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

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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 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 " y e m purchase"?

7.4 PRINCIPLES OF RENT CAPITALISATION m T H O D

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. *

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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.

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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. ' h e 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,.:. , , 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.

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.