FUNDAMENTALS OF VALUATION

Introduction

Valuation of the property is a very old concept. We can date it back with the time of
beginning of civilization of human mankind. Man had learnt how to cultivate land
and grow agricultural produce for his food requirements. He had also learnt art of
developing land by erecting small huts for protection and shelter of his family
members and for his associates in the group. This development of immovable
property (asset) was also associated with development of herds of cow, horse, sheep
etc. which we may call as development of movable asset.

This development of community settlements, an advent of civilization, also gave rise

to system of exchange of commodities between different community groups. This
exchange system was called barter system. To assess fair barter value, it was
necessary for the group leader, to estimate fair worth of a commodity in terms of
labour of its production and its need to his community as against worth of the
commodity offered by him in exchange. Thus valuation of assets started with the
beginning of civilization. We can say that earliest valuers were those group leaders
(Community chief or Kabila chief).

Subsequently, exchange of commodity was evaluated in terms of money. Today we

can say that women are the best valuers because every day ,they estimate value of a
consumer goods in the market place, they haggle a lot and obtain fair exchange
value for their money. Ultimate settled price of the commodity is between a willing
buyer and a willing seller. Final settled price may or may not be same as original
estimate but price is normally pretty close to the estimated value. This is the exact
process of Valuation.

In this chapter we shall learn development of art of valuation in India. We shall also
study various types of value and its meaning.
1.10 Principles of valuation were practiced in ancient India. King of the state used
to appoint expert valuer (officers), who would assess value of consumer
goods brought for sale from out side the state, by the tradesman (Saudagar).
On this assessed value of goods, appropriate State Tax was levied. Valuers
(Revenue officers) were also appointed by King to levy and collect state tax
on agricultural land on the basis of the area of land and quality of land
(fertility of soil).

1.11 The above practice clearly establishes the fact that economics and art of
valuation was already developed in ancient India several years before Christ.
However , systematic attempt to assimilate this knowledge was made by
KAUTILYA (Chanakya) 2300 years ago by writing masterly treatise (Total 15
Volumes) popularly known as Kautilya’s Arthashashtra. Some of his
statements even today amaze valuers and economists alike. Only one line
statement about ‘Land Value’ in his volume 7 Chapter 11 would convince us
about his great understanding of the subject. In this single line verse he says
“The Value of the land is what man makes of it” Today economists and
valuers can not fully explain about land values even in 10 hours lecture
,which this great thinker, policy maker and law maker explained in a single
sentence.

1.12 Subsequently during British Rule in India, principles of valuation emerged out
more systematically on account of various acts like Rating Laws of 1822, Land
Acquisition Act of 1894. In modern India, the development of subject of
valuation can be attributed to Rent Control Acts of 1947, Estate Duty Act of
1953, Wealth Tax Act of 1957, Gift Tax Act of 1958 and Income Tax Act of
1924.

1.20 Valuation of Real Estate is a multidisciplinary subject involving study of

economics, law, building construction, study of human behaviour, social
customs and study of government policy. Some valuers call it an “Art” and
some others call it a “Science”.

In case of Gold Coast Selection Trust Ltd. V/s. Humphrey1, justice Viscount
Simon stated that “Valuation is not an exact science. Mathematical certainty
is not demanded, nor indeed is it possible. It is for Commissioners to express
in terms in the money value, attributed by them to the asset, their estimate,
and this is a conclusion of fact to be drawn from the evidence before them”.
 Thus valuation is not considered an exact science but an art. However in bank
nationalisation case2, the supreme court used the words valuation science.

1.21 To understand valuation, we must closely examine factors and circumstances

that each valuer takes into account at the time of valuation of the property.
There are innumerable factors that influence the value of the property in an
open market. We can classify all these factors into following four basic
groups. Most of these factors would fall in any one of these four groups.

(i) Economic Aspects.

(ii) Social Aspects.
(iii) Legal Aspects.
(iv) Technical Aspects.

First three viz. Economics, Social Studies and Law are subjects of Art faculty
and only Technical or Engineering aspect belong to Science faculty. We may
therefore say that valuation is 75% Arts and 25% Science. In any case we may
safely say that valuation is both Arts and Science. It is an Art of estimating the
value of the property based on scientific data.

1.30 Property may be of several types. It can be classified as movable property

and immovable property. Cash, jewellery, furniture ,plants, machinery and
personal belongings are movable properties where as land with or without
building is an immovable property. Under Transfer of Property Act properties
are classified mainly into following two parts:-

(i) Personal Property :- Money, cash deposited in bank, Gold and Silver
Bullion, jewellery and personal belongs.
(ii) Real property or Real Estate like land with or without building. Whole
or part rights arising out of land and buildings are also real property.
Immovable property is a better word for use in place of Real property
,Real Estate or landed property.

1.31 Real Estate properties can be classified under three basic groups, keeping
marketability in view.

(i) Income fetching marketable properties : Rented properties, Hotels,

Cinemas fall under this group.
 (ii) Non Income fetching marketable properties : Owner occupied
bungalows, flats, shops, offices, factories fall under this category.
(iii) Non income fetching – non marketable properties : Temple, Church,
School, College, Public buildings, Museum, Fire station and Govt.
buildings fall in this category.

1.32 Based upon different characteristics of above referred three types of

properties, three different approaches of estimating value of the property are
evolved.

(A) Income Approach :

This approach is generally useful to value income fetching marketable
properties.

(B) Market Approach :

This approach is generally recommended for the non income fetching
but marketable properties.

(C) Cost Approach :

This approach is generally adopted for non income fetching and non
marketable property.

Valuation method under these three basic approaches are discussed in the
subsequent chapters.

1.40 There are three basic words which are frequently used in valuation
terminology. Cost, Price and Value. We must thoroughly understand different
meaning of these words and should not use these words in wrong context.

1.40 Cost :

It is expressed as actual expenditure in terms of money incurred on labour

and materials of the asset (property).

1.41 Price :

It is an amount paid and expressed in terms of money for acquiring

ownership rights or interest in the asset (property) .Price normally includes
profit of seller over and above actual market situation is adverse to the
 sellers. cost of labour and cost of materials that has been incurred by the
seller in creation or acquisition of the said asset. However some times sale
price may show loss to the seller instead of profit if the market has fallen
down.

1.42 Value :

“Value” is defined by different authorities in different terms. However all

these authorities concur with the view that value is an estimate and not an
actual fact. The word ‘value’ is highly subjective. Value or worth of the
property depends on individual persons own perception of ‘Better life’.
Persons from different economic strata in the society will have different view
points on the fair value of an asset. Thus we can say that value is mainly
person specific concept. But we must understand the difference between
value to the individual and value to the market.

Some of the interpretations of word “Value” are as under :

Justice Hadley has stated that “Value is an estimate of the price as it ought to
be”. This is the simplest and most concise definition of value.

In case of Raja Vyricherla Narayana Gajapatiraju Bahadur Garu V/s. Rev.Div.

officer Vizagapatam 3, Lord Romer of Privy council explained estimation of
market value of land in following words.

“In the case of land, its value in general can be measured by a consideration
of the price that have been obtained in the past for land of similar quality and
in similar position, and this is what must be meant in general by terms the
market value”.

1.43 Subject matter of valuation :

Subject matter of valuation is the interest of a person in the property (Land

and building). We may define “Interest” in property as the right of a persons
to derive benefit (Existing or future) by putting land/land and building to
Legal and Best possible (Potential) use. Thus subject matter of valuation is
not physical but abstract. In other words we can say that physical
characteristics of land (Soil, size) and materials used in the building (Brick,
cement, steel) are not valued but right to derive benefit (existing or future
 benefit) by putting the property to lawful use and highest and best use, is
being valued.

1.50 Characteristics of sound investment

The following factors determine the soundness of investment which has a

direct or indirect bearing on the valuation of assets including plant and
machinery.

1.51 Security of capital

The vast majority of investors will only wish to place their money in an
investment if there is a strong probability that they will be able to recoup
their capital at any point in time should the need arise. The greater the
chances of their being able to get their original money back at any point in
time (or the greater the security of their capital), the greater will be their
willingness to invest. If the chance of getting the original money back is
slight, then an investment will be considered insecure and relatively
unattractive.

1.52 Liquidity of capital

The investment which can be converted into liquid cash in a short time is
considered a sound investment.

1.53 Security of income

In return for giving the use of his (investor) money to someone else, he
(investor) requires payment, and this payment will be the interest his money
earns. It is his reward for foregoing the use of his own money, and before he
is prepared to give it up he will wish to be reasonably certain that he will get
adequate payment for such use.

1.54 Regularity of income

Regularity of payment of interest is naturally coupled with certainty of

interest. If regular payments are made, the borrower is less likely to get into
arrears, whilst the receipt of interest at regular intervals enables the lender
 to phase such receipts to meet regular expenditure which he may be
incurring, and this will assist his own budgetary control.

1.55 Ease of purchase and sale

Investments which are easy to exchange at market place by buyers and

sellers will be particularly attractive to an investor who may be likely to
require his capital in relatively short notice.

1.56 Least costs of purchase and sale

The cheaper it is to invest and withdraw money, the more attractive will be
an investment.

