UNIT - I

REVISION OF FUNDAMENTALS

INTRODUCTION:

The students have studied the basic principles of valuation and the simple
elements of the three approaches to valuation in the first semester. It is
absolutely necessary that a student of valuation (including a practicing valuer
who is expected to be a learner all the time) should have crystal clear
understanding about these fundamentals which should be so ingrained in his
mind that he should be able to express them in precise words at any point of
time. With such clarity of fundamentals and their simple logical application a
valuer will be able to successfully deal with any crucial problem in valuation
which he may come across in actual practice. No revision of these fundamentals
of valuation will ever be enough.

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STRUCTURE OF THE UNIT - I

1.0 General

1.1 Cost, Price, Value and Valuation

1.2 Subject Matter of Valuation, Interest in A Property

• General
• Types of Interest
• Important Aspects in Valuation
- Net Income
- Time Factor
- Security

1.3 Benefits – Gross Income and Net Income

1.4 Security

• General
• Criteria of Security
• Rate of Interest
• Dual Rate of Interest

1.5 Study of Real Estate Market

• Analysis of A sale Transaction

• Rates of Interest by Market Studies
• Capital Erosion and Capital Appreciation

1.6 Characteristics of Property Market

1.7 Property classification, value characteristics, primary element of value and

value ingredients

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1.0 GENERAL

It has been learnt during the first semester that the entire structure of real
estate valuation stands on the foundation of four basic and fundamental
concepts of

• Value
• Interest in a property which is the subject matter of valuation
• Benefit
• Security

A valuer must therefore firstly acquire a thorough and crystal clear

understanding and grasp of these fundamental concepts, and secondly he
must put to use common sense and logical thinking based on the
fundamentals.

1.1 Cost, Price, Value and Valuation:

Cost is the price paid for goods or services or the amount required
to create or produce the goods or services. When goods or
services are referred to its cost is a historical fact. The price paid for
producing goods or services becomes its cost to the buyer.

Price is a term used for the amount asked, offered, or paid for
goods or services. Sale price is a historical fact, whether it is
publicly disclosed or kept confidential. Because of the financial
capabilities, motivations, or special interests of a given buyer and/or
seller, the price paid for goods or services may or may not have
any relation to the value which might be ascribed to the goods or
services by others. Price is, however, an indication of a relative
value placed upon the goods or services by the particular buyer
and/or seller under particular circumstances.

Value is an economic term referring to the price most likely to be

concluded by the buyers and sellers of goods or services that is
available for purchase. Value is not a fact, but an estimate of the
likely price to be paid for goods and services at a given time in
accordance with a particular definition of value. The economic
concept of value reflects a market view of the benefits that accrue
to one who owns the goods or avails himself of services as on
effective date on valuation.
(Ref: International Valuation Standard Committee (IVSC) )

In the context of value, it is worthwhile to have an idea of two expressions

‘value-in-exchange’ and ‘value-in-use’.

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Value-in-exchange is the price that would tend to prevail in a free, open
and competitive market on the basis of an equilibrium set by the forces of
demand and supply.

Value-in-use is the worth of an asset to a specific user or set of users. As

value-in-use is related to specific user’s needs, it is often referred to as
subjective value.

Bridges, roads, flyovers and other infrastructural assets are generally not
exchanged and they have value-in-use and their value depends on benefit
derived by the society.

Value of a thing/commodity in terms of other thing/commodity i.e. power of

one commodity to command over other commodities in transaction of
exchanges, is known as exchange value. When however, an
object/commodity is exchanged for and is measured in terms of standard
monetary unit i.e. money, it is known as ‘Price’ of a commodity. Price is
determined by the on-the-spot interaction of demand and supply. Price
tends to restore the balance between supply and demand and is in fact a
mechanism balancing demand (at a price) and supply (at a cost). Price
thus takes into consideration both demand schedule and supply schedule.
When we say ‘market value’ it actually refers to market exchange value or
‘market price’.

It is note-worthy to mention that in certain countries ‘market value’ is also

known as ‘Fair Market Value’ and ‘Open market value’.

In India unaccounted money plays an important role in real estate

transactions and market operates in a peculiar way. International
Valuation Standards Committee stresses that a valuer must carefully
analyse and reflect the actions and attitudes of market. Due to
unaccounted money price not being fully disclosed. IVSC definition of
price mentioned earlier covers this aspect of disclosing price fully or partly.
Unaccounted money varies from transaction to transaction and unless one
is involved in transaction, one would hardly know about it. But it is a fact
that unaccounted money is intended to evade taxes. Therefore there is a
misconception in India that Fair Market Value is estimated without
consideration of unaccounted money. In fact, valuers in India provide the
services with the limiting condition about unaccounted money and
therefore he has to carry out the detailed exercise of identifying genuine
transactions.

