5 Methods of Valuation

8/11/2019 5 Methods of Valuation

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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 Ex ped ed on Capital Employed

7 4 4 Estimated Future ife 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 D evelopment Schem e

7 8 2 Hypothetical

Building

Scheme

7.9

Valuation Under Schedule-I11of 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. n 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 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


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aluation

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

s

(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, he annual installment will be

or, if the im 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.

n

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


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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 ND USE OF V LU TION

T BLES

n 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

i t

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

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

shouldbe 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 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

YE RS PURCH SE

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

YE RS PURCH SE

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


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Valuation

It would be observed that the formula has 9 e e variables which determine the magnitude

of the

EARS PURCHASE.

Variable I represents th e rate of return ex pected by the

society fr om 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 is the number of

years for which, according to the valuer's ex pert estimate, the property will remain in the

serviceable condition. Standard tables are available for giving years pu rchase 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.

S AQ

i

Explain

in your word, what is sinking fund ? W ha t is

itS

philosophy and how

calculations

re

to be made'?

ii What

is

y e m purchase ?

7.4

PRINCIPLES

OF

R EN T CA PIT AL ISAT IO N m T H O D

This m ethod of valuation is based on the assump tion that the property market is an

investment m arket where the capital employed will bring reasonab le re hun s. 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 und er 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 employ ed.

Estimated future life of the structures.

Rate of interest for sinking fund.

Unexp loited potential, if available for possible exploitation.

Qu antum o f special capital repairs, if required.

7 4 1 GrossRent

Th e basic intent is to estimate the rent that the property is expected to fetch in the years to

come. W e 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 o r concessional,

the actual rent gives the best guide for the gross rent from the prop erty because in such

cases it may reasonably b e expected that the property will continue to fetch the same rent

in future too. n other cases the rent fetching capacity of the property has to be determined

by m arket 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 fro m the

property is far less than what may reasonably be exp ected. In such cases it is to be

examined wh ether 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 o n certain

specified grounds. In such cases it is reasoilable to assum e 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. Th is may happen

when the tenant has taken the property fo r short periods or he otherwise has a fancy for

that particular property. If that be so, the likelihood o f the rent being maiqtained in future

may be rather bleak. Suitable discoullting n lay have to be done for possible reduction in

rent when the present tenant leaves. Such cases would, however, b e rare in actual

applications.

W hile asses sing the gross rent of a property all Ule coilditions of the rent agreem ent should

be prop erly analysed to arrive at the monetary equiv alent of other indirect benefits that

the

tenant may hav e given to the owner also. For exanlple, a tenant bank m ay have granted an


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interest free loan to the o wner and co rresponding ly 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 own er 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 dire ctly related to property maintenance.

Typica lly, 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 loca l 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 ch arges, if form ing a liability of the owner, has to be

allowed as an outgo. Most of the rent con trol acts have placed this liability on the owner to

the extent of one m onth s rent in a year. Income Tax Act allow s this outgo at the rate of

116th of the gross rent in assessment of incom e from the house properties. U sually, this

outg o is allowed at the rate of one month s rent in a year.

Ground rent, as actually payable by the owne r for a property co nstruited on leasehold land

is allowed as an outgo.

Collection and management expen ses 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 tenan ts

complaints etc. Income Tax Act allows a maximum of 6 deduction on this account. The

figure may vary between to 6 depend ing on the assessment of the effort and expense

to be incurred by the owne r.

Insurance charges may be allowed on the basis of laid down slabs of the insurance

companies. These may com e to the order of about VL of rent in normal cases.

Vacancies and bad deb ts constitute a loss of income from the property. If su ch losses have

occurred in the past, these may occur in future too. Th erefore, 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 cann ot be evicted

due to rent control restrictions. Fo r a fa ct, the value of the property g ets substantially

depressed under these restrictions. It is w ell known that the market value of a v acant

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 op portunity for instituting proceedings against the defaulting tenants. n

either case the cha nces of getting better rents become brighter. Under these circum stances,

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 comm on areas may e 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 m ost controversial facto r in rent capita lisation method fo r

evaluating the immovable properties. Some people tend to relate it to the bank deposit


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Valuation

rates and others make wild guesses. The most ap propriate way to w ork out the reasonable

rate could be prov ided by an actual anawsis of new ly constructed buildings, fully

deve loped and let out for the first time at the marke t rate. Working back from the actual

rent fetched and the assessed value oh the basis of Land and Building method could give

the m ost logical level of expectations in the market. How ever, this data is usually difficult

to obtain. Even if the data is availab le for one category of prope rties, it may not be

straightaw ay applicable to'the other kind of properties. By and large , therefore, the valuers

depend on theoretical assessment of the reasonable rate by com parison 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,

stability and m aintainab ility of incom e,

certainty of realisation,

ease in collection of income, and

liquidity of capital.