1.57 Divisibility of holdings

Many a time an investor is interested in withdrawing part of his money. In

such cases he will be at a great advantage if he is able to sell part of the
holdings, but this is not always possible. For instance, if he has invested in a
piece of real property it may be impossible for him to sub-divide and sell a
portion of it. The question of whether an investment is divisible into smaller
lots which can be sold, as and when convenient, may be of considerable
importance to an individual investor.

1.58 Security in real terms

An investor will wish to have his money in something in which capital

appreciation enables him to withdraw it after a period of time and he is able
to purchase, with that money, the same amount of goods and services he
could have purchased when the money was originally invested.

1.59 Capital appreciation prospects

When an investment is secured in real terms it is often referred to as being a

good hedge against inflation, or as being inflation proof. In recent years this
quality perhsps bears the most desirable quality of an investment, and the
 fact that property has generally satisfied this requirement has tended to
make it a very attractive investment for those who require security in real
terms.

1.20 International Valuation Standard Committee (IVSC) have defined “Market

Value” in following words. “Market value is estimated amount for which an
asset should exchange on the date of valuation, between a willing buyer and
a willing seller, in an arms length transaction after proper marketing, where
in the parties had each acted knowledgably, prudently and without
compulsion”. This is an excellent definition of ‘value’ and valuer must
consider all these aspects while estimating value.

(i) As valuer has to estimate the amount, he should assume hypothetical

buyer and hypothetical seller both willing to transact the deal in
hypothetical market and no one being under any compulsion. This
means that sentimental aspect and forced sale conditions are to be
ignored in fair market value estimate.
(ii) Both buyer and seller must be knowledgeable. If they are ignorant of
ruling market trend, transacted price can not be fair. Again both must
be man of ordinary prudence and not super intelligent person or
speculator. Deal should be in accordance with normal business
practice.
(iii) Hypothetical market should be open market where all types of buyers
and sellers compete with each other. It should not be a closed or
restricted market.
(iv) Transaction has to be considered at arms length. It means that
transaction between related buyers and sellers or between close
friends should be ignored.
(v) The words “estimated amount for which an asset should exchange”
means that valuers estimate should be as close and near as possible
to the asset’s probable sale or exchange price in the actual market.
(vi) Words “after proper marketing” means bargaining for fair price i.e.
price determined after process of higgle/haggle.

1.21 In addition to various factors considered under above referred definition of

TIAVSC, we can also add following two important considerations.

(i) The valuer while estimating market value of the property should
ensure minimum assumptions.
 (ii) The valuer should give reasons for adoption of certain basics, while
undertaking valuation for market value. In fact at every stage of value
estimation, reasons must be given.

1.7.00 There are many types of values depending upon its use and purpose. The
adjective to the word ‘value’ would explain its meaning as explained
hereafter.

1.7.01 Annual Letting Value (Annual Ratable Value) :

It is a rental value of the property fixed by the local authority for levy of
property taxes. The Annual Ratable Value of every property existing in
different wards of the local authority are recorded in the register maintained
by each local authority.

1.7.02 Accommodation Value :

It is a value of the land which is not independently buildable on account of

odd shape, odd size or small area or land lacking legal access road .Normally
such land is useful only to adjoining plot owners along its periphery. Such
plots invariably fetch less price than prevalent market price and land value
greatly depends on needs of the adjoining plot owners and competition
amongst them.

1.7.03 Book Value :

It is written down value of an asset as shown in books of account and Balance

Sheet of the owner of the asset. It is accountant’s method of indicating
present value of the asset after deducting depreciation, for the period of use,
from the original cost. Final W.D.V. of each asset is notionally shown at Re.1/-
in Books of Accounts.

1.7.04 Breakup Value :

When any established production unit (running unit of an enterprise) is

closed down and sale of each individual assets is envisaged or planned
separately, it is termed as breakup value of the property. Value of each asset
 is estimated separately in isolation of the other asset. Machinery and building
may be sold separately and to different parties.

1.7.05 Distress Value :

Value of the property offered for immediate sale by the owner who is in
distress is called distress sale value of the property. There is absolute urgency
to liquidate asset in terms of money. Owner may be in financial difficulty due
to heavy loss in business or may have social or health problems like need of
money for daughter’s marriage or for family problem or for hospitalization
cost for major illness or surgery. Sale of property due to communal riots is
also distress sale. This value is always lower than fair market value of the
property.

1.7.06 Fair Market Value :

‘Market Value’ is ideally defined by TIAVSC as stated in para 1.50 above.

There is not much difference between the words ‘Market Value’ and “Fair
market Value”. However in India word ‘Fair Market Value’ is more common
and more popular amongst valuers, for the simple reason that it clearly
signifies fairness of value of the property. This term automatically implies
rejection of distress sale or forced sale transaction as well as transaction
between relatives at concessional price. This term also rules out transaction
by speculators or purchasers having special purpose to pay fancy price or
special price for the property.

1.7.07 Forced Sale Value :

It is an estimate of the price the property (including running or closed down

unit) would realise in open market on “As is where is basis” in shortest
possible time. The forced sale is conducted by negotiations amongst limited
group of buyers or by public auction but it is conducted with the sense of
utmost urgency and with assumption of unwilling seller. In fact seller is
compelled and forced to sale the property to liquidate it in terms of money to
clear his debt or compelling circumstances. Auction sale of Non Performing
Assets by Banks is one such example. Sale of property by borrower of bank
loan by finding out prospective buyer by private negotiations is also an
instance of forced sale value. Normally buyer brought by borrower by private
negotiations offer better price than that is likely to be realised under auction
 sale by the bank. Sale of property by urgent private negotiations under
warlike conditions and sale of the property in the riots prone areas are also
instances of forced sale value of the properties.

1.7.08 Going Concern Value :

It is an estimate of the price of the running business of an industrial or

commercial establishment, in the open market, with its all tangible and
intangible (Goodwill value) assets as well as all liabilities of the enterprise on
the date of valuation. It is an estimate of the business assets as a whole block
and the precondition is that the business unit must be profit making and
running unit. It is also assumed that unit will continue to operate in future i.e.
continued use of all assets. Total breakup value of each individual asset of the
enterprise plus goodwill value of the business may or may not be same as the
Going Concern Value of the enterprise. Sometimes optimum value (Balance
Potential or Highest and Best use of the assets) of individual assets is not
reflected in sale transaction price of the running business unit which is
executed on the basis of business valuation of the unit on ‘Going Concern
Value’ principles.

1.7.09 Hope Value :

Sometimes property owners expect some likely changes in Government or

Municipal policies and such likely seller, expects value of the property to rise
in the near future. Relaxation in coastal regulations or scrapping of U.L.C. Act
or likely increase in F.S.I. rules etc. are instances of Hope Value.

1.7.10 Intrinsic Value (True Value) :

It is the actual value or true value of the property. In India even common man
understands difference between Intrinsic Value and Agreement Value. A
property is purchased for Rs.40 lacs and agreement is made for 25 lacs to
save on stamp duty. Rs.40 lacs is Actual purchase price or Intrinsic value and
Rs.25 lacs is Recorded purchase price or Agreement value.

1.7.11 Liquidation Value (Auction Value) :

It is an estimate of the price that would be realised by putting up the

property of an enterprise or an individual, for auction sale in the market. This
 sale under Public Auction is done after proper advertisement. Auction may be
under an order of the Court or otherwise but it is a case of sale by unwilling
seller and willing buyer. The enterprise may be running unit or closed down
unit. If adequate time is given to Liquidate the assets, it is known as orderly
liquidation value. If it is to be sold as quickly as possible with minimum time
for market exposure, it is termed as Force Liquidation Value. However
concept of compulsion to sale exists in both the case.

1.7.12 Monopoly Value :

A certain property may command an excellent situation in highly developed

area. Due to prime location and absence of supply or any other similar
property in the vicinity, said property will be sold at premium i.e. at fancy
price. This is the monopoly value or a special value due to its unusual and
peculiar advantages.

1.7.13 Mortgage Value :

It is an estimate of mortgage loan amount that could be safely advanced by

the Mortgagee (Financial Institutes or the individual) to the Mortgagor
against the prime security or the collateral security offered by the mortgagor.
Each financial authority has its own safety margins. To arrive at the safe
mortgage value of the property, proportionate deductions are made on the
market value of the security (property). This safety margin deductions varies
from 25% to50% of market value.

1.7.14 Net Present Value (Depreciated Value) :

It is the present day value of the property derived by deducting depreciation

amount from the Replacement Cost of the property.

1.7.15 Notional Value (Hypothetical Value) :

It is an imaginary value of property worked out for some special purpose ,say
for purpose of taxation. Under Wealth Tax Act, valuer has to imagine
hypothetical buyer and hypothetical seller transacting sale of property in
 hypothetical market, to arrive at hypothetical price of the property for
taxation. In reality, owner of the property (Assessee), does not intend to sell
his property at any time, in fact he is not a seller at all, yet valuer has to
assume that assessee is a willing seller. It is a fiction and not a reality. We
may also call this a “Virtual Reality Value” of the property.

