UNIT 7 METHODS OF VALUATION

Structure
7.1 Introduction
Objectives
7.2 sinking Fund-Underlying Principles and Mathematics
7.3 Construction and Use of Valuation Tables
7.4 Principles of Rent Capitalisation Method
7.4.1 Gross Rent
7.4.2 Outgoings
7.4.3 Rate of Return Expeded on Capital Employed
7.4.4 Estimated Future Life of the Structures
7.4.5 Rate of Interest for Sinking Fund
7.4.6 Unexploited Potential, If Available for Possible Exploitation
7.4.7 Quantum of Special Capital Repairs, If Required
7.5 Reversionary Value
7.6 A Typical Example of Valuation by Rent Capitalisation Method
7.7 Profit Capitalisation Method
7.8 Hypothetical Development and Hypothetical Building Schemes
7.8.1 Hypothetical Development Scheme
7.8.2 Hypothetical Building Scheme
7.9 Valuation Under Schedule-I11 of W.T. Act
7.10 Summary
7.11 Answers to SAQs
7.1 INTRODUCTION
After reading Unit 6, you have now broadly understood the various methods that can be
employed for determining the value of an immovable property. You also know as to which
method is most appropriate in certain situations. You have further understood, in depth, the
principld of valuation by Land and Building method. In this unit we propose to get further
insight in the other methods of valuation. We also propose to study the fundamentals
involved in formation of the standard Valuation Tables and their utility in valuation work.
Objectives
After going through this unit you should be able to :
understand the mathematical principles of sinking fund method of accounting
for depreciation,
comprehend the principles involved in formation of the valuation tables,
make use of the standard valuation tables in immovable property valuation,
understand the principles of income capitalisation and profit capitalisation
methods,
understand the principles of Hypothetical Development and Hypothetical
Building Schemes, and
comprehend the principles embodied in Schedule 111 of Wealth Tax Act for
valuation of immovable properties.
7.2 SINKING FUND-UNDERLYING PRINCIPLES AND
MATHEMATICS
Sinking fund method is a sort of an accountant's method of accounting for depreciation in
immovable properties. The underlying basic principle is that any prudent person would
Valuation
like to keep apart a small amount every year in a safe security to take care of the
depreciation in the immovable property. The idea is that a fund should be built up which
may provide adequate money for re-building of the property when the property becomes
totally unhabitable due to accumulated depreciation. For this purpose, it is assumed that
the fund is built up by depositing a fixed annual amount in a long term security which
earns a reasonable rate of interest as a recurring deposit account. The assumption, further,
is that the rate of interest is such as is available from absolutely safe long term securities so
that there is no risk of losing the accumulated sum. The depreciation at any stage, during
the life of the structures, is the amount accumulated in the fund upto that stage. The yield
from gilt edged securities, i.e. long term government securities, is considered to be the
most appropriate rate of interest for this purpose.
Let us now examine as to how this principle is put in operation.
Let us assume that an amount of Re 11- is proposed to be deposited in the sinking fund
account every year out of the earnings of the year from the property. Let us also assume
that this amount is deposited at the end of the relevant year. Let us further assume that the
sinking fund account earns annual interest at i percent. Let us now examine as to how this
account grows.
Re 11- deposited at the end of the first year does not earn interest. It remains as Re 11 at the
end of the first year. It earns interest in the second year and becomes 1+ i at the end of the
second year. This further becomes (1+ i)2 at the end of the third year, (1+ i)3 at the end of
the fourth year, and so on.
Thus,
Re 11- deposited in 1st year becomes Rs (1+ i)"-' inn years
Re 11- deposited in 2nd year becomes Rs (1+ i)n-2 inn years
Re 11- deposited in 3rd year becomes Rs (1+ i)n-3 in n years
Re 11- deposited in (n -2)th year becomes Rs (1+ i)2 in n years
Re 11- deposited in (n -1)th year becomes Rs (1+ i) in n years
Re 11- deposited in n th year remains as Re 1 in n years
Now if we use the term S, to represent the total amount in the fund after n years are over,
Multiplying (i) by (1+ i)
(1+ i) x Sn = (1+ i)" + (1+ i)"-' + . . . + (1+ i13 + (1+ i12 + (1+ i) (ii)
Deducting (i) from (ii),
Now, our original assumption was that the annual installment deposited in the account is
Re I/-.
If Sn is the total accumulation, the annual installment is 1.
