worth to us at that moment (i.e. what was their value)? A heck of a lot more.
Last, but certainly not least, we come to something I’ve touched on a couple of times already: “value”. Value is the amount which a buyer and seller agree upon in a given marketplace. What price and cost will a well-informed buyer and seller mutually agree to? Put another way, what will the market bear?
It’s extremely important to note that value cannot be generalized; it must be specific. A buyer coming straight from the Southern California property market and buying property in Idaho, May not believe the property they get for $300,000 in the latter compared to the former. What I sometimes see is they can pay over the market value if they don’t put the time and effort into researching the local market.
Value is intrinsically wrapped up in the law of substitution. If two things are the same, or at least very similar, the buyer will usually gravitate towards the cheaper option. It’s simple logic. Let’s say you’re in a grocery store and you want a pack of gum. You see the pack costs $2.50 there, but you know that – at the place next door – the same pack costs $1.50. You’re going to the place next door, right? It offers better value for you.
As appraisers, it is our duty to understand the difference between price, cost and value. If these terms aren’t properly understood and are used interchangeably, then it leads to confusion and frustration, for both our co-workers and our clients. The differences between them are subtle, but they are important. The terms are similar, but they are certainly not the same.
For more information on this subject, please download and listen to The Appraiser Coach Podcast Episode 348 – Cost, Price and Value.