Two useful concepts to understand in real estate (or indeed, in any business) are the concepts of fundamental and relative or positional value.

Fundamental value is best thought of as “cost plus”or “cost savings”.  As in, if the land costs x, and the structure costs y to build, then the builder should sell it to me for x + y + z (z = profit).  Or, if I buy x, it will eventually save me y dollars.  This is the mode under which you purchase a bunch of screws at Home Depot, most of your food at the supermarket, and perhaps how you justify buying a new PC that will improve your productivity.

When we think of “fundamental value” in real estate, we most often see this used as a good  baseline of value in areas with lots of land and more remote locations.  Almost by definition, these areas have plenty of supply in the form of interchangeable homes and office space, limited only by the desire of the builders to build in response to demand.

Relative or positional value is much more complex.  Viscerally, it’s easier to explain the concept by working backwards from examples such as luxury cars, art, and jewelry … none of which seem to serve much fundamental purpose for going about your day … and yet all of which still sell like hotcakes.  That’s because people buy these items to appease their own needs for self-actualization or to signal their status to others.  In other words, to show off.

Relative or positional value in real estate occurs in “hot” areas where everyone wants to be.    At this point, we’re not talking exclusively about how much it costs to build somewhere.  We’re mostly accounting for the fact that someone else might be willing to spend more than you to be there.  Purchasing thus pivots towards the zero sum game … where there can only be one winner.  Charlie Munger calls this “the Rembrandt effect”.

Examples

Being able to buy real estate for less than fundamental value is a pretty rare situation, but it does happen.  In the case of Las Vegas over the past 5 years, it was literally like picking up a dollar for 80 cents based on fundamentals alone (with construction costs at 300 to 400 per sqft), unless you thought that Las Vegas was going to crater and blow up (I did not think that).  There are cases, like Detroit, where being able to buy below fundamental value was actually a symptom of much worse problems (an accelerating dystopian environment).  Obviously, you should avoid those scenarios.

Relative or positional valuation is what accounts for the majority of the pricing here in San Francisco, New York and other urban centers.  Business (and hence money) tends to concentrate in these urban cores.  Rich people want to be close to work, and they value the dynamic and varied lifestyle that a city brings.  Supply is constrained by regulations and existing structures, which stokes the fires even further.

Also, some hot vacation destinations are prime areas for positional valuation.  Ocean views are hard to come by!

In addition, one very important positional issue is simply that rich people like to live around other rich people.  Now, you may not think highly of the class warfare implications that this might imply.  But it’s hard to say it isn’t true.

In general, you can assume that people (both rich and poor) are willing to spend some percentage of their income to live in better, safer and more interesting areas.  It just so happens that this translates to a lot of actual dollars when the wealthy want something.

As you may have guessed, real money can be made (and lost) in areas where the valuation is based on relative and positional factors.  As positional valuations are based purely on the desires of a crowd, you must be very confident in being able to read the conditions of a market.  You won’t have an obvious and immediate “save x dollars” value proposition in front of you.

Location, current demographics, and future demographics are all very important positional valuation factors.  These are fairly obvious, and I won’t go into them too much right now.

One interesting caveat for buyers that I would like to mention, however, is the fallacy of incorrectly comparing two properties and equating their values by some amount.  For example, property 1 in prime location A is worth X, so property 2 in location B one or two cities over should be worth 80% of X.  Or “I get 30% more square feet for my money in location B, and it’s only a couple of cities away!  Let’s save some money!”

This is how a lot of people lost their ass in the last real estate crash.  There is absolutely no substitute for buying either in a truly up and coming area, or in one that has already arrived.  When money comes flocking back into a market, you must own in an area where people with money want to buy.  Or, you must do your homework and be confident that the area you are buying in is going to contain more and more of the positive positional pricing effects that are lifting the pricing in the best areas.  Period.