If 1 is to be total accumulation, the annual installment will be
or, if the aim is to collect Re 11, the annual installment should be
You may wonder how all this mathematics helps us in finding out the depreciation in an
actual property. In this topic we have learnt how to calculate the amount that will be
accumulated in the sinking fund if annual installment deposited in the fund is Re I/-. We
have also learnt as to what the annual installment should be if the aim is to collect Re 11- in
--
a given number of years. But what should the quantum of annual deposit be in an actual
case is still not discussed. As such how this gives us the actual depreciation may still not
be clear. For understanding the manner in which this concept is used to account for
depreciation, we have to learn the method of construction of valuation tables, which we
will do in the next topic. The mathematical terms derived here will be used in study of the
Construction of Valuation Tables.
7.3 CONSTRUCTION AND USE OF VALUATION TABLES
An immovable property is expected to generate some income for the own2. Even if the
property is not actually let out, it is expected to command some income earning capacity.
In certain circumstances it is this income earning capacity which imparts value to the
property. We have seen in the previous topic as to how a prudent owner would like to
generate funds for reconstruction of property at the end of its economic life. In other
words, we saw that the sinking fund approach provides a means for recapturing capital lost
in depreciation. However, a prudent person is not only interested in making provision for
recapturing lost capital alone. He expects a reasonable return on the capital employed in
the immovable property too. Thus, the income generation from the property-whether real
as in the case of properties actually let out or notional as in the case of self occupied
properties-should take care of both, the reasonable return on the capital employed and also
a component for recapturing capital lost in depreciation.
We have seen in the previous topic that if the capital employed is Re I/-, it can be
recaptured in n years by depositing an amount of il((l+ i)" -1 } in a safe account every
year, that is to say that the income from the property-whether real or notional-must
contain this component against each rupee of capital employed to take care of
depreciation. In addition, if the expectation for the rate of return on capital employed is of
the order of I per cent, each rupee of capital employed must also be capable of generating a
return of I. Thus, the total annual income fetching capacity of the immovable property
should be of the order of
This will take care of the reasonable expectations for the return on capital as well as
depreciation in capital when the capital employed is Re 11- and the expected future life of
the building is n years.
Now against this, if the income earning capacity of the property is Re I/-, the capital
employed would be
Or, for earning capacity of each rupee, the capital employed is
You will observe that now we know the amount of capital cmployed for each rupee of
income earning capacity of the property. This is given by the term (ii) above. This is also
known in valuation parlance as YEARS PURCHASE or simply the multiplier. You will
notice that it is not necessary to achially bifurcate the annual income into two parts for
determining the depreciation separately. The netannual income earning capacity when
multiplied by the YEARS PURCHASE directly gives the capital employed which in
other words is the prudent persons estimate of the purchase price for him, or, the fair value
of the property. The figure so assessed has automatically taken into account the element of
depreciation by suitable apportioning of the income into the return and the amount
required for recapturing the sapital.
The formula at (ii) above looks rather cumbersome if these calculations were to be done in
cach and every case. Fortunately, this is not required in actual practice.
Methods of Valuation
Valuation
It would be observed that the formula has 9 e e variables which determine the magnitude
of the *EARS PURCHASE. Variable I represents the rate of return expected by the
society from the investments in the property, variable i represents the rate of interest that is
available to the society from absolutely safe very long term deposits and n is the number of
years for which, according to the valuer's expert estimate, the property will remain in the
serviceable condition. Standard tables are available for giving years purchase for different
combination of values of these three variables. These tables are given as an appendix to
this compilation. These tables give the values of the years purchase calculated by the
formula at (ii) above.
SAQ 1
i)
Explain in your word, what is sinking fund ?What is itS philosophy and how
calculations are to be made'?
ii) What is " yem purchase"?
7.4 PRINCIPLES OF RENT CAPITALISATION mTHOD
This method of valuation is based on the assumption that the property market is an
investment market where the capital employed will bring reasonable re huns. Courts have,
time and again, held that this is the most suitable method for determining the value of the
properties that are let out to tenants and are subjected to rent control laws under which the
rents cannot be enhanced and the tenants are protected against eviction. For'deterrnining
the value of a property the following information is required.
* Gross rent.
* Oulgoings.
*
Rate of return expected on capital employed.
*
Estimated future life of the structures.
*
Rate of interest for sinking fund.
*
Unexploited potential, if available for possible exploitation.