1.7.12 Potential Value :

It is an estimate of the price the property with existing inferior or under

utilised use would fetch in the open market by putting it to the highest and
best use in place of existing inferior use. A property with only 40% consumed
F.S.I. has balance potential of future development of 20% more built up floor
area in the property, if permissible F.S.I. is 1.00. Similarly property put to
residential use in the commercial zone has high potential value of the
property by putting it to commercial user. The property which had fully
utilised permissible F.S.I. area of 1.00 once, will become under utilised
property, due to 1.00 additional permissible loading on the plot in form of
T.D.R. under new policy. This extra benefit adds potential value to the land
value.

1.7.17 Replacement Value :

It is an estimate of the cost required to be incurred today, to create similar

(identical) property at current prices of material and labour. It is an estimate
of the cost of replacement of an old existing asset assuming it as if new
today.

1.7.18 Reported Value (Appraised Value) :

It is an estimated price of the asset as finally arrived at by the valuer after full
scrutiny of the documents, physical inspection of the site conditions and
study of relevant facts and circumstances of the case.

1.7.19 Rounded Value :

Final value reported by the valuer by rounding off the worked out value
nearest to its decimal. If worked out value is Rs.40,28,273/- it should be
rounded as Rs.40,28,000/- but if worked out value is only Rs.4,528/- it should
be rounded off to the figure of Rs.4,200/- and not to Rs.4,000/-.
1.7.20 Salvage Value :

It is an estimate of the sale price of the old property after its probable
services life is over (useful span of life) but it is still in continued use due to its
physical conditions.

1.7.21 Scrap Value (Junk Value) :

It is the value of the property receivable for its material content in the market
when it is completely useless for any further use. In case of old buildings, it is
the sale price of reserviceble materials obtained from the building on
demolition of the building less cost of labour for demolition. Normally 10% of
present day replacement value is estimated as scrap value of the building.

1.7.22 Sentimental Value (Personal Value) :

It is a value of the property, to the buyer or to the seller as the case may be,
who determine price on sentimental grounds rather then considering market
forces. It may be a special or fancy price due to sentimental attachment to
the property. A buyer may offer 30% higher price for an old dilapidated house
in the village only because he was borne in the said house and sweet
memories of childhood golden days are connected with it. A seller may refuse
to part with his plot even at 50% higher price than ruling market price only
because he has cultivated an excellent rose garden in his property and he
loves each plant as if his own child. Thus “sentimental value” is a personal
value to an individual and has no consideration whatsoever in the fair market
value estimation.

1.7.23 Speculative Value :

It is a value of the property to the speculator who invests in the property with
sole motive of selling at profit after short period of time. If the speculator
thinks that certain area is likely to command greater importance in the near
future, he may invest his funds by acquiring properties in said sector, even by
paying little higher price than that is ruling in said sector. A speculator may
foresee likelihood of change of zoning in certain area from “No Development
Zone” to Residential Zone. If such intelligent guess work materialises in to
reality, speculator would earn enormous profit.
1.7.24 Special Value :

This is also a personal value because it is a value to an individual buyer or

seller. However here sale or purchase is not governed by sentiments of
individual but are governed by personal reason of an individual. A purchaser
may pay special price (fancy price) for a flat only because it is close to his
work place as well as close to his children’s school. Other competing
purchasers have no such criteria in mind. An entrepreneur may be willing to
pay higher price than ruling market price for an open plot of land next to his
factory because said extra land would enable him to expand his rapidly
developing industry in most profitable manner. Other buyers have no such
consideration. In one of the case a trust was prepared to pay higher price for
purchasing shares of a private company yet the English Court adopted lower
value by observing “The price which the trust would have paid, was not an
element of the open market value of the shares, but was a fancy price,
beyond the open market price, which such a trust would have paid for special
reasons of its own”. Purchase price paid by the sitting tenant of the property
to acquire full ownership rights in the property, is also the special price and
not fair market price of the property.

1.7.25 Statutory Value :

It is a value of the property estimated in accordance with the provisions of
the concerned statute. Value for Wealth Tax worked out as per Rule
3/Schedule III of W.T. Act is the classic example of statutory value. It has no
base of valuation principles and market forces but it has only legal base of
provisions of W.T. Act. Present market value of the property may be 20 lacs
but as per Rule 3, statutory value for Wealth Tax purpose could be as low as
Rs.1 lac.

1.7.22 Stigma Value :

It is an estimate of the price of the property based on assumption of unwilling

purchaser for such a property. Many a times it is seen that some properties
though in good physical condition do not get any buyers in the market
because most of the prospective buyers have stigma or disliking for the said
property for certain reason. House may be believed to be haunted by Ghosts.
It may also be possible that murder of a popular personality might have taken
place in the said house or the property and hence the stigma. Stigma could
 be due to belief or suspicion that the plot was used as burial ground or
cremation ground in the past or that land is affected by radio activity due to
past atomic reactor working on plot.

There could be many more types of values such as Justified value, Economic
value, Investment value, Nuisance value, Face value, Subjective value,
Objective value, Sound value, Exchange value, Auction value, Realisable
value, Bogus value etc.

COST APPROACH

Cost approach is very much useful in evaluating non marketable properties in Real Estate. It
is also useful in estimating values of assets for financial statements of an enterprise. This
method is invariably adopted in determining cost of construction of a building, viz
investments done by the assessee in the real estate, for the purposes of Income Tax Act.

In order to find out true investment done by the assessee in an immovable property , this
method is frequently resorted to by the valuers. Under income tax act, it is necessary for
the assessee, to establish and prove that the cost of investment in an immovable
property, shown in books of account , is not more than the sources of income of the
assessee. If the cost of investment as worked out by this method is less than the cost shown
in books of account, than it would prove that there is no concealment of income by the
assessee. This is the reason why this method is popular amongst valuers.

Cost approach is also adopted by the valuers while estimating cost of construction of the
building under construction, and for which the owner has asked for loan from the financial
institution. Even for valuation of the owner occupied bungalows, offered as security to the
banks for mortgage, this method is used.

In this chapter we shall learn various methods of cost estimation as well as various methods
of depreciation to arrive at net present worth of the asset by cost approach. Only elements
of Cost Approach are discussed here. Detailed study of Cost Approach shall be discussed
subsequently in the next semester studies of the subject.

2.1.0 Cost approach is the third basic approach of valuation, with the help of which
we can work out ‘cost’ as well as ‘value’ of certain types of assets.
 There are mainly two methods under this approach.
(i) Book Value Method.
(ii) Land and Building Method. (Depreciated cost method)

2.1.01 In Book Value Method, historic cost of the asset in the year of acquisition is
taken as basis and with the help of cost index figures (Multiplying factors for
different years, indicating price rise in the market due to inflation and other
factors like variation in cost of materials and labour), replacement costs and
value of the asset are determined for the relevant year of valuation.

2.1.02 Land and Building Method is also known as Contractors method, Physical method or
Depreciated cost method. This method is useful to estimate cost or value of the
structures like Temple, Church, Museum, School and College buildings. Bungalows
and factories can also be valued by this method. This depreciated cost method of
valuation is also used to estimate present day value of the plant and machineries.

2.1.03 This method basically consists of estimating value of land and value of building
separately and then adding these two values to arrive at fair market value of the
property in relevant year of valuation.

2.1.04 Present day value of land is determined by finding out cost of acquiring
similar land from the market in the year of valuation. Such land should be
having similar characteristics as of subject land. In case of variations,
adjustment in cost of land should be made to arrive at final value of the land.

2.1.05 Present day value of the building is determined by first finding out present
day replacement cost of the building. Replacement cost of the building is the
cost of construction of similar building (Same specification having similar
amenities) as if new today. (Year of valuation). After having determined
replacement cost of the building, depreciation is allowed for the age of the
building, to finally arrive at the net present day value of the building.

Thus formula to work out present day market value of building is :

Net Present Value = Replacement Cost as if new today less

Depreciation for age
 Plant and machineries are also valued in this manner. Present purchase price (cost)
of similar machine is obtained from the market and then depreciation is allowed for
the age of the machine in service ,to find out present day sale value of such old
machinery.

2.1.10 Following examples will explain how replacement cost (present day cost) of the asset
can be worked out with the help of Book value cost and Cost Index figures.

6.2.01 Replacement cost of building can be worked out by any of the following
methods.
(i) Book Value Method.
(ii) Flat Rate Method.
(iii) Building Cost Index Method.
(iv) Quantity Survey Method.

6.2.02 In Book Value Method, replacement cost is estimated based on historical cost
from books of accounts and cost index factors data maintained by the valuer,
as shown in above examples.

2.2.03 In flat rate method, replacement cost of the old building is estimated on the basis of
current cost of similar building construction. This cost is indicated on unit area rate
basis .Say Rs.8,500/Sq.Mt. of total built up floor area of the building. This rate varies
for different types of the buildings like residential, factory and office buildings in the
same year. It also depends on specification of the building.

Local market inquiry would indicate the unit area rate of the cost of construction
prevalent in the locality, for a new construction with standard specifications.
Necessary adjustments in the rate will be necessary for variations in the
specifications and amenities.

