Principle of substitution

Key Takeaways

• Substitution holds that a buyer will pay no more for a property than the cost of acquiring an equally desirable alternative.
• All three approaches to value rest on substitution, not only the sales comparison approach.
• Washington's assessment statute builds substitution into law by basing true and fair value on sales of similar properties within the past five years (RCW 84.40.030).
• A substitute the zoning would not permit does not count, because RCW 84.40.030(3)(a) bars a value that assumes a use not allowed under existing land use rules.

What It Means

The principle of substitution is the idea sitting underneath every method of valuing property: a buyer will pay no more for one property than the cost of getting an equally desirable one somewhere else. It is a ceiling set by the buyer's alternatives, and it explains why a seller cannot price a house off what the seller needs, what the seller spent, or what the seller hopes to get.

Course material treats substitution as the central principle of Appraisal, and all three approaches to value lean on it. The sales comparison approach measures a property against recent sales of similar homes, the Comparables an appraiser adjusts up or down for real differences. The cost approach asks what it would take to build a substitute today, then subtracts the value the existing building has lost to age and wear. The income approach asks what a substitute investment would return on the same money.

Substitution is also why an appraisal can land under the contract price. Buyers bidding against each other can push a number past what the alternatives support, and the appraiser is looking at the alternatives rather than at the bidding. Our guide to what happens when a home appraises low walks through the options when that gap opens up in a Washington transaction.

How It Works in Washington

Washington's assessment statute is substitution written into law. RCW 84.40.030(1) requires that "all property must be valued at one hundred percent of its true and fair value in money." Subsection (3)(a) bases that value on "any sales of the property being appraised or similar properties with respect to sales made within the past five years." It also bars an assessment "determined by a method that assumes a land usage or highest and best use not permitted" under existing zoning or land use rules. A substitute the zoning will not allow is not a substitute. Subsection (3)(b) then lets an assessor consider "cost, cost less depreciation, reconstruction cost less depreciation, or capitalization of income." That is the same three-approach structure a lender's appraiser uses.

The line between an appraisal and a broker's opinion of value matters here too. RCW 18.140.020(1) provides that no person other than a state-certified or state-licensed real estate appraiser "may receive compensation of any form for a real estate appraisal." RCW 18.140.020(2) still allows compensation "for brokers price opinions prepared by a real estate licensee." A Washington broker may therefore be paid for a broker's price opinion or a Comparative Market Analysis. There is a catch in RCW 18.140.020(6). A written broker's price opinion issued to someone other than a prospective seller, buyer, lessor, or lessee as the only intended user must state that it "is not an appraisal as defined in chapter 18.140 RCW." It also "may not be used as an appraisal in conjunction with a federally related transaction."

Example

Dev Raman is buying in Spokane Valley. The house he likes on South Ridgeview is listed at $479,000. Two streets over, a nearly identical 1998 rambler with the same square footage, the same three bedroom two bath layout, and a slightly larger lot is listed at $455,000. Substitution says Dev will not pay $479,000 for the first house while the second one is available at $455,000. He negotiates and the parties agree at $470,000.

The appraiser on the lender's file reaches her number a different way. She pulls three closed sales from the past six months at $448,000, $455,000, and $462,000, adjusts each one for lot size and a finished basement, and reconciles to a Market Value of $455,000. The contract price is $15,000 above that, so the lender will lend against $455,000. Dev brings the extra $15,000 to closing, renegotiates, or walks. The seller's remodel receipts change none of it, because the buyer's alternatives set the ceiling, not the seller's costs. Gaps like this open more often in a seller's market, which our comparison of buyer's and seller's markets lays out.

Common Mistakes and Exam Traps

• Substitution sets a ceiling, not a floor. It caps what an informed buyer will pay and it promises a seller no minimum price.
• All three approaches to value rest on substitution, not only the sales comparison approach. The cost approach compares the property to building a substitute, and the income approach compares it to what a substitute investment would return.
• A comparable the zoning would not allow is not a substitute. RCW 84.40.030(3)(a) bars a value that assumes a use not permitted under existing zoning or land use rules.
• A broker's price opinion is not an appraisal. RCW 18.140.020(6) requires the written statement saying so and bars its use as an appraisal in a federally related transaction.