* Quantum of special capital repairs, if required. -
7.4.1 Gross Rent
The basic intent is to estimate the rent that the property is expected to fetch in the years to
come. We have to estimate the rent fetching capacity of the future and not the past. When
the property to be valued is actually let out, and the rent is not collusive or concessional,
the actual rent gives the best guide for the gross rent from the property because in such
cases it may reasonably be expected that the property will continue to fetch the same rent
in future too. In other cases the rent fetching capacity of the property has to be determined
by market survey to get the data for rents at which similar properties in similar localities
are actually let out. Many a times it may be observed that the actual rent received from the
property is far less than what may reasonably be expected. In such cases it is to be
examined whether the property is governed by any rent control laws and if so, the
restrictions imposed by those laws have to be studied. Invariably it will be found that the
rent control laws have forbidden any increase in the rent at the will of the landlord. These
laws usually provide for protection to the tenants against eviction too except on certain
specified grounds. In such cases it is reasoilable to assume that though the existing rent is
low yet there are hardly any chances of increasing the rents in future. The existing rent will
have to be taken to be the rent fetching capacity of the property. Position is different when
the rent is higher than what may be expected from that class of buildings. This may happen
when the tenant has taken the property for short periods or he otherwise has a fancy for
that particular property. If that be so, the likelihood of the rent being maiqtained in future
may be rather bleak. Suitable discoullting nlay have to be done for possible reduction in
rent when the present tenant leaves. Such cases would, however, be rare in actual
applications.
While assessing the gross rent of a property all Ule coilditions of the rent agreement should
be properly analysed to arrive at the monetary equivalent of other indirect benefits that the
tenant may have given to the owner also. For exanlple, a tenant bank may have granted an
interest free loan to the owner and correspondingly reduced the rent payable from month to
Methods of Valuation
month. In such a case the interest not charged is also to be included in the rent fetching
capacity of the property.
7.4.2 Outgoings
Outgoings are the expenses that the owner has to incur for keeping the property in a fit
slate for earning the rent. They also include all the expenses that the owner is obliged to
incur. These, however, do not include the charges of the kind of private mortgage, created
by the owner for liabilities other than those directly related to property maintenance.
Typically, they may consist of
*
Municipal taxes or other property taxes.
*
Expense incurrable on annual repairs and maintenance.
*
Ground rent in leasehold properties.
*
Expenses on collection and management.
*
Expenses on insurance of property.
*
Loss of income due to vacancies and bad debts.
*
Any other expenses which the owner is required to incur as a direct charge with
respect to the property. ,
Municipal and other local bodylstate taxes, to the extent that they are payable by the
owner, form a legitimate expense from the rent earning capacity of the property.
Annual repairs and maintenance charges, if forming a liability of the owner, has to be
allowed as an outgo. Most of the rent control acts have placed this liability on the owner to
the extent of one month's rent in a year. Income Tax Act allows this outgo at the rate of
116th of the gross rent in assessment of income from the house properties. Usually, this
outgo is allowed at the rate of one month's rent in a year.
Ground rent, as actually payable by the owner for a property construited on leasehold land
is allowed as an outgo.
Collection and management expenses will depend on the number of tenants and the
running about that the owner has to do for collection of rents and attending to the tenants'
complaints etc. Income Tax Act allows a maximum of 6 % deduction on this account. The
figure may vary between 0 to 6 % depending on the assessment of the effort and expense
to be incurred by the owner.
Insurance charges may be allowed on the basis of laid down slabs of the insurance
companies. These may come to the order of about VL% of rent in normal cases.
Vacancies and bad debts constitute a loss of income from the property. If such losses have
occurred in the past, these may occur in future too. Therefore, this forms a legitimate outgo
in ilonnal cases. However, as mentioned earlier, invariably the rent capitalisation method
is adopted in cases where the rents cannot be enhanced and the tenants cannot be evicted
due to rent control restrictions. For a fact, the value of the property gets substantially
depressed under these restrictions. It is well known that the market value of a vacant
property is usually much higher than a rented property, particularly when the property is
subjected to the rent control restrictions. That being so, vacancies are welcome and bad
debts give an opportunity for instituting proceedings against the defaulting tenants. In
either case the chances of getting better rents become brighter. Under these circumstances,
the vacancies and bad debts may not really become rent reducing factors and there may not
arise any necessity for allowing this outgo in valuation calculations.
Other miscellaneous expenses may be of various kinds. For example, in a multi-storied
building there may be several flats occupied by several tenants. Maintenance and
cleanliness of common areas may be the responsibility of the owner. Similarly, pumping
of water may be the owner's responsibility. If the tenants of individual flats are not
separately charged for these services, the expenses on providing these services will
constitute a legitimate outgo.