2.2.04 In building cost index method, Replacement Cost is worked out from some fixed base
year as determined by C.P.W.D. At present, C.P.W.D. has adopted 1-9-1999 as base
year with Building Cost Index at 100 for city of Delhi. By this method, cost index of
any place in India can be worked out for any year by comparing cost of building
materials and labour in subject town with rates of building materials and labour in
Delhi in year 1999. This difference with appropriate weightages for the different
materials, could give cost index for relevant year subsequent to year 1999. Previous
 base years norms adopted by CPWD were 1-10-1972 and 1-1-1992 with cost
index at Delhi in the said years as 100.

2.2.05 Building cost for the residential building in Delhi, as per 1-1-1992 cost index as100,
was Rs.2810/Sq.Mt. Now if Cost Index of Mumbai in 2005 is 250 as compared to
1992 base index 100, Building cost for residential house in Mumbai, in year 2005 =
2810 x 2.50 = Rs.7025/Sq.Mt.

2.2.02 Quantity survey method is more precise and accurate. It involves working out of
detailed quantity of the building and apply current scheduled rates for each building
items for the year of valuation. This gives very accurate Replacement Cost of an
existing building.

2.3.01 As stated before, it is necessary to allow depreciation from the replacement cost of
the building to arrive at net present value of the asset. It is therefore necessary to
first learn the meaning of word depreciation and also learn various methods of
depreciation as discussed below.

2.3.02 Depreciation is an important concept, which enables a person to find out wearing
out of the capital value of an asset whether it is a movable asset like machineries,
vehicles or an immovable asset like buildings. Land is considered to be an
undepreciable asset, though some land do depreciate in value because of erosion or
damage to land due to natural forces like earthquake and Tsunami. All businessmen,
industrial entrepreneurs, tax experts and financial institutions are seriously
concerned about this vital factor which erodes the value of capital invested in
immovable or movable asset (Buildings/Plant & Machinery).

2.3.03 It is common experience that physical objects are subject to wear and tear and
deterioration whether in use or not. Depreciation can be therefore defined as “loss
in service value due to usage of an asset and passage of time”. This loss in value
cannot be restored back by current maintenance.

In case of Workmen N.G. Bank V/s. N.G. Bank (A.I.R. 1972 S.C. 211), Supreme Court
of India defined “Depreciation” as “Decrease in value of the property through wear,
deterioration and obsolescence”.

2.3.10 There are four types of depreciations.

(i) Physical depreciation.

 (ii) Depreciation due to economic obsolescence.
(iii) Depreciation due to functional obsolescence.
(iv) Depreciation due to technological obsolescence.

6.3.11 Physical depreciation :

This is very common. The physical depreciation occurs due to usage of the asset. It is
the normal wear and tear of the asset. All similar objects do not observe similar
depreciation. Quantum of this depreciation depends on several factors.

(i) Manner of usage :

If the property is properly used it will observe normal depreciation
but if property is roughly used ignoring basic principles for its usage, higher
depreciation will be observed. We find that well maintained building has
longer life span than the building which is subjected to neglected repairs for
years. Similarly machine used for 1 shift/day lasts longer than machine used
for 3 shifts/day.

(ii) Environmental aspect :

A building along sea shore may deteriorate faster than the building
away from sea shore. Similarly a factory building in chemical zone
would wear out faster than the factory in engineering zone.

(iii) Natural Force Aspects :

The building which are located in areas, which are frequently
subjected to natural forces like earthquakes, cyclone, Tsunami or
monsoon flooding ,observe sudden damage to property due to such
forces. Even otherwise these forces contribute to higher depreciation
and higher wear and tear to the buildings.

(iv) Accidental Aspects :

Sometimes due to fire, building is partly or wholly damaged. Similarly,
due to structural design defects in the building frame or foundations,
serious damage to the building is caused and sometimes even
collapse of the structure also takes place. Some times due to War or
Riot or Bombing on the structures ,serious damage to the building is
caused.

6.3.12 Economic obsolescence :

 These type of assets are under utilised. Optimum economic benefit of the land and
building is not achieved.

2.3.13 A residential building existing on the plot which is placed in commercial zone is
glaring example of economic obsolescence. Highest and Best use of land and building
is not made. The asset is put to inferior usage of residence instead of commercial
user resulting in an economic loss. Higher depreciation in such case will not be
unreasonable.

2.3.14 Similarly due to legislative enactment and policies also property may remain under
utilised. The policy of government to protect slums and not to permit removal of
unauthorized hutments in the plot without providing free alternate accommodation
to dwellers is yet another example of economic obsolescence.

2.3.15 Policy of government to permit 100% T.D.R. over and above permissible F.S.I. on the
plot, resulted in severe economic obsolescence of the buildings. Several developers
demolished even 20 years old good building for optimum use of the plot.

2.3.12 Dilapidation of building or heavy structural repair cost for the building is also
economic obsolescence. The structure becomes uneconomic to maintain. Due to
dilapidation, repair costs becomes prohibitive. Similar situation arises when rental
value of the premises in a particular locality falls severely either due to bad
neighbourhood or due to migration of the population to the buildings in newly
developed town centres having better amenities.

6.3.20 Functional obsolescence :

These types of assets are out dated and their planning and designing are of types
which are contrary to the present day requirements of its users. An old palace
becomes obsolete for usage as there is no demand for such palaces in the market
though they are in good structural condition. Due to this functional obsolescence
many palaces are converted for hotel users for which there is high demand and
usage in the market.

2.3.21 Old chawl buildings with common toilet blocks is yet another example of functional
obsolescence. No one prefers such out dated planning and design. Every one now
requires self contained tenements and flats. Today’s trend of constructing new
shopping Molls and Multiplex theaters would make present shopping centers and
single screen theaters obsolete in few years time.
2.3.22 A brand new machine or a computer may suffer from functional obsolescence hardly
within two or three years period if more advanced technologies introduce much
superior product at much lesser cost. A new machine may become functionally
obsolete, if product manufactured by said machine do not have any demand
whatsoever in the market.

6.3.30 Technological Obsolescence :

Old load bearing structures with thick walls are not preferred now in the city areas.
Every one now desires to stay in high rise R.C.C. framed structures having thin
partition and external walls. This is now possible due to technological advancements.
Timber structures are also now replaced by R.C.C. framed or steel framed
constructions. Wooden windows are replaced by aluminium windows. Now modern
technologies and planning concepts have made it possible to design and erect even
an intelligent building.

2.4.01 There are several methods of working out depreciation of an asset. Depending upon
the purpose and requirement, the depreciation is based either on historic cost or on
replacement cost. Again selection of the method is also based on the purpose and
requirement of the user. An accountant may adopt written down value method of
depreciation for buildings and machineries to prepare financial statement or balance
sheet of a company. A valuer wishing to arrive at market value of the same factory
and machineries may adopt straight-line method of depreciation or Sinking Fund
Method of depreciation.

2.4.02 Some of the important methods of depreciations are as under :

(i) Direct Appraisal Method (Lump sum depreciation).

(ii) Written down Value Method, (Accountant’s Method).
(iii) Straight Line Method. (More preferred for machineries)
(iv) Constant Percentage Method .(This linear method is preferred by
P.W.D. Engineers).
(v) Sinking Fund Method (This interest based method is used for
buildings).
(vi) Sum of the digit method.
(vii) Declining Balance Method. (Accounts method).
(viii) Statutory Depreciation Method. (Taxation purpose)
(ix) Other modern methods of depreciation.
 An asset suffering from severe economic or functional obsolescence may have very
high depreciation. Perhaps such an asset may be worth as scrap(Say 90% depr.),
even if it is not very old.

6.4.10 Direct Appraisal Method :

(Lump sum method) : In this method of estimating depreciation, the valuer decides
and adopts lump sum depreciation for the asset by physical inspection of actual
deterioration of the asset. An experienced valuer could arrive at an adhoc % of
depreciation based on his own experience. There is no process or reasoning but it is
absolutely arbitrary method based on experience. It may be useful in case of
machines and for small structures like compound wall, wells, roads where wear and
tear are unpredictable and even repairs and restoration costs are beyond
calculations.

6.4.20 Written down Value Method :

This is generally adopted by Chartered Accountants for preparation of balance sheet
of a company or firms for use of the company or for taxation purposes or for use of
financial institutions.

2.4.21 Depreciation is allowed at uniform and fixed percentage. But it is not on

original actual capital cost (Historic cost) but on reduced depreciated values
of the previous year.

Written down value ( Vn ) is denoted by formula : -

Vn = C (1 – p)n Vn = Value in the year.

C = Original Capital Cost (Historical cost).
p = % of rate of depreciation.
n = No. of year in which value is required.

6.4.30 Straight Line Method :

This method of working out depreciation, is used for the machines as well as for the
buildings. In this method, equal % of depreciation is allowed on its original capital
cost for each year of life. This is more common for assets like plants and machineries.
Depreciation amount for each year is exactly same till full cost is written off.

The formula is D = C – F
N
 D = Annual depreciation.
C = Original capital cost.
F = Final value or salvage value at the end of the life.
N = Total number of year of asset i.e. total life.

