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Real Estate: A case of value in use vs. value in exchange

Trade has been part of our day-to-day activities even before civilization. Since the early days, goods and services have been exchanged for other goods, precious metals, credit, paper currency and most recently cryptocurrency.

What really determines the amount of exchange? According to economics, the law of demand and supply determine the price of the commodity; as demand increases and supply falls short, the price of the good or service will increase and vice versa. The question that begs is, does the price of this commodity really reflect its value?

Early economists’ and philosophers addressed this in the paradox of value, also known as the diamond-water paradox. The paradox is the apparent contradiction that although water is more useful in terms of survival than diamond, diamond commands a higher price in the market.

To solve this paradox, Adam Smith a Scottish economist and philosopher in his book, An Inquiry into the Nature and Causes of the Wealth of Nations, he discusses the concepts of value in use and value in exchange in which he notes that the word value can be observed to have two different meanings,

The former expresses the satisfaction of a particular object and the latter, the price at which goods and services in the market exchange.

In further explanation to this paradox, the theory of marginal utility states that the price at which a commodity trades in the market is neither determined by the inputs exerted in production nor its usefulness, but rather by the commodity’s importance to the person purchasing it. That is, people tend to obtain less and less need or satisfaction (marginal utility) from getting more and more of the same product; they will perceive a commodity to be of high value to them until more and more of the same product is available to them.

Also, different individuals can derive different utility (value in use) from the same commodity. One person could perceive it to be more useful and could be willing to pay more for it, however, the price in which it exchanges would not necessarily reflect the value in exchange.

How does this concept of value relate to real estate?  Are the properties worth what we pay for? Is the value of exchange equivalent to the benefits? Kenya has experienced robust growth in real estate for the last decade; the growth was driven by the development of new infrastructure resulting in demand and values along these developments soaring to unprecedented levels.

As the new infrastructure are set in place, possible uses of properties also increase. For example, ease of accessibility because of a new road network increase the population that would result in the need for more housing and shopping facilities. This means an increase in the value of use, which in turn would match the higher value in exchange. Using this rationale, we could say that the resulting increase in market value is justified.

The growth in the sector increased the appetite for real estate investment and land buying companies bought large tracts of land, serviced them and sold them to the public. Some of this land rural with little or no direct value in use. For instance, an eighth of an acre curved out of a ranch in a remote area of Maasai land; say, 60 kilometres from Nairobi; what would really justify its market pricing, first, you will want to ask yourself, what can I do with this piece of land?

If you have no idea of what you could do with the land, it is advisable for you not to purchase it. However, if there is an applicable venture you could start, it is advisable that just like any other investment; consider the returns from the venture to see if they justify the price of the land. For example, if you decide to build a residential house, are the savings you make on rent justify the price you would offer for the property? You could also decide to do farming, consider if the profits from the venture are adequate to recoup your investment including the price paid for the land.

From the rationale above, it is clear that just like any other investment in any other industry; the potential use of a particular property should reflect its market pricing, i.e. the value in use should reflect the value in exchange. Otherwise, you would be relying on speculation of capital appreciation, which more often than not is a gamble based on promise and marketing gimmicks. So next time you invest in a piece of land, consider its potential use before investment, and if its potential use does not justify its pricing ask for a price reduction or just look for another land to invest altogether.

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