Broad ly 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 pu ts up

structures at his own cost. There is usually a condition that the lessee will hand o ver the

structures to the owner in the ev ent of termination of lease or in the eve nt of defau lts in

paym ent. This is conside red to be most secure tenan cy and hence a low rate of return is

justified. The rate taken is the rate of return av ailable from gilt edged secu rities. 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 somew hat lower than in the previous case. The rate of

return expected is, therefore, a bit higher than the rate of return expected from secu red

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 exp ectations 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 m ultiplicity and the level of tenants suggests likelihood of more defaulters and delay

in receipt of rents. The rate expe cted may be still higher by about

U .

The rate,

accord ingly, may be of the order of 8 to

9 .

hopsand Offices

Apart from the no rmal risks, this kind of properties suffers, at least to som e extent, from

the business risk of the tenant also. There fore, the expectation w ill be for a still highe r

return by

1

to

2 .

The rate, in this case may co me to about

9

to

10 .

Godowns and Factories

This kind of properties suffers from usual business risks and a lso from risk of industrial

problem s as well as of difficulty in getting other tenants on vaca tion of premises. The

expec tation for the rate of return will, therefore, go up by another U r 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 cinem a bouse or a hotel will

be

rather

limited. Such properties can usually not be put to alternative uses. The expectations for


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rate qf return for rents from such properties, therefore, goes up further by aboutU 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

e

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


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Valuation

of

the

property. If, however, the repairs requued are of ordinary annual maintenance kind,.

then no deduction need be made s such repairs are acc ounted for in the outgoings.

SAQ 2

i

What is rent capitalisationmethod ? Where is it usedin valuation

ii

How

do y u

decide

the r te o

return?

7 5

REVERSIONARY

VALUE

Going back to the definition of value, we had seen that the value of an im mov able

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

Now, X is the value assessed by the process described in the preceding p aras and Y is the

comp onent which we have still to work out. As indicated, Y represent s the value of land

becom ing available after .the life time of the struc tures . Its present worth, is given by

Land value/ l+

On

where r is the rate of interest expected on the inve stment in land.

Usually r is taken to be somewhere in between i and I. This compon ent of value is known

s Reversionary Value of land.

The above ana lysis 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

estim ation of the future life of the bu ilding s, particularly w hen the estimated life is rather

long-say of the order of more than 40 to 50 years. In such cases, the reversionary value

itselfre duc es 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

e

omitted. This tentamount to saying that a period o f 40 to 50 years is a long period

may be considered ~ r ,pproxim ate to perpetuity. This also means that the depreciation in

the first few years of perpetual life is negligible and hence the fa ctor for sinking fund

becomes insignificant in calculations for determining the m arket value of the property and

can be ignored. Position would, howeve r, be different when the balan ce life of the

structure is small. In such cases the depre ciation as well as the reversionary value play a

very significant role in the estimation of the m arket value oft he property.

.


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7 6

A

TYPICAL EXAMPLE OF VALUATION BY RENT

CAPITALISATION ME THOD

Methods

of Valuation

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.

part

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

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

625


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7 8

HYPOTHETICAL DEVELOPMENT AND

HYPOTHETICAL BUILDING

SCHEMES

Methods

o Valuation

7 8 1 Hypothetical Development Scheme

With ever increasing pressure on land in most of the urban are as it becomes necessary to

extend the developmental activity at the periphery of the town limits. It also happens tha t

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 b e

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 sm all plots, hypothetical developm ent schem e

method of valuation is found to be quite useful.

In this method a development scheme is planned for the land w herein a hypothetical

distribution of land into sm all building plots with necessary road netw ork and parks etc . is

contemplated. The ex penditure to be incurred on p roviding 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 saleab le area of the plots. The d ifference of the two after

suitable discounting.for he time element gives the value of the land. h e method will

better be understood by following the exam ple given below.

Example

7 1

Let us assume that the follow ing piece of lan d is to be valued

A development plan can be co ntemplated for this piece of land as in Figure 7.1

It will be observed that the plan as proposed accomm odates 30 plots of size 20 metres by

30 metres and 1 42 plots of size 1 0 metres by 3 0 metres. Having made a development plan

25 plots of

size 2

3

2 ROAD

5

plots

of

size 1

3

Figure

7 1

9


12/14

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 Averag e rate

Upto 300 sq. m.

Rs. 2,000 per sq. m.

300 500 sq. m.


500 800 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 s follows

Total expenditure

=

Land area

x

Cost of development per sq. m.

=

(200

x

500)

x

125

= 1 00,000 125

=

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, .e. Rs. 1,15,74,074or 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 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

uilding

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.


13/14

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.

.

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

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

S Q

i) What

is

reversionary value ?

n

What

IS

profit-cspit~llsatl,.:.

, C L L 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.


14/14

aluation

Rule 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

r

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

axes 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 tobe 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

r

provided any other perquisites to the owner at the time of initial hiring of the

accommodation.

Rule 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


area required as per bye-laws by more than ten percent

but not more than fifteen percent

30


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.

Documents

5 Methods of Valuation