2.4.33 (i) Drawback of this method is that it gives higher depreciations in initial years of the
asset when actual wear and tear or deterioration is minimum. It gives exactly same
depreciation amount for each year, even for the later period of life of the asset,
when physical or actual deterioration per year is very high.
(ii) In this method, interest amount that would be available on the set aside fund
(Depreciation Fund) for recoupment of capital is not considered.
(iii) This method is therefore good for asset having short life span like machines and
semi-permanent structure.

6.4.40 Constant Percentage Method :

In this method, rate of depreciation is first assumed and instead of working out
depreciation separately, the formula straight away gives the net present value i.e.
depreciated value. The formula for working of depreciation in this method is:

D = P {100 – r d }n
{ 100 }
D = Depreciated value (Net present value).
P = Present day Replacement Cost.
Rd = Rate of depreciation.

It is 1% for 100 years life and 1/2 % for 50 years life.

Rd is determined by dividing 100 by total estimated life 100/50 = 0.50%
100/20 = 1.22 % and so on.

n = Number of years since construction (Age of building).

6.4.50 Sinking Fund Method :

This method of depreciation is widely used for estimating N.P.V. of the buildings. It is
more preferred by valuers because it gives lower depreciation per year in initial
years or life span of the asset and higher depreciation per year in later period of life
of the asset or building. This is more in concurrence with the actual physical
deterioration pattern of most of the buildings. Again it takes into account interest
income available on set aside fund (Sinking Fund). It is therefore considered more
appropriate method and more scientific for working out depreciation of the
permanent type of buildings which has pretty long life span.
2.4.51 There are 4 stages of finding out % depreciation and net present value by this
method.

(i) To first work out Annual Sinking Fund by formula :

S = R.
(1+R)n – 1

R = Rate of interest
n = Total life span in number of years

(ii) Next step is to find out accrued sum ‘A’ for Re.1/- in number of years
age by use of formula :

A = (1+R)m - 1
R
m = Age of building
R = Rate of interest

(iii) Then total depreciation is found out by formula :

% Depreciation = 100 x S x A

(iv) Finally N.P.V. is found out by the use of formula :

Net Present Value

= Replacement Cost - % Depreciation for age

It should be remembered that the rate of interest should be so selected that below
said rate, interest rate is not likely to fall in next 20 years. Interest rate is thus
minimum because life span of the buildings is 20 to 80 years. 3% could be fair rate
for redemption of the capital sum if on Savings Bank A/c. similar 3% yield is available.

6.4.60 Sum of the Digit Method :

 This method is not much in use. It is based on “Digit” derived by summation of years
of total life span of the asset. Then depreciation is worked out for age of the asset.

6.4.80 Statutory Depreciation Method :

In this method rate of depreciation is adopted as prescribed in Income Tax Act. This
is also W.D.V. method and for accounting and tax purposes only. However in this
method there is no scope to fix rate of depreciation as per condition of the asset but
it is a fixed rate of depreciation as per statute. Under Indian Income Tax Act, rate of
depreciation for different types of assets are fixed. As per sec.32 of I.T. Act ,
following rates of depreciation are permissible. This however goes on changing from
time to time as per budget proposals of finance minister.

(i) Residential building 5 % per year.

(ii) Non residential building 10 % per year.
(iii) Hotel building 20 % per year.
(iv) Temporary erections. 100 % per year.
(v) Motor Car 20 % per year
(vi) Plant and machineries 25 % per year.
(vii) Computer 20 % per year.
(viii) Furniture 15 % per year.

It should be noted that under the current year budget for year
2005/2002,rate of depreciation for the general plant and machineries is reduced from 25 %
to 15 %.

MARKET APPROACH.
Market Approach to value the property is most important and widely used approach to
value any type of asset. It may be consumer goods, shares and stocks, plant and machinery
or Real Estate viz. open land or land with building. All these assets can be valued by this
approach, provided the asset is marketable.

Each one of us is fairly familiar with market place. It may be market for consumer goods. It may be vegetable
market, Gold market, Iron market or Cloth market or Stock Market where trading (Buying & selling operation)
of specific goods are carried out. We are also aware of haggle and bargaining system prevalent at such market
place and manner in which deal is finalised. Real Estate Market also has most of these phenomena except that
it does not have a common market place as we have in case of consumer goods.

However principle operating in market of consumer good are also effective in Real Estate
Market. Demand and supply factor and quality of product are equally important aspects in
determining exchange value of asset in both the market. Similarly for both market, the
concept “Market is Supreme” is applicable, as all appurtenant factors are considered by
buyers as well as sellers in both the market, while settling final price of the asset.

In this chapter we shall learn various factors for consideration of the valuer while estimating
value of the property by this Market Approach. Only elements of Market Approach are
discussed here. Detailed study of Market Approach will be discussed subsequently in the
next semester studies of this subject.

3.10 Market Approach to value the property is most important and most favoured
approach of valuation by Valuers and Courts.

Basically there are two methods under market approach of valuation.

(i) Sales Comparision Method.

(ii) Development Method.

5.20 Sales Comparison Method is based on principle of comparison and

substitution.

3.30 It is human tendency to compare and select. A customer intending to buy consumer
product will compare quality and price of such a product available in one shop with
quality and price of substitute similar product, may be of other brand , available in
same shop or other shop in the market. He would finally select the product only after
comparison of both products from all angles including price. It is said that ‘to err’ is
human. Likewise we can also say that “to compare” is human.

3.40 While on the subject of necessity of considering similarity and comparison before
determining final price, we may also study an old story on the subject, which is very
educative.

The story is like this. Once a tradesman (Saudagar) came to the Court (Darbar) of
king Akbar and produced three exactly similar looking beautiful dolls. He than
demanded that wise person of the Court estimate fair value of each of these 3 dolls.
 Akbar asked Birbal to do valuation. Birbal collected 3 dolls and asked for 1 days time
for valuation. Next day Birbal came to the Court and declared value of first doll at Nil
value. He said that value of second doll is 1000 gold mohars (Gold coins) and further
added that the third doll is invaluable but he put its value at 1 lac gold-mohars.
Saudagar agreed with valuation.

However Akbar asked for reasons for different valuation of similar looking dolls. Birbal gave
practical demonstration. He put up a thin wire in ear of first doll it came out
of the mouth of the doll. Birbal said that this doll symbolises a person who
listens to the secret of his friend and tells every one about it and hence such
person has no value in the society. Wire put in ear of second doll came out of
second ear. Birbal said such persons are less harmful as they neither help the
friend nor do such person cause any harm to the friend. Hence he valued
second doll more than first doll. When he put wire in third doll’s ear it did not
come out but remained inside the doll. Birbal explained that such persons are
invaluable because they not only keep the secret with themselves but they
also try to solve problems of friend.

There are three important lessons to be learnt from this story.

(i) The similarity of property may be deceptive. We must thoroughly

investigate to find differences of attributes between even similar
looking properties.
(ii) Valuer should not immediately jump to conclusion. Case must be
thoroughly studied by asking for time for valuation and then only
considered opinion about valuation should be given.
(iii) User of report should ask for reasons for giving such a valuation and
valuer should support and prove his valuation by giving
demonstration or supporting evidence.

3.30 In case of property valuation, subject property has to be compared with

other available sale instances, having similar attributes and falling in the
same locality. Appropriate positive or negative weightages are considered for
variations and magnitude of attributes, to arrive at final adjusted value of the
subject property. Thus valuation by comparable sale instances is based on
principle of substitution which operates not only in consumer goods market
but also operates in Real Estate Market with equal force.
3.31 Like commodity market, there are 3 types of market conditions in Real Estate Market
also.

(i) Buyers Market.

(ii) Sellers Market.
(iii) Stable Market.

5.32 Buyers Market :

When number of units available to the purchasers are far in excess of demand, it is Buyers
Market. Prices tend to decrease because of greater bargaining power of
purchasers and availability of plenty of alternative and substitute properties.
Sellers compete with each other to sale their units at lesser price.

5.33 Sellers Market :

When supply of units are less than demand for such units, prices tend to go up due to
competition amongst buyers to purchase these units even at higher price.
Bargaining power of purchaser reduces. Moreover Real Estate Units are such
that like consumer products it cannot be brought into market in short span of
few days or few months. It takes pretty long time to increase the supply to
meet with market demand.

5.34 Stable Market :

Sometimes in market demand exists, supply also exists but due to various reasons,
purchasers stop purchasing or defer the purchase of premises. Artificial
stoppage of demand in the market prevails. The reasons could be likely
changes in Government policies or lack of paying capacity of people at large
in the locality, to pay high or prohibitive price of properties.

Expectations of people about likely fall in price of real estate in near future also results in
Stable Market conditions. Prices do not fall nor rise but remain stable year
after year. No material transaction takes place in the market. Stray sale
transactions in market do not change stable market situations.

5.40 There are two types of property so far as Market Approach is concerned.

(i) Marketable properties like flats, shops, offices, factories etc.

(ii) Non marketable properties like Schools, Temples, Museum, Public or
Government buildings, Municipal Public utility buildings like Fire
station, Hospitals, Monumental building. etc.
3.41 When we are considering Market Approach, we should keep in mind two other basic
aspects also in addition to the principle of substitution operating in the real estate
market. First aspect to be considered is highest and best use of the property. Though
the property is put to inferior use or has under utilised F.S.I. area, price it would
fetch in open market would be for superior use and for full utilisation of land.