7.4.3 Rate of Return Expected on Capital Employed
Rate of return expected is the most controversial factor in rent capitalisation method for
evaluating the immovable properties. Some people tend to relate it to the bank deposit
Valuation
rates and others make wild guesses. The most appropriate way to work out the reasonable
rate could be provided by an actual anawsis of newly constructed buildings, fully
developed and let out for the first time at the market rate. Working back from the actual
rent fetched and the assessed value oh the basis of Land and Building method could give
the most logical level of expectations in the market. However, this data is usually difficult
to obtain. Even if the data is available for one category of properties, it may not be
straightaway applicable to'the other kind of properties. By and large, therefore, the valuers
depend on theoretical assessment of the reasonable rate by comparison with the rate of
return from gilt edged securities and making suitable allowances for the extent of risk
involved in the kind of property under consideration. The factors affecting the expectations
may be of the following kind :
* safety and security, 1:
*
stability and maintainability of income,
* certainty of realisation,
*
ease in collection of income, and
* liquidity of capital.
Broadly the categorisation for the level of expectations for the rate of return is done as
follows :
Secured Ground Rent
Land belongs to the owner and is leased out to the lessee on the condition that he puts up
structures at his own cost. There is usually a condition that the lessee will hand over the
structures to the owner in the event of termination of lease or in the event of defaults in
payment. This is considered to be most secure tenancy and hence a low rate of return is
justified. The rate taken is the rate of return available from gilt edged securities. The rate
may be of the order of 6 to 6U%.
Unsecured Ground Rent
As in the previous case but with no obligation on the tenant to put up any permanent
structures. The security available is somewhat lower than in the previous case. The rate of
return expected is, therefore, a bit higher than the rate of return expected from secured
ground rent. This may be about U% higher than the expectations for secured ground rent.
The rate may be of the order of 61h to 7%.
Residential Houses
This category will involve a little more risk as the building is also constructed by the
owner and the tenant's stake is further reduced. The expectations in this case will be for a
rate of return which is still higher by U to 1 %. Accordingly, the rate may be of the order
of 7~ t o m%.
Residential Chawls
The multiplicity and the level of tenants suggests likelihood of more defaulters and delay
in receipt of rents. The rate expected may be still higher by about U%. The rate,
accordingly, may be of the order of 8 to 9%.
&hops and Offices
Apart from the normal risks, this kind of properties suffers, at least to some extent, from
the business risk of the tenant also. Therefore, the expectation will be for a still higher
return by 1 to 2 %. The rate, in this case may come to about 9 to 10%.
Godowns and Factories
This kind of properties suffers from usual business risks and also from risk of industrial
problems as well as of difficulty in getting other tenants on vacation of premises. The
expectation for the rate of return will, therefore, go up by another U% or so. The rate for
such properties may be of the order of 91h to IOU%.
Single Use Properties
The clientele for taking such single use properties as cinema bouse or a hotel will be rather
limited. Such properties can usually not be put to alternative uses. The expectations for
rate qf return for rents from such properties, therefore, goes up further by about U% or so.
The reasonable expectation in such cases may be to the tune of 10 to 11%.
While assessing the reasonable rate of return, it should be kept in mind that a simple
comparison with the bank rates will not be in order for the simple reason that in spite of all
the rent control restrictions etc. it still is a fact that the properties appreciate in value. There
is, thus, a substantial capital growth which is not there in the bank deposits. For a fact, it is
well known that the retum in company shares is extremely low because the people expect
substantial capital appreciation. Higher the expectations for the capital growth, lower is the
rate of return.
7.4.4 Estimated Future Life of the Structures
Estimation of the future life of the structures has to be done carefully, taking into account
the physical condition of the buildings, their age and other environmental conditions. The
valuation cell of the income tax department has laid down certain guidelines for assessing
the total life of the structures of various kind. These are given in Appendix 2. The
estimation of the balance life should be done judiciously taking into account the
obsolescence factors too. Many a times it is found that the structures have become
economically obsolescent and have been demolished to make room for more intensive
utilisation of land, though there may still be some physical life left in the structures.
*
6'
7.4.5 Rate of Interest for Sinking Fund
As already explained the underlying idea behind the sinking fund concept is that a safe and
absolutely secure account be created for recapturing the capital. This account should
involve no risks and should be absolutely safe. The rate of interest on such an account
would naturally be low. This may be more or less equal to the rate of return expected on
the secured ground rent. There is another school of thought which advocates adoption of
the rate equal to the expected rate of return from the property itself, on the plea that no
owner actually thinks of bifurcating the return into two different form, and two different
accounts. However, by and large, the accepted practice in the market is to adopt the rate
and the concept of an absolutely safe security.
Having determined the rate of return, future life of structures and the rate of interest for the
sinking fund, it is possible to refer to the standard valuation tables and get the YEARS
PURCHASE for the case. This years purchase when multiplied by the net rent from the
property (that is GROSS RENT - OUTGOINGS) gives the capitalised value of the
property. In absence of any potential for further development and in absence of any need
for capital repairs, lhis gives the market value of the property. If, however, there is any
potential for further development or if the structures are in need of some immediate capital
repairs, necessary adjustments have to be made as explained in subsequent sub-sections.