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Calcutta High Court in case of Competent Authority and Others Vs. Smt.
Bani Roy Chowdhary and others have held that :-

The untrue statement about the agreed consideration is made only

for the purpose of evasion of tax. When the Govt. or any statutory
body is a party to the transfer, the question of evasion of tax does
not arise. In the instant case, the LIC is the transferor and it is
impossible to think that it would allow respondent no.1 to make an
untrue statement in the conveyance regarding the consideration as
agreed to between them.

A valuer has to create his own data by contacting parties to the

transactions, agencies involved in real estate development.

Valuation

Valuation of immovable property utilizes logical processes which are

dictated by and justified by the generally established findings of land
economics. In order to have a sound valuation technique it is necessary
to have some knowledge of the economic background of immovable
property values. This is so because the values with the estimation of
which the valuation is concerned are the consequence of interacting
economic forces.

The valuation process takes into account uses of land, productivity of land,
land policies, geography, transportation, natural resources and alike value
phenomenon. In the valuation of immovable property one values
“properties”. Property refers to certain rights which an individual enjoys by
virtue of ownership of wealth. Wealth consists of useful things owned by
man. Wealth and property differ. The former is the material thing; the
latter is the right to use the things. The valuation technique is concerned
with the valuation of the rights of ownership. One who owns wealth
possesses certain rights, which are simply the rights to enjoy the benefits
of wealth. It is the possession of these rights which constitutes property.
These property rights are not material things but are merely abstract
relationships and may be included under the term ‘ownership’. Since past
benefits expire with time, the property consists only of rights to future
benefits. Property may be defined as rights to future benefits arising from
ownership.

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Immovable properties may consist merely of land or of land and
improvements. Improvements may be to the land or on the land.
Construction of a building on the land is an improvement on the land.
Improvements like providing means of access, drainage, services etc. are
also improvements to the land.

Land has productive capacity, but not without the application of labour and
capital on it. In the case of agricultural land, labour for cultivating it and
the working capital in the shape of seeds, fertilizers and water have to be
provided before it becomes productive. Labour and capital have similarly
to be applied to the urban land before it is productive.

In the combination of these factors (land, labour and capital) economist

distinguishes wages, interest and rent. The services of labour are
reckoned as wages, and the services of land as economic rent. In this
system the product of land, viz., rent, was considered residual quantity
remaining only after sufficient portion of the product had been allocated to
wages and interest to satisfy the demands of labour and capital.

In the development of valuation technique there is a practical identity

between the elements of the product, except that the return to land is
residual in character and the value of land is an appropriate proportion of
the joint product which remains after adequate returns to labour and
capital.

Land has value because on the application of capital and labour the joint
product produces rents or services which are sufficient not only to meet
the interest charges on the cost of labour and material, but also leave
residual income attributable to land.

Immovable properties have value because they serve mankind and are
capable of satisfying their wants. The differences in the quality and
advantages of immovable properties are the difference in the utility. These
differences of various kinds of properties have brought about competition
between individuals in the possession of particular property and
recognition of relative worths. Sales, exchange and renting of immovable
properties have given them values. The differences in exchange values or
prices will be found to be a reflection of difference in potential productivity
that is future benefits. These future benefits may be in terms of money
income or in terms of amenities.

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 The method of valuation of immovable property comprises a technique of
estimation.

The valuation technique is concerned with valuation of the rights of

ownership.

It is the possession of these rights which constitutes property.

Since past benefits are expired the property consists only of rights to
future benefits. Property may be defined as rights to future benefits arising
from ownership.

It is the failure to recognize this economic principle that produces

disagreement between valuers. On the one hand these are those who see
in a property a physical thing or an area of land limited by boundaries, a
pile of bricks, mortar, steel, cement, timber and with a street address.
These men say “there is the thing”; that is what we are going to value. On
the other hand there are those who see in a property not only its physical
features, but its legal and economic characteristics. Such valuers are not
valuing the advantages of the ownership of the physical property.

A purchaser of immovable property, purchases it on the expectation of

future productivity. The price he would pay, i.e. the capital value of the
property is proportional to the character, importance and the extent of the
future productivity anticipated by him. The degree of certainty attached by
him to the future productivity, the period of time for which it will continue,
the amount of it, and the tendency to increase or decrease over the years
- all reflect into the capital value of the property to him. He first estimates
the quantity, quality and duration of anticipated future productivity into a
capital sum which is known as capitalization. It will be seen that the
anticipated productivity is the primary consideration in the purchase. The
capital value is secondary in character and derived from it.

It is now a well established fact that immovable property market is an

integral part of the investment market and therefore, the same factors
which influence the investment market will influence the immovable
property market.