Another aspect operating in most of the market is the concept of supremacy of the market.
Strong market forces which are operating in the real estate market will force
everyone to believe that “MARKET IS SUPREME”. Market conditions takes
into account all types of factors operating at a relevant period of time. No
one can control market for long period of time. Temporarily for short
duration market can be controlled but then strong market forces would start
operating and person or authority trying to control or over power market
would be wiped out.

Even Government can not control market by law ,for long period. Government’s policy to
control the market would fail because “Market is supreme”. Classic example
of this attempt to control the market artificially is the enforcement of Rent
Control Legislation by various State Governments. Though on paper Rent
Control Act appears to be successful and effective but in actual reality,
market has found out its own ways to over power and defeat the legislation
by establishing new trends and practices in market by taking premium,
pugree, salami or key money. Even system of giving premises on leave and
license basis is also to circumvent provisions of Rent Act. Of course this
concept of supremacy of the market is applicable only to marketable
properties and not to non-marketable properties.

3.42 When we are considering market, whether it is commodity market or real

estate market, we always consider supply and demand which is most
important and powerful factor affecting price level in the market.

3.43 The principal of supply and demand states that the price of a commodity, or service
varies inversely with the increase in the supply of the item. Where as price varies
directly with the increase of the demand of the item in the market. This principal can
be better explained by Supply and Demand Curve shown below.

3.44 In the demand and supply curve shown below, Price is plotted vertically as ordinate
(Y Axis), indicating price of the commodity against different quantity of the product
 available in the market. Quantity of the goods available in the market is plotted
horizontally as abscissa (X Axis), indicating Number of units.

3.43 In the above figure, Demand Curve indicates that at the price of Rs.400/No. demand
for product is hardly for 300 pieces. As price reduces to Rs.200, demand in market
increases to 2300 pieces. When price falls down to Rs.30/piece, demand in market
rises to 9000 pieces. On the other hand supply curve indicates that at the price of
Rs.30/No. the supply of product is negligible. When price rises to Rs.200/No. supply
of commodity increases to 2300 Nos. and when price in market rises to Rs.400/No.
supply also increases to 9000 Nos. However the point of intersection of the two
curves gives us equilibrium price of the product or the fair price of the product.
Hence price of Rs 123/piece would be an ideal price for the said product.

3.30 Apart from demand and supply aspect, it is interesting to study how price of a
commodity is determined in common market place between a buyer and a seller.
There are group of buyers in the market who compete with each other to acquire
the commodity. Each buyer determines highest price he is prepared to pay, on the
basis of his individual capacity to pay (wealth). He also at the same time estimates
fair cost of product and his need and urgency to acquire the said commodity. In fact
his attempt is to get the product on payment of minimum price.

On the other hand, there are group of sellers in the market who compete with each
other to sell their product. Each seller determines lowest possible price for sale on
the basis of same parameters viz. cost of products, profit margin, capacity to
withhold sale of product, need and urgency for sale. In fact expectation of seller is to
get highest possible price for his product but he succumbs to the market forces. If
offered price is higher than highest price determined by the buyer or it is lower than
lowest price determined by seller, the transaction or sale of commodity does not
take place. But in all other cases transaction takes place after higgle haggle
(Bargaining) for the price. This process can be easily explained by the Bell Curve
shown below.
3.31 Buyers curve A-B-C shows number of buyers at different price levels. ‘A’ price
is offered by the minimum number of buyers in the market. Said price being
unviable price, transaction does not take place. At ‘B’ price, there are
maximum number of buyers who are willing to buy. Transaction may take
place or may not take place. At ‘C’ price again there are minimum number of
buyers because said price is considered very high by buyers.

3.32 Sellers curve D-E-F shows number of sellers at different price levels. At ‘D’
price there are hardly any sellers able to sale their product because buyers
will consider said price too high. At ‘E’ price there are maximum number of
sellers. Transaction may or may not take place at this price. Again at ‘F’ price
there are minimum sellers because said price is considered by sellers as too
low.

3.33 Thus most of the transactions takes place in the market in the price range of ‘F’ to
‘C’. Price ‘G’ can be said to be ideal price as it is average price of highest price that
would be offered by a willing buyer and lowest price that would be acceptable to any
willing seller. It is said that in perfect competition market, transaction takes place at
ideal price ‘G’.

3.34 In real estate market, there is no such common market place, as we have for
commodity market. However these concepts do operate in Real Estate
Market also. There is a range of prices for any specific property depending
upon individual buyers needs, their paying capacity and estimation of cost of
 said property by each individual buyer. Demand and supply factor and factor
of availability of substitute property in the market operate in this market also
with equal force.

3.20 In order to arrive at fair price of a commodity in the market, buyer as well as seller
consider various characteristics of the product viz. its use, its physical benefit, service
life etc. Similarly for Real Estate viz. land or land with building also buyer and seller
consider various characteristics of properties viz. its usage, its service life (in case of
building) its resale value, benefit of infrastructure amenity and civic amenities etc.

3.21 Various characteristics of the property and various market forces influencing
determination of price in the Real Estate Market can be broadly classified into
following four groups.

(i) Economic Factors.

(ii) Physical (Technical) Factors.
(iii) Social Factors.
(iv) Legal Factors.

These are detailed in following para :

3.22 Economic Factors :

• Demand and supply of properties.
• State and Central Govt. policies for land development.
• Economic and Taxation policies of Government.
• Income and wage level of residents, trends for saving and paying
capacities of people in the locality.
• Money market situation.
• Cyclical boom and recession periods in real estate market.
• Expected rental yields and returns on investment in real estate.
• Inflation or deflation in nations economy.
• Availability of money on credit from Banks and other institutions and
rate offered for such advances.
• Burden of property tax and other maintenance outgoings.
• Better alternative use against current inferior use.
• Employment opportunities and development potential in area.
• Availability of alternative or substitute asset in the market.
3.23 Physical (Technical) Factors :
• Land characteristics : Size, shape, plot area, frontage, vista,
orientation, soil type, topography etc.
• Infrastructure facility : Good network of roads, water supply, drainage
system, power supply and telecommunication links.
• Prominence and placement : Main road, by-lane, remote area
location.
• Building characteristics :
➢ R.C.C. framed or load bearing structure.
➢ Expected future life and age of structure.
➢ Deterioration and present condition.
➢ Specification of building, (Civil, electrification and plumbing
items).
➢ Aesthetics and workmanship quality.
➢ Obsolescence due to change in technology or change in life
style.
➢ Maintenance and repair liability.
• Functional aspect : Optimum use of space, good planning and design
with no wastage, high utility value, modern habitation style.
• Amenities : Swimming pool, garden, lift, security system, car parking
facility, Health club, Children’s play area.
• Environmental aspect : Noise and smoke pollution level, sea or lake
frontage, nuisance due to railway track, industries or airport, climatic
condition.
• Natural calamity : Earthquake prone areas, flooding and cyclone
hazards, Tsunami prone areas.

3.24 Social Factors :

• Locality : Poor class, middle class, posh areas (Life style and living
standards of residents of the locality).
• Neighbourhood : Well developed, less developed, slum like,
cremation ground, dumping ground, nuisance due to community hall,
cinema, school on adjoining plot.
• Civic amenities : Proximity of shops, Mall, market, school, cinema,
community hall, hospital, railway station, bus stand, garden.
• Population : Density in area and population growth, congestion.
• Means of communication : Railway, road way or water ways.
 • Prestige aspect : Prestigious building, prominent location, renowned
personality like film star or industrialist or politician as neighbour.
• Political factor : Linguistic or Religious communal unrest.
• Racial habitation : Parsi colony, Mohmedan locality, Hindu colony,
Catholic colony. Brahmanwada and Maharwada.
• Religious factor : Proximity of Temple, Church, Mosque, Place of
worship.
• Personal factors : Sentimental considerations, beliefs in ‘Vastu’
principles or Feng Sui norms, Liking for specific neighbourhood,
Speculative intent.
• Stigma aspects : Haunted house, Dislike for Vyagramukhi or Tee
junction plots, fear due to past history of cyclone, Tsunami ,flood or
earthquake, case history of murder or suicide on property, previous
use of land as Kabrastan or Cremation ground.

3.23 Legal Factors :

• Social legislation like The Rent Control Act 1948.
• Land Reform Legislation like : The Urban Land Ceiling Act 1972.
• Ecological Restriction Like : Coastal Regulations.
• Transfer of Property Act with lease provisions.
• Covenants under lease or conveyance deed.
• Land Acquisition Act.
• Laws Governing Building Construction like Development Control
Rules/ Building Bylaws/ Town planning and Zoning Regulations.
• Laws Governing Land : Town Planning Act/Municipal Corporation Act/
U.L.C. Act/Rent Act.
• Wealth Tax Act/Income Tax Act.
• Law on earthquake resistant building.
• Reservations under different Acts.

5.70 In Sale Comparision method, most popular comparision technique is Adhoc

Comparision Technique which is also known as Hedonic Method
.