7.4.6 Unexploited Potential, If Available for Possible Exploitation
The rent fetching capacity, to a great extent, depends on the building area constructed on
the land. If there is an unexploited potential for more construction, it may be possible to
further enhance the rent fetching capacity by spending some amount on additional
constructions. Most of the rent control legislation, in the country, do provide for the
contingency of severance of additional land andlor for permitting additional construction
by the owner. Of course, much may depend on the terms and conditions of the tenancy
agreement, but by and large further exploitation may not be impractical. Under such
circumstances, it is customary to work out the notional land that may be considered to be
married to the existing accommodation, by taking proportionate area on the basis of the
permissible bye-laws and considering the remaining area, to be freely available. For such
remaining area addition is made to the rent capitalised value on the basis of assessed land
rate. Further, in cases where there is likelihood of a delay in exploitation of the balance
proportion due to expected litigation or settlement, such additional value is invariably
discounted for a year or two at the rate of retum expected from the property to assess the
present worth of the additional potential and added to the capitalised value to come to the
market value of the property.
7.4.7 Quantum of Special Capital Repairs, If Required
If a physical inspection shows that the structures require immediate repairs of a capital
nature-say repairs required for grouting of some structural cracks-then the amount
required for such capital repairs should be estimated and deducted from the assessed value
Methods of Valuation
Valuation
of the property. If, however, the repairs requued are of ordinary annual maintenance kind,.
then no deduction need be made as such repairs are accounted for in the outgoings.
SAQ 2
i)
What is rent capitalisation method ? Where is it used in valuation?
ii)
How do you decide the rate of return?
7.5 REVERSIONARY VALUE
Going back to the definition of value, we had seen that the value of an immovable
properties is the present worth of the rights to the future income from the property.
Right to future income from the = Right to future income from the + Right to future income from the
PmPertY structures land
= Right to future income from the + Right to future income from the
structures during life time of land during life time of the
the structures. structures.
+ Right to fiture income from the
land after the life time of the
structures.
= Right to future income from the + Right to future income from the
property during life time of the land after the life time of the
structures. structures.
= Capitalized value of the + Land value to become available
immovable property after lifetime of structures.
1 I
Now, X is the value assessed by the process described in the preceding paras and Y is the
component which we have still to work out. As indicated, Y represents the value of land
becoming available after .the life time of the structures. Its present worth, is given by
(Land value/(l+ On) where r is the rate of interest expected on the investment in land.
Usually r is taken to be somewhere in between i and I. This component of value is known
as Reversionary Value of land.
The above analysis proves that theoretically the value of the property is incomplete if
reversionary value of land is not added. The courts have however not been kind to the
concept of reversionary value of land due to the uncertainties involved in precise
estimation of the future life of the buildings, particularly when the estimated life is rather
long-say of the order of more than 40 to 50 years. In such cases, the reversionary value
itselfreduces to a small figure and the value of the property may be assessed by taking the
years purchase at inverse of the rate of return that is I l l and the reversionary value of land
may be omitted. This tentamount to saying that a period of 40 to 50 years is a long period
may be considered ~ r , approximate to perpetuity. This also means that the depreciation in
the first few years of perpetual life is negligible and hence the factor for sinking fund
becomes insignificant in calculations for determining the market value of the property and
can be ignored. Position would, however, be different when the balance life of the
structure is small. In such cases the depreciation as well as the reversionary value play a
very significant role in the estimation of the market value ofthe property.
" ".
7.6 A TYPICAL EXAMPLE OF VALUATION BY RENT
CAPITALISATION METHOD
Methods of Valuation
j
Let us now take the same property as taken in Unit 6, assuming however, that the property
is tenanted, and work out the value by rent capitalisation method. For this purpose, let us
assume that the following additional data is available.
The property is tenanted.
*
The monthly rent is Rs 2500. There is no specific stipulation as to whether the
repairs will be carried out by the tenant or the landlord.
*
Municipal taxes is the liability of the landlord.
*
Apart from the monthly rent, the tenant has not given, or agreed to give, any
other pecuniary benefit to the landlord.
*
The municipal taxes are leviable at 10% of the rateable value.
*
The property is located in a city where rent control laws are applicable to such
categories of properties.