1.2 INTEREST IN A PROPERTY: SUBJECT MATTER OF VALLATION

1.2.1 General

The subject matter of valuation i.e. what is to be valued is the ‘interest’ in a

property and NOT the physical asset comprising of land i.e. soil, morum
etc., and building i.e. bricks and mortar, steel, cement etc. ‘Interest’ is
defined as “Right to derive benefits by use of a property”. A person

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 interested is a person who has legal rights of deriving benefits by putting a
property to use.

1.2.2 Types of Interests

A person may have legal right as

(a) An owner or lessor including legal heirs bearing right to derive

benefits in perpetuity
(b) Lessee having right to derive benefit of profit rent (difference
between fair market rent and rent reserved (payable) under the
lease/sublease or for a limited (short term or long term) period of
lease, sublease etc.
(c) Monthly tenant, protected or unprotected, holding property from
month to month i.e. extremely limited period of 30 days and
therefore virtually having no right to derive monetary right except as
may be provided by law
(d) Licensee occupying property by specific permission (usually from
the owner) to do so at the pleasure of owner (i.e. so long as the
owner pleases) and having no right to derive any benefit except of
occupying the property on payment of license fee.

1.2.3 Important Aspects

In estimating fair market value of an interest in a property, three important

aspects are required to be considered. These are:-

1) Net Income : The amount of annual Income that can be legitimately

expected to be derived by a person interested by putting property to
lawfully permissible use including highest and best permissible use i.e.
including potential use. In the case of freehold interest the net income
would be gross income at the fair market rent less all types of
outgoings including annual taxes annual repairs etc. In the case of
lessor, net income will be rent reserved under the lease for the
unexpired period of lease and after such period, reversion to net
annual income of fair market rent with deduction of all annual
outgoings. In the case of lessee, sub-lessee etc. net income would be
annual profit rent i.e. fair market rent (or rent reserved under sub-
lease) less rent reserved under lease or sublease as the case may be.
In the case of a tenant or licensee he is permitted to occupy or enjoy
use of property only on payment of rent or license fee and normally he
is not legally expected to derive any monetary benefits by transferring
or assigning the property.

2) Time Factor or Period: A free holder can enjoy the net income from
a property, in general, in perpetuity. In case of land, net income would

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 be perpetual. In case of building net income can be enjoyed for the
future life of the building. If such future life is sixty years or more, it is
considered as perpetual and in case the future life is less than 60
years, net annual income can be capitalized for perpetuity allowing
deduction of cost of reconstruction of the building deferred for the
future life of the building. In the case of lessor he is entitled to receive
(i) lease rent for the unexpired period of lease and (ii) fair market rent
after the unexpired period of lease i.e. reversion to net income (fair
market rent less outgoings) in perpetuity, deferred for unexpired
period of lease. In the case of lessee or sublessee the period for
which he can enjoy profit rent is the income receivable during
unexpired period of lease.

3) Security or Rate of Interest for Capitalization :

The rate of interest for capitalization of net annual income for the
appropriate period should be estimated by the study of the real estate
market in the area concerned. Temptation to adopt adhoc rate of
interest should always be resisted. This important aspect is discussed
in details at 1.4 below.

1.3 BENEFIT

1.3.1 General

Expecting or anticipating benefit is one of the natural instincts of all living

creatures. No one acts or takes any action unless there is some benefit
existing or anticipated. Benefits can be tangible or/and intangible and are
ultimately measured/counted in terms of saving of time and saving of
money or conserving or recouping energy.

1.3.2 Gross Rent

In the case of real estate benefit arise out of (a) Safety, design or hygienic
conditions including light and ventilation etc. of structure (b) provision of
utility services like water supply, sewerage electricity etc. (c) locational
advantages like nearness to facilities, amenities, shops and markets, work
places etc. which are reflected in fair market rent and net annual income.
Better the safety, design and hygienic conditions etc. of structure or better
the provision of utility services and better the locational advantages,
higher will be the gross rent and vice versa. Fair market rent (gross) of a
property is normally estimated by – comparison with properties rented,
looked at from the angle of several factors of comparison grouped into
seven broad categories viz. land, location, building (including engineering
and architectural aspects) services; social, economic and legal aspect and
their levels.

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1.3.3 Net Annual Income

The benefit accruing due to ownership and occupation is in the form of net
annual income and is estimated by deducting all annual outgoings
including annual payable, annual cost of maintenance and repairs,
services provided if any, debts and vacancies, insurance etc. from the
gross annual income from rent and other sources of income from use of a
property. In income approach to valuation such net annual income is
considered as annual interest on capital invested in buying a property.

1.4 SECURITY

1.4.1 General

Security is also the natural and basic instinct of all human beings. Every
one needs safety and minimum risk. Feeling of security is the same as
that felf by an infant in the lap of his mother and is universal, irrespective
of town, city or country/nation. The protection (safety of self) and
assurance of upbringing are the two basic components involved in the
security felt by an infant irrespective of whether the mother is a queen or a
beggar woman.