In this method, price is expressed by the formula:

P = f (STLA)
P = price of property in the market.
f = It stands for “function of”
 S = Size or covered area of premises.
T = Time factor at which asset is traded in the market.
L = Locational aspects of the property.
A = Age or physical condition of the property.

3.71 In this method, sale instances of comparable properties in the locality are compared
with subject property only from four important aspects viz. Size factor, Time factor,
Locational factor and Age factor. There are many other factors affecting value of the
property in the market but under this method only four major factors are considered
to arrive at overall weightage difference.

INCOME APPROACH

The income from the property, whether property is only land, land with
building or other types of assets like plant and machinery and other equipments, is
conceptually a return on investment made in acquiring such an asset. This return may be in
form of rent, profit, hire charges or such other forms of return. In this chapter we shall learn
the basics of the Income Approach to value the asset. Only elements of Income Approach
are discussed here. Student will learn more details of the Income Approach subsequently in
the next semester studies.

4.10 This theory of return on investment is as old as art of cultivating land for
agricultural purposes. Famous economist David Recardo for the first time
analysed and established theory of rent by considering and comparing return
received by sale of agricultural produce with capital invested in production of
crop i.e. cost of seeds, fertilizer, water and cost of labour paid for such
agricultural production. He termed surplus return as “Rent” which could be
paid to land owner for use of land. Thus rent for more fertile land was higher
than the rent of land having less fertile soil.

4.11 Subsequently, lot of other non-agricultural use of land started like housing, industrial
and commercial developments. Depending upon its utility, demand and supply, the
rental values for non agricultural use also started establishing. Land in heart of town
had thus high rental value than rental values in out skirts of the town. Rental value
for commercial user of land fetched much higher value as compared to rental value
of land for residential use.
4.12 The basic concept of valuation under Income Approach is thus linked with
rented income or yield or return on investment in the immovable property.
From the details of the amount of capital invested and expected rate of
return on investment, we can find out amount of receivable rent or yield.
Conversely, from details of rental income or yield and given rate of interest,
we can find out fair investment value of the property. The formula to
estimate value of the property under income approach is :

CV = NI x Y.P.

where

CV = Capital value of the property.

NI = Net Income receivable from property.
YP = Years Purchase based on interest rates.

Details of years purchase, Gross Income and Expenses are discussed hereinafter in
this chapter.

4.20 To understand types of rent we must first understand relationship of land

owner and land occupant (user) viz. Lessor and Lessee or landlord and
tenant.

4.21 Lessor :
He is the owner of the land or land with building, who gives away possession of his property,
on rent, on certain terms and conditions. He can be distinguished from full owner of the
property (Freeholder) in the sense that he does not possess 100% rights in the property but
holds only partial rights. Some of his rights in property are passed on to land user (Lessee).

4.22 Lessee :
He is the tenant of the property owned by and belonging to Lessor. He holds and
uses the property, for period stated in lease agreement, on rental amount mutually
agreed on terms and conditions set out in lease agreement.

4.23 Sub-lessee :
Some times under lease agreement, a right is given by Lessor to the Lessee to permit
sub-letting of land or land with building to the third person. This sub-tenant is called
sub-lessee. Main Lessor in such a case is called Head lessor.
4.30 There are basically four types of leases.
(a) Building Lease.
(b) Occupational Lease.
(c) Sub Lease.
(d) Lease for Life.

4.31 Building Lease :

This type of leases are most common in which open plot of land is given on lease by lessor to
the Lessee for the construction of the building. Lease period may be 40 years, 20 years, 99
years or even 999 years. 99 years and more period is called long term lease or lease in
perpetuity. Short terms leases are also not uncommon. In all these type of leases, rental
income from building is received by lessee out of which he pays ground rent for the land to
lessor.

Some times in the beginning of lease , some premium amount is also charged
by the lessor as an advance lease rent for the land. These leases may be
renewable for further periods on same rent or may be renewable with
enhanced lease rent. There are leases which are not renewable and on expiry
of lease period, lessee is required to surrender back land with improvements
on land to the lessor free of cost. Some leases provide for payment of market
value of building (Improvement on land) to the lessee by the lessor ,at the
time of maturity of lease. Some leases also provide increase of ground rent at
fixed intervals even during initial lease period.

4.32 Occupational Lease :

This lease is for use of land and building together which belongs to lessor. The lease
period is normally short 3 years, 5 years or 10 years. There is a clause for rent review
after 2 or 3 years period and there is a clause for renewable lease for further
periods. These types of leases are not much common in India for residential
premises due to freezing of rent provisions under Rent Control Act. Instead of leases,
short period licenses are created for such residential premises. However still,
commercial premises are freely leased to limited companies as well as individuals by
granting occupational leases.

4.33 Sub Leases :

In this type of lease, Head Lessor leases land to Head Lessee for a fixed lease rent for
a fixed period. Head Lessee is given right to sub lease as and when required. Head
Lessee sub leases the land to sub-lessee for enhanced lease rental but for shorter
 duration than the head lease period. If main lease is for 99 years, sublease is for 98
years.

4.34 Lease for Life :

Under this type of lease, period of lease is fixed as the remaining life span of the
Lessee. The lease period will mature on the date of death of the Lessee. This type of
lease is not common in India.

4.4.00 Words Landlord and Tenant are normally used instead of lessor and lessee to
distinguish building tenant (premises occupant) from land tenant. There are
several types of rent as detailed below :-

4.4.01 Ground Rent :

It is the rent charged by the land owner (Lessor) to the tenant (Lessee) for use of land under
specified and mutually agreed lease terms and conditions. It can be monthly rent or annual
rent. The ground rent may be fixed for entire period or may be increasing at fixed intervals of
years or may be reviewed at the time of renewal.

4.4.02 Rack Rent :

It is the actual full rental value (Gross Rent) receivable from the property in a year. It may be
rent for land or for land and buildings.

4.4.03 Virtual Rent :

It is the virtual gross rental value to the lessor receivable from the lessee for leased out
property. In some cases lessor receives some fixed lump sum amount called
premium from the lessee in advance, in the beginning of the lease. This
premium amount is nothing but an advance rental for the property. Thus
returns to the lessor is divided in two or more parts. Gross Rent actually
received from lessee during the lease period plus notional rental value that is
receivable on the lump sum amount (premium) received from the lessee,
constitutes total rental or the virtual rent.

Some times improvements are done on the property by lessee which would
ultimately belong to the lessor as per lease agreement. In such a case
notional rental value on such capital improvement works also becomes the
part of the virtual rent. Thus virtual rent is sum of the total of actual rent
received from lessee during lease period, notional rent receivable on
premium amount and notional rent (annual equivalent) receivable on capital
sum invested by lessee in the property.
4.4.04 Head Rent :
Many a times the main Lessee called Head Lessee sub-leases the property to another person
called sub-lessee. To distinguish between lease rent paid by sub-lessee to head lessee and
rent paid by head Lessee to freeholder Lessor, the term Head Rent is used for lease rent paid
by the Head Lessee to Head Lessor, the freeholder.

4.4.05 Profit Rent :

When Head Lessee subleases the property ,he normally charges higher rent than “head
rent”. This increased rental is called Improved Rent. The difference between head rent and
improved rent is called Profit Rent. If ‘A’ leases property to ‘B’ for Rs.2000/month and ‘B’ in
turn subleases to ‘C’ for Rs.3000/month, Rs.2000 is head rent, Rs.3000 is improved rent and
difference Rs.1000 is profit rent.

4.4.06 Contractual Rent :

It is the rent mutually agreed between the landlord and the tenant under the tenancy
contract, which may be written or verbal. The rent may be for use of land alone or for land
and buildings together. This rent may or may not include property taxes and other outgoings.
Tenancy contract would fix the agreed norms and conditions.

4.4.07 Standard Rent :

The concept of Rent is established under Transfer of Property Act which governs and
regulate relationship between landlord and tenant. However since independence of India
and due to post world war situations in our country, most of the states thought fit to bring
out Rent Restriction Act for protection to tenants against exploitation and ejectment. This
freezing of rent and protection against ejectment were contrary to provisions of Transfer of
Property Tax. Hence these Rent Control Acts were treated as special legislation superior to
Transfer of Property Act.

Under these Rent Control Acts, the norms for rent payable by the tenant to
the landlord were fixed. This was called as Standard Rent. Hence “Standard
Rent” can be defined as the rent fixed by the Court for land or land with
building (premises) in accordance with the provisions of Rent Control Act.
Most of these Rent Acts, defines this terms “Standard Rent” and also clarifies
what it includes and what it excludes under different situations. The landlord
can not charge or receive from the tenant, any amount in excess of this legal
rent i.e. Standard Rent.
4.4.08 Market Rent :
It is the highest rent that is receivable for the property, by the landlord, in the open market,
after considering all advantages and dis-advantages of the property as well as market
conditions, in the prudent manner. It can be more than Standard Rent and in some cases
may be even lower than Standard Rent.

4.4.09 Concessional Rent :

When landlord gives premises on rent to some relatives or friend at token or nominal rent
which is much below ruling rent in the locality it is called concessional rent. It is always lower
than the Standard Rent and market rent of the premises.