Salient features of the rent control act are :
i)
Tenants cannot be evicted except on specified grounds such as requirements
for self occupation, continuous defaults in payment of rent, misuse of property
etc.
ii) Rents cannot be enhanced.
iii) If the landlord wants to put up additional construction, he may be allowed to
do so as long as the occupation rights of the existing tenants in respect of the
accommodation occupied by them already, are not affected.
iv)
It is the obligation of the landlord to keep the building in a state of good repair
and maintenance.
Note 1
The analysis of the past cases shows that eviction, even on the grounds given in the rent
control laws, is usually difficult and even in genuine cases may take several years and in
some cases even decades.
Note 2
The analysis of rent data in newlly constructed properties shows that people expect a
return of about 8% in residential properties.
Note 3
Though landlord is allowed to put up additional construction, yet the analysis of the past
cases in the city shows that invariably the tenants resist such attempts to construct
additional storeys in the same compound and it takes about two years to sort out this issue
either by direct negotiation or through court.
We may now proceed withthe actual calculation work.
Gross rent : Gross annual rent = 2500x 12 = 30000
Outgoings :
Municipal taxes = 10% of 30000 = 3000
Repairs and maintenance = 30000112 = 2500
Ground rent : The land is freehold = Nil
Collection and management charges.
There is only one tenant. We may,
therefore, take this as 2%. = 2% of 30000 = 600
Insurance say 0.5% = 0.5% of 30000 = 150
Vacancies and bad debts Nil
Any other charges Nil
Total of outgoings 6250
I
Valuation
Estimated life of the buildings of such specifications is 60 years. The building is alzeady
12 years old. The balwce life of the structures may be taken to be 48 years.
Referring to the valuation tables, we find that the YEARS PURCHASE, for 8% return on
capital and with 6% rate of interest on sinking fund, when balance life is 48 years, is
11.91928.
Capitalised value of the property
= Years Purchase x Net rent
= 11.91928 x (30000 - 6250)
1
The property has potential for addition of two more storeys. Assuming that there is no
difference in rent fetching capacity of the ground, frst and second floors, the land that may
1
be considered to be appurtenant to future first and second floors, may be taken to be 213 of
the total land area. In other words an area of 166.67 sq. metres may be considered to be
available for future exploitation. Value of this portion of land at the rates as estimated in
Unit 6 may be assessed as follows :
Land appurtenant to future storeys = 166.67 m2
Current land rate = 2539 per m2
Current land value = 166.67 x 2530
Exploitation of future potential value nlay take 2 years. The potential value may, therefore,
be available after 2 years.
Deferring the current. land value at 8%, i.e. the return expected from the property as a
whole,
Deferred land value = 49219675 = 3,61,518
1 .0s2
Adding A and B,
Market value of the tenanted property is Rs. 6.44.601 say Rs 6,44,600
7.7 PROFIT CAPITALISATION METHOD
In single use properties of the type of cinema houses or hotels, many a times it is found
convenient to work out the market value of the property by referring to the income
generation capacity of the property through the running of the business venture for which
the property is meant. Even if the property is not actually let out, and even if the business
is run by the owner himself, it is argued that the profit of the business venture is
predominantly attributable to the capacity of the property itself. Take, for example, the
case of a cinema house in an old city area. The business of showing films in the cinema
house will generate a profit for the owner. This profit is partly due to the entrepreneurial
skill of the owner and partly due to the very fact that the propertjl is locationally and
structurally built for running of the show business. For valuation of such properties, the
profit and loss account of the business venture is examined and the net profit after allowing
for all the business expenses and the property outgoings is worked out. A suitable
reduction is then made-at say 10 to 15%-to account for the entrepreneurial skill and effort
of the owner in running the business. The balance profit so worked out is taken to be the
income generation capacity of the property. The value is then worked out in the same
manner as described in the previous topic with appropriate rate of return, estimated future
life and the rate of sinking fund. Though profit capitalisation method is a recognised
method of valuation of single use properties, yet it has to be noted that the method is
fraught with several uncertainties. The method is quite sensitive to the variations in
business acumen and there is no reliable method for bifurcating the vagaries of business
venture from the real capability of the property for generation of income. The method
shouldiherefore be used with caution and only if there is no adequate data bank available
for estimating the market value by other methods.
7.8 HYPOTHETICAL DEVELOPMENT AND
HYPOTHETICAL BUILDING SCHEMES
Methods of Valuation
I
7.8.1 Hypothetical Development Scheme
1
With ever increasing pressure on land in most of the urban areas it becomes necessary to
! extend the developmental activity at the periphery of the town limits. It also happens that
sometimes large pieces of land within the urban limits, earlier earmarked for industrial or
some other use may have to be converted for use as a residential colony. Valuation may be
required for such large pieces of land but, it may not be possible to get reliable data of land
rates applicable to such large tracts of land in the vicinity. In such areas, particularly when
the land is capable of being developed into small plots, hypothetical development scheme
1
method of valuation is found to be quite useful.
In this method a development scheme is planned for the land wherein a hypothetical
distribution of land into small building plots with necessary road network and parks etc. is
contemplated. The expenditure to be incurred on providing developmental facilities is then
estimated. The sale price of the plots is estimated on the basis of land rates in adjoining
areas and applying it to the total saleable area of the plots. The difference of the two after
suitable discounting.for the time element gives the value of the land. ' he method will
better be understood by following the example given below.
Example 7.1
Let us assume that the following piece of land is to be valued :
A development plan can be contemplated for this piece of land as in Figure 7.1
It will be observed that the plan as proposed accommodates 30 plots of size 20 metres by
30 metres and 142 plots of size 10 metres by 30 metres. Having made a development plan
25 plots of size 20 m x 30 m
20 m ROAD
IIIIIIIII I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I (
50 plots of size 10 m x 30 m
Figure 7.1
29
Valuation
we may now proceed to work out the expenses to be incurred on such a development and
the sale proceeds that will be available by sale of various small plots.
Let us assume that the average rate for the plots of varying sizes as analysed from the data
for the adjoining areas is as follows :
Plot size Average rate
Upto 300 sq. m. Rs. 2,000 per sq. m.
300 - 500 sq. m. Rs. 2,500 per sq. m.
500 - 800 sq. m. Rs. 3,000 per sq. m.
Let us further assume that the cost of providing development services such as roads, water
supply, sewerage, storm water drainage system etc. is estimated to be around Rs. 125.00
per square metre of total land area and that it will take two years to develop the land. Let
us also assume that the rate of return expected is of the order of 8%.
The total expenditure on development may be worked out as follows :
Total expenditure = Land area x Cost of development per sq. m.
= (200 x 500) x 125
= 1 ,00,000 x 125
= Rs. 1,25,00,000.
This amount is to be spent in a phased manner in a total period of 2 years. Accordingly, the
average point of time for the entire expenditure may be taken to be one year. Hence the
present worth of this expenditure may.be taken to be its discount value at the rate of 8%.
The present worth of the amount of Rs. 1,860 lakhs when discounted at the rate of 8% for
one year comes to Rs. 1,25,00,000/1.08, i.e. Rs. 1,15,74,074 or say 116 lakhs. Assuming
10% profit for the developer, the present worth of the cost of development including the
developer's profit will be :
1,16,00,000 x 1.1 = 1,27,60,000 say Rs. 128 lakhs.
On the other hand, the sale value of the plots after development will be as follows :
Plot of 20m x 30m size 30 x 600 x 2000 = Rs. 3,60.00,000
Plot of 10m x 30m size 160 x 300 x 3000 = Rs.14,40,00,000
( 5 0 +5 6 +1 8 +1 8 +3 +6 +6 +3 =1 6 0 )
Total = Rs. 18,00,00,000
This amount is expected to be available after the development of area is completed, that is
after a period of two years. Its present worth will have to be worked out by discounting
this amount by a period of two years as follows :
Present worth of sale value = 18,00,00,000/(1.08)~
= Rs. 15,43,20,988 say Rs. 1,543 lakhs.
The net value of the land in its present shape may be worked out by deducting the present
worth of the cost of development from this figure.
Accordingly, the value of land = 15,43,00,000 - 1,28,00,000
= Rs. 14,15,00,000.
The value of land in its present shape, therefore comes to Rs. 1,415 lakhs.
7.8.2 Hypothetical Building Scheme
In several cities we find large plots of land with small bungalows located in central areas
of the town. These are the legacies of good old days when the culture of multi-storeyed
construction and apartment type of living accommodation was virtually non-existent. With
increasing pressure on land and with ever increasing intensive development being brought
in by successive master plans, such bungalows with spacious lawns are giving way to
multi-storeyed concrete structures with consequent redensification of such areas. If
effective sale data for such old properties is available, the task of a valuer becomes simple.
But, instances are not wanting where the need for assessing the market values of such
properties arises but effective and reliable sale data is not available. Valuers have to devise
suitable methods for determining the value of tJ1gpropertie.s in such cases too.
Hypothetical building scheme method is one such method which helps in solving the
problem when land sale data is not available but the valuer is able to get reliable data for
the prevailing rents in the colony or in similarly situated colonies. The steps involved in
this method are as enumerated below. (It may be noted that in such cases the value of the
building is hardly of any consequence. This is invariably taken to be only the scrap value
of the structures.)
*
Prepare a suitable building scheme for the plot of land in conformity with the
latest building bye-laws.
*
Work out the cost of construction for the proposed building.
*
Estimate the time required for construction of the building.
*
Make necessary additions for the entrepreneur's effort and profit.
*
Work out the present work of the cost of construction taking the period for the
expenditure to be the average point of the construction period as was done for
the development cost in the hypothetical development scheme.
*
Work out the area that can be let out in the new building on its completion and
then work out the income that can be earned by letting the spaces in the new
building.
*
Work out the market value of the property on its completion by income
capjtalisation method.
i
. .
. , *
Work out the present worth of the market value assessed in the previous step in
the same manner as was done for the land value in the hypothetical
development scheme by deferring the amount at a suitable rate of interest for
the likely period of construction.
*
Work out the market value of the land as the difference between the present
worth of the income capitalised value and the present worth of the expenditure.
*
Add the scrap value of the structures.
Like the hypothetical development scheme, hypothetical building scheme method should
also be used with caution and only if thq other methods cannot be applied with a
reasonable amount of rqliability. As a matter of fact, this method is even more sensitive to
the assumptions made in the process and hence, all the parameters regarding the rates of
interestheturn, estimated periods of construction, estimated costs of construction etc.,
should - be chosen with extra care.
Methods of Valuation
SAQ 3
i) What is reversionary value'?
n)
What IS profit-cspit~llsatl,.:. , , CLL .t.. . . : .sum?
7.9 VALUATION UNDER SCHEDULE-111 OF W.T. ACT
The Government of India, through the Direct Tax Laws (Amendment) Act, 1989,
introduced Schedule III in the Wealth Tax Act, to be effective from 1st April, 1989. By
introducing this schedule, the Government virtually gave up the principle of taxation on
the basis of Fair market value of the properties for the purposes of the Wealth Tax Act and
the Gift Tax Act. Without specifically stating so, a concept of the type of a taxable value
was introduced through this schedule. Specific rules were laid down for the purposes of
determining the value of the properties for the purposes of these two Acts. The rules
relating to the immovable properties are contained in Part B of this schedule. The
procedure given in these rules basically follows the income capitalisation method for most
of the properties with a modification to the extent that instead of determining the various
parameters such as the outgoings, rate of return, potentiality etc., on the basis of the market
forces, these have been specified in the hifa themselves. The salient features of these rules
are enumerated below.
Valuation *
Rule 3 stipulates that the multiplier (i.e. the years purchase) will be 12.5 for
properties built on freehold land and 10 for the properties built on leasehold
lands if the unexpired portion of the lease is fifty years or more and 8 if it is less
than fifty years. There is a further proviso that in cases where the properties are
acquired after 31.03.1974, the figure worked out by applying the
above-mentioned multipliers will be changed to the figure of the cost of
acquisition if the cost of acquisition is higher. Also, there are some relaxations
in relation to one self occupied house.
*
Rule 4 defines the outgoings. The outgoings admissible are :
- taxes actually levied by the municipality.
- 15% of the gross maintainable rent to cover all other outgoings.
*
Rule 5 stipulates that the gross maintainable rent will be taken to be the actual
rent received in the case of rented properties and the rateable value assessed by
the municipal authorities in other cases. There are further provisions to enhance
the rent if the expenditure on municipal taxes or the repairs etc. is borne by the
tenant in addition to the rent or if the tenant has earlier paid a premium or
provided any other perquisites to the owner at the time of initial hiring of the
accommodation.
*
Rule 6 provides for additions to be made for potentiality. The addition on this
account is to be made as follows :
Addition to be made
If the actual unbuilt area is higher than the unbuilt
area required as per bye-laws by more than five percent
but not more than ten percent 30%
If the actual unbuilt area is higher than the unbuilt
area required as per bye-laws by more than ten percent
but not more than fifteen percent 30%
If the actual unbuilt area is higher than the unbuilt
area required as per bye-laws by more than fifteen percent
but not more than twenty percent 40%
*
Rule 7 deals with cases where the lease stipulates that a portion of the unearned
increase will go to the lessor in the event of a sale. The law stipulates that such
a portion as is payable to the lessor is to be allowed as a deduction.
*
Rule 8 provides for residuary cases as cannot be dealt under the
--
above-mentioned rules.
7.10 SUMMARY
In this unit you have learnt what is sinking fund method of accounting for depreciation and
have gained proficiency in the use of tables. You have been exposed to the income
capitalisation and profit capitalisation mehods of valuation. You have been explained what
is a hypothetical building scheme in valuation
Valuation of properties from wealth tax angle as required under income tax act has also
been explained.
7.11 ANSWERS TO SAQs
Check answers of all SAQs with respective preceding text.