1.4.2 Criteria of Security

In the case of all types of investments, including that in real estate, there
are five criteria which go on to decide the level of safety of investment (or
conversely the risk factor) viz.-

1) Safety of Capital - Capital invested must be safe.

2) Liquidity of Capital - Capital invested must be realizable,

capable of being recouped at any time.

3) Safety of Income - Income from the investment must be

guaranteed/assured.

4) Regularity of Income - Income from the investment must be

received regularly.

5) Ease of Collection of - Income shall be collected easily spending

Income minimum time, energy and money.

An Investment where all the five criteria are 100% satisfied is called a ‘Gilt
Edged Security’ as found in investment in long term Government bonds
and generally considered as gilt-edged security.

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1.4.3 Other criteria affect the security of investment in a qualified manner. For
example, inflation will have effect on rent, i.e. amount of income only and
not on the security of investment. Similarly, divisibility of investment (in
the case of property various types of interests which are separable), cost
of transaction may increase the price or exchange value but will not have
effect on the security of investment. Though security of investment is
irrespective of the amount of income but it nevertheless depends on the
guaranteed regularity of income however high or low it may be.

1.4.4 Rate of Interest

The degree of security gets reflected in the rate of interest for

capitalization of net annual income. Higher the security (i.e. lower the risk
factor) lower is the rate of interest for capitalization (i.e. higher the Y.P.
multiplier) and vise-versa. In other words the rate of interest is inversely
proportionate to the degree of security. For estimating the appropriate
rate of interest for capitalization of net income it is necessary to ascertain
the degree of security of investment by asking questions regarding the
safety and liquidity of capital as well as regularity and ease of collection of
annual net income. The estimation of fair market value of a property
depends on correct estimation as far as possible at the appropriate rate of
interest for capitalization. A valuer should therefore get these five aspects
of security so ingrained in his mind that he should be able to distinctly
reproduce these aspects whenever and wherever asked to do so.

1.4.5 Dual Rate of Interest

Another important basic principle is in respect of use of dual rate of

interest for capitalization of net income. The two rates of interest are as
follows. The ‘remunerative’ rate of interest, is the remuneration on capital
invested and the other is ‘accumulative’ rate of interest at which the
annual sinking fund accumulates, at the end of certain period, to the
original capital invested. The pertinent question arise “which dual rate of
interest should be used for capitalization of net income”. It is evident from
the above discussion that there exist two types of interest rates, “in the
case of Terminable Annuity or Income”. This answer should always be
on the tip of the tounge of a valuer who should be able to express it in
precise words. Since the purpose of accumulative rate of interest is that
the amount of annual sinking fund at the compound rate of interest MUST
accumulate to build up the capital invested (which is unavoidable liability)
at the end of the term when income ceases/terminates, the accumulative
rate of interest should be minimum i.e. 2 ½% to 3% and shall never
exceed 3½%. The use of dual rate table (valuation table) automatically
takes care of sinking fund element of net income and hence the amount of
sinking fund to be kept aside need not be worked out separately. The
appropriate remunerative rate of interest which depends on the degree of

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 security offered by investment should be estimated by conducting study of
real estate market in the area concerned. The remunerative rate of
interest should never be adopted on adhoc or thumb rule basis. The Rate
of Reversion i.e. the rate at which income or capital receivable in future
should be deferred is usually the same as the remunerative rate.

1.5 CAPITAL EROSION AND CAPITAL APPRECIATION

The market studies conducted by the students of Master of Valuation,

Sardar Patel University, Gujarat have revealed that the rates of interests
yielded by residential and commercial properties vary from about 4% to
5% and about 6% to 10% respectively which are lower than the rates of
interest yielded by the investment in long-term Govt. bonds which is
considered as gilt-edged security i.e.100% secured investment yields
interest at the rate of 8.5% to 9%. Any other investment which is less
secured than that in Govt. bonds is normally expected to yield interest at
the rate of ½% to 1% more than that yielded by Govt. bonds i.e. at 9.5% to
10%. This is true where the rate of inflation is low say 2% to 3% and
where the urban areas are more or less saturated and do not expand
rapidly. In India, the rate of inflation is usually 5% and above and urban
areas are rapidly expanding by size of population and also in geographic
area.

When the rate of inflation is high the value or purchasing power of money
i.e. rupee decreases with the result that value of any capital invested in
the form of money – monetary investment – also decreases in real terms.
Such decrease in capital value is known as ‘Capital Erosion’. In the case
of investment in real estate when value or purchasing power of rupee
goes down the market value – i.e. exchange value or price of the property
also increases. Investment in real estate in India is thus guarded against
the element of ‘Capital Erosion’.

Further since urban areas in India are expanding rapidly, values of

properties