4.4.10 Monopoly Rent :

Some property has unique location in the locality. This locational advantage can be exploited
by charging monopoly rent to the occupant. This rent is normally higher than ruling market
rent in the locality. The only hotel in front of railway station or only single office building in
residential zone are the examples of monopoly situations.

4.50 Having learnt different types of rental income, we can study types of expenses or
outgoings that the owner of property is required to incur to maintain rental income.
The outgoings for immovable property differ to great extent with outgoings for
movable assets like plant and machinery. However in both cases, contract
agreement with tenant (actual user of asset) and terms and conditions of renting
out, decides actual outgoings from rental income received by the asset owner. Some
of the outgoings that are required to be incurred by the owner of the house property
are as under :

4.51 Property Taxes :

Every local body or municipality levy house tax on the buildings and in return provide
civic amenities including, road net work, water supply, drainage facility, conservancy
services, street lights and garbage disposal services. These property taxes are
normally based on actual rents received or receivable for the premises. Taxes can
not be fixed on the basis of actual rent which is higher than the Standard Rent of the
premises. In such case taxes are based on standard rent of the premises.

It is now the new trend of many municipal corporations in India to delink

taxes from rental base and instead fix taxes on the basis of builtup area of
the premises and user of the premises. In year 2003 Delhi Municipal
Corporation Act was amended to introduce new system of rating called “UNIT
 AREA SYSTEM” of rating/taxation. Similar system of area based taxation are
already operating in cities like Amdavad, Patna, Bangalore and Hyderabad.

While allowing outgoings for property taxes, valuer should deduct only legally
payable taxes and should ignore actual taxes if found very high and excessive.
Special levy of tax like “Repair Cess” if levied on the property should also be
deducted as an outgoing.

4.52 Land Revenue :

For every property in urban areas, Government tax on land is payable by the
landlord for non agricultural use of the land. This N.A. tax is fixed depending upon its
user viz. Residential, Commercial or Industrial. Till land is unbuilt upon even in city
area N.A. tax is not payable as said land is deemed to be considered as agricultural
land.

4.53 Ground Rent :

If the property is not freehold but of leasehold tenure, landlord has to pay lease rent
or ground rent for the use of land till the date of expiry of lease. This outgoings
should be allowed on the basis of actual.

4.54 General Repairs :

Every human being requires upkeep and regular health care for long and healthy life.
Like wise buildings also requires regular upkeep and maintenance and also
occasional repairs for long service life. For continuity of rent and for same level of
rent , premises has to be in tenantable and in the up to date condition.

It is however seen that we Indians do not believe in maintenance and repairs at all.
Landlords repair the building very reluctantly. Even house owners who have not
rented out the premises but occupy the premises themselves, they also give last
priority to repair and maintenance of the building. It is a matter of last resort and not
a matter of routine. Rent Control Act has aggravated this situation further as
landlords now have excuse for not repairing premises in low, uneconomic frozen
rents. This is the reason why we see in every part of our country, several buildings in
disrepair conditions.

However in spite of all these factual position, it is for a valuer to allow appropriate
amount towards repairs and maintenance of the building. This outgoing is essential
 for estimated future life of the building and also for maintaining present level of rent
fetching capacity of the building. If building is in bad condition, rent receivable would
fall. It is customary to link Repair outgoings with gross rental income from the
property. Some valuers prefer to link repair allowance with cost of construction of
the building.

It is but natural that entirely new building does not need heavy repairs but as it
becomes old, higher repair outgoings are needed. Repair and maintenance outgoings
can be considered in the range of 3% to 12% of gross rent depending upon age of
building, amount of rent received and type of wear and tear to which the building is
subjected. For new residential building of say 5 years age with fairly good rental
income, 3% of gross rent may be sufficient. On the other hand for building having 40
years age yielding controlled rent even 10% of G.R. may be inadequate.

Actual average cost of general repairs and maintenance of the property over
last 5 or 10 years period , could be a better guide for making proper
allowance for the repair outgoings, rather than adhoc percentages.

This repairs and maintenance expenses does not include for cost of upkeep and
services like regular sweepings and security services which should be separately
allowed as outgoings. These repair expenses also does not include accrued structural
repairs like leakages through terrace slab waterproofing, cracked pillars and beams
etc. which should be separately allowed as accrued repairs. Valuer who connect
repairs with cost of construction, adopt repair outgoings at 1% to 3% of cost,
depending upon permanent or semi-permanent type of building.

4.55 House Insurance :

Many landlords do not insure the house against the risk of fire, flood, earthquake
etc. Even the owners who insure the house against these perils, they under insure
the house , not intentionally but out of ignorance and carelessness. However valuer
should estimate and allow appropriate and adequate insurance premium in every
case, as an outgoing in the interest of safety and continuity of rental income in
future, from the house.

Even if house is not insured, outgoing for the insurance premium should be allowed
assuming that the owner himself takes up the insurer’s burden. The insurance
premium rates goes on changing. It is linked with insured amount. For residential
building it may be about Rs.1.25 to Rs.2.00/1000 of sum insured.
4.56 Upkeep and Services :
This is also a regular outgoings required to be incurred by the landlord of tenanted
building. Landlord will have to employ services of sweeper for day to day sweeping in
compound and common areas of building. He may have to employ pump man for
regular water supply. If lift is provided in building, lift man in shifts are required to be
employed. If security staff is provided, watchman’s salary has to be allowed.

In some offices central A/c. facility is provided to each and every tenant. These
expenses are normally allowed on the basis of actual. Some times tenants pay
separately for all these services. In such a case, rental income should be
corresponding increased or expenses for services should not be allowed as an
outgoing.

4.57 Collection and Management Charges :

The landlord will require services of Rent Collector if number of tenants in building
are many. Actual salary paid to the rent collector can be considered as Rent
Collection charges. To collect rents from tenants in slums or chawls is more difficult.
Rental are low and paying capacity of tenant is also low. Regular flow of the rental
income in such cases is rare. Rent collector may have to visit tenants more than once
for payment. In some cases legal notice and litigation in Court may be necessary.
Hence rent collection charges in such case may be higher. Large rentals may also
become irregular if there are disputes between landlord and tenants.

Considering factual position in each case, these expenses can be allowed. Normally
3% to 2% of Gross Rental Income may be sufficient towards collection charges. In
case where landlord himself collects rents from the tenants, yet this outgoings
should be allowed.

4.20 Having studied income and expenses, we must now learn basis of rate of
return on investment. Following terminology must be thoroughly understood
for said purpose.

4.61 Annuity :
It is defined as the Net Annual payment (Return on investment) for the capital
invested in an immovable property or any other form of investment. Rent from land
or house, interest on Bank fixed deposit or yield on Government security are the
examples of Annuity.

4.62 Capitalisation :
 It is a concept (Mode/style) indicating the amount required to be invested by a
person desiring to acquire right for future benefit (income) or profit. Here future
benefit means net income or net profit expected in future. Future benefit is in
context of time or number of years and not with reference to increased or decreased
net income at later period. If a person desiring income in form of interest would
invest his funds in Bank fixed deposit or he may invest fund in the property to derive
future benefit in form of Rental Income , such fund is called capital investment.
Word “Capitalised Amount” by accountants means expenditure in land and building.

4.63 Rate of Capitalisation :

It is a rate of return at which an investor is willing to invest his capital (funds) to get
future benefits (income). If a person deposits Rs.1,00,000 in Bank fixed deposit, and
Bank offers interest of 8% on F.D., rate of 8% is called rate of capitalisation.

4.64. Sinking Fund :

It can be defined as an annual recurring fund (amount) required to be set aside every
year, for a given period of time, at the given rate of interest, to recoup capital
invested in a property, interest or return from which would cease after a given
period of time.

4.25 Thus, valuer is sometimes required to find out the amount required to be set apart
every year for a certain number of years to recoup capital which is terminable after
some time. In case when income (lease rent) from leasehold properties (land),
ceases with the maturity of the lease (If there is no renewal clause), it is necessary to
allow for recoupment of initial capital invested in addition to return on capital
investment. Similarly in case of capital investment in building which is a depreciable
asset, it is necessary to provide for return of capital invested in building and also for
recoupment of capital invested (Accumulated sum in form of Annual Sinking Fund
Amount).

4.22 The rate of interest adopted for return on capital investment is called
remunerative rate of interest. The rate of interest adopted for working out
Sinking Fund i.e. recoupment fund, is called recoupment rate of interest.

4.27 Remunerative rate of interest (For perpetual income) is always higher than
Accumulative rate of interest (Interest rate for recoupment of capital
invested in property having terminable income).
4.28 Remunerative rate of interest is decided by comparing market yield rates from
similar other sound securities available in the market. Where as recoupment rate of
interest is decided at lowest possible maintenable interest rate at which rate interest
income is guaranteed and said income should not fall even in a very long period of
time for the investment , say 40 to 20 years time period. Hence this rate is generally
pretty low and is compared with interest rates offered by Banks on amounts
deposited in Saving Bank account.

4.69 Years Purchase :

Years purchase is defined as capitalised value required to be paid once and for all, in
order to receive annual income of Re.1/- for specified period of Time at specified
rate of Return.

Capitl Value x Re .1
Y.P. =
Rate of Capitalisation