The principle of substitution is very important for both buyers and sellers to keep in mind in real estate. The principle states that if a buyer can purchase a 2005-built, 4-bedroom, 3-bath, 2200 square-foot house for $480,000 in central Ventura, why would someone pay $570,000 for a similar 2005-built, 4-bedroom 3-bathroom house in central Ventura (similar neighborhood)? The $570,000 would appear overpriced and buyers would be attracted to the $480,000 house. Moreover, why would someone pay $1,600 per month to rent a 3-bedroom 2-bath house if they could rent a 3-bedroom 2-bath in a similar neighborhood for $1,495?
The principle of substitution is essentially a method for determining the relative value of a property.
Anytime you hear the principle of substitution, just think: What else is on the market that is similar to this price?
Disclaimer on Location vs Appraisal:
The principle of substitution is used in appraisals to determine which properties are similar and what they are selling for. This is essentially how the above example works when a buyer determines whether or not they feel a house is priced well.
The principle of substitution can be extended from its use in determining value in a specific area to comparing how far someone’s dollar will go in different areas. For example:
For $500,000, a buyer can purchase:
- 1) A 3-bedroom, 1-bath, 1100 square-foot, 1920s house in midtown Ventura.
- 2) A 4-bedroom, 2-bath, 2000 square-foot, 1970s tract house in east Ventura.
- 3) A 5-bedroom, 3-bath, 2200 square-foot, newly built, fully upgraded house in north Oxnard.
- 4) Three single-family houses in Bakersfield, CA.
In this case, the principle of substitution is used to show a buyer how far their dollar will travel in different areas. However, this does not mean that someone could argue that the 3-bedroom, 1-bath house is overpriced because they are able to purchase 3 separate houses in Bakersfield. That’s not how the principle works.
This is why it is imperative that Realtors educate home buyers on the availability of properties on the market and what they can buy for their money.