One of the most important components of a real estate market study is an analysis of government regulations and how they may impact the subject property. The reason for this is that government regulation may legally prevent an owner from using a piece of property in desired manner. Alternatively, the costs of adhering to government regulations may be so costly as to make the property investment not feasible. So, a real estate market analysis should consider the impact of government regulation on the subject property and how those regulations could impact the use, development, and value. Excluding external economic factors, the impact government has on property falls into two categories: building codes and zoning regulations and public goods and services.
Building Codes and Zoning Regulations: A Historical Perspective
Early in United States history, building codes and zoning regulations did not exist. Property owners were free to use the land as they saw fit. As cities became more populated and the number of complaints between neighbors rose, however, city governments were pressured to begin regulating land use. New York City passed its first zoning ordinance in 1916. Then, in 1922, the U.S. Department of Commerce created and distributed its Standard State Zoning Enabling Act. This document encouraged many city governments to enact zoning regulations.
Zoning regulations, however, quickly moved from being a tool for managing urban development and planning into a tool for suburban homeowners to protect property values. These practices came under attack in the civil rights era, and suburban zoning regulations then became focused on managing the growth that resulted from the population exodus from the inner cities. High tax rates in urban areas pushed more residents and businesses into the suburbs, and the suburban towns struggled to handle the growth.
Building codes also originated from the problems that resulted from early urban development. In particular, building codes were a response to the devastating destruction from inner city fires such as the Chicago fire of 1871. City governments began to develop building codes to protect the health of their citizens. Early building codes addressed the dangers of wooden chimneys and the need for safety features such as ventilation, fire escapes, railings, and proper sanitation.
Building Codes and Zoning Regulations: Valuation Concerns
A real estate market analysis should include an examination of building codes and zoning regulations affecting the subject property. Since local governments create their own building codes, the requirements can vary substantially by location. All things being equal, a property that already satisfies current building codes is more valuable than one needing to be brought up to code. In addition, it is more expensive to comply with more stringent building codes. Therefore, the cash flows generated by the subject property must be high enough to compensate for the additional construction costs. Building codes may also address hazards unique to the area, such as the risk for earthquakes in California and hurricanes in Florida. There are fewer legally permissible and financially feasible real estate development projects in areas with more stringent building codes.
One of the unique features of real estate is that the asset’s valuation is impacted by the surrounding properties. You can’t consider the subject property without considering its neighbors. For this reason, it is important that the zoning of the plots around the subject property are either the same or complementary. For example, it is better for residential lots to be located next to other residential lots and commercial lots to be located next to other commercial lots. In addition, a property that is already zoned for the intended use is more valuable than one that is not. The local planning board can change a property’s zoning designation, but the time and challenge associated with a zoning change may not be worthwhile.
Public Goods and Services
Public goods and services are defined as economic products consumed by all citizens. Federal, state, and local governments provide differing levels of public goods and services. For the purpose of the real estate market analysis, the primary concern is the provision of goods and services by local government. The quality of the water, sanitation, schools, road and highways, and fire and police protection impact property values.
The economic theory that explains how and why public goods and services impact property values is the economic capitalization effect. Government goods and services such as roads, police and fire protection, education, and sanitation services make cities more attractive and productive. These benefits get capitalized into the underlying value of the land in the city. As the underlying value of the land increases, the potential property tax income the city can generate also increases. Those cities that provide superior public goods and services attract additional residents and businesses that also generate tax revenue for the city.
So, the real estate market analysis should consider the overall quality of the public goods and services in the surrounding area. It can be difficult, however, to quantify the relative quality of public goods and services. For example, you might know that a certain area of town has roads that are in terrible shape, but how do you quantify those potholes? Likewise, the crime rate and number of fires or fire stations are not necessarily a reflection of the quality of the police and fire departments. School quality is the easiest to quantify because school districts publish information like test scores and graduation rates for public schools in the area. In addition, a national nonprofit called GreatSchools publishes data and ratings for primary, middle, and high schools. Academic research finds that school quality is correlated with property values. It is easier to attract new residents and businesses into an area where they know their children will receive a quality education. It is much more difficult to attract new businesses and residents when the public school system is performing poorly.
One other component of the capitalization effect of public goods and services is the overall property tax rate that provides the funding for these goods and services. In general, it is true that people prefer to have a lower tax rate than a higher tax rate. In fact, high city property tax rates are one of the main contributing factors in the development of urban sprawl or suburbanization. Yet, it’s not uniformly true that higher property taxes make a location undesirable. It is more important how residents perceive the value, or capitalization, of their tax dollars. So, a city with a high tax rate that capitalizes those taxes into well-kept roads, effective police and fire protection, and high quality schools is still likely to attract residents and businesses. On the other hand, a city with the same property tax rate in which residents have a poor relationship with the police and complain about failing schools is likely to experience a decline in property values, population, and economic growth.
Government regulation and government services impact the long-run prospects for growth in a city. Zoning regulations and building codes can be so restrictive as to make a new real estate development financially infeasible. So, it is important for a real estate market analysis to consider the cost of adherence to regulations. In addition, property tax rates and the capitalization of tax dollars into public goods and services impact both property values and future growth of a city. So, government regulation can impact market rents, vacancy rates, population and income growth prospects, and overall property values.