What is the Principle of Substitution in Appraisal?

Are You Familiar With The Principle of Substitution?

When appraising homes, appraisers rely on various methods and approaches to arrive at an educated and market-supported opinion of value. Today I would like to discuss one of the basic principles that appraisers learn when training to become an appraiser that influences these methods and approaches, and that is The Principle of Substitution.

What is the Principle of Substitution in Appraisal

What It Is

The Principle of Substitution states that a buyer will not pay more for a house than they would have to pay for an equally desirable and available substitute property. What this means is that if there are three very similar houses available for sale a buyer will not choose the one that is priced significantly higher than the other two.

When comparing the similarity of houses it’s important to consider the physical attributes of the home but you don’t want to forget other important factors as well. These factors include location, school system, land uses in the area, economic conditions such as job availability, population trends, rate of growth, city infrastructure, and availability of services such as hospitals to name a few.

It’s important to keep in mind the difference between sales or listings and comparables. While it is true that a comparable is most likely a recently sold or actively listed property, not all sales and listings will be comparables.

While this may seem a little confusing, if you keep in mind The Principle of Substitution, it will help to make sense of the differences. A recently sold home in the same neighborhood qualifies as a sale, however, it may not be comparable because a buyer would not consider it a substitute for the property being appraised because of significant differences between the two.

The recent sale may be much larger, have a swimming pool when the subject property does not, or be of much higher quality. This property would not be comparable because it is not an equal substitute due to the various superior physical differences and because the buyer for the subject property may not be looking for these features at the price they are willing to pay.

Approaches to Value

This important principle also comes into play when comparing the different approaches to value that an appraiser uses. The two most used approaches are the cost approach and the sales comparison approach.

When considering these two approaches the principle indicates that the approach that would allow the buyer to obtain the home at the lowest price would be the most desirable.

If it is cheaper to build a similar home as it would be to buy an existing one then that is what buyers will typically do. On the other hand, if they can buy an existing home cheaper than it would be to build one then this is what the majority of buyers will do.

Of course, you would also need to take depreciation into consideration when comparing the cost and sales comparison approach.

This principle is also relevant when looking at the lesser-used income approach to value. Buyers will consider the stream of income generated from a property, however, if the price of the rented property is considerably more than a similar non-rental property that is similar in all other aspects they will most likely purchase the one that is not rented or even build one if it is cheaper to do so.

In markets where there is a large number of rental properties, the income approach and sales comparison approach may very well be similar. In areas where there are very few rentals present, there may be a significant difference between these two approaches.

Most of the time, if there are no unusual motivations, the typical buyer will choose the lower-priced home if all else is equal. This is a key point to remember when pricing a home for sale.

Conclusion

As you can see, the Principle of Substitution is present in many areas of the appraisal process. It can be a helpful reminder to anyone pricing a home that even in a low inventory appreciating market like we are in now buyers will not pay more for a home if similar lower-priced alternatives are available.

If you have any questions feel free to leave a comment below and as always thanks for reading.

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Comments

  1. The tough part about the principle of substitution is trying to figure out what is truly a comparable home and/or feature. Especially when things like location and neighbors are taken into consideration.

    • From my appraisal education, we learned that there are various items that can be looked at when trying to determine what a good substitute is. These include location, size of the home, physical features of the home such as bedroom/bath count, amenities (such as pool, barn, etc), quality of construction, price range, among other things. I have never really considered the neighbor option when searching for homes that would be good substitutes for the property being appraised. We are taught to appraise the actual house and not the people buying it or those living around the house.

  2. Andy Widener says

    Great topic & great article. It’s a great tool to set the “ceiling” of value. It’s also a overwhelming data point when realtors/sellers are contesting value. At times, I search competitive listings BEFORE I search sales.

    • Great points, Andy. That is a great tip to search for competitive listings before the sales. Since active listings typically set the upper limit of value they can definitely help you know your upper limit parameters.

  3. Thanks Tom. And one of the tells when an appraisal is too low in value is that a buyer literally could not buy a similar house for that price. I know that’s a tangent. Just something that crossed my mind while reading. Happy New Year friend.

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  1. […] What is the Principle of Substitution– Birmingham Appraisal Blog […]

  2. […] are many factors used to determine a home’s current worth. One of those factors is called the principle of substitution, and Tom Horn explains it at Birmingham Appraisal Blog in his recent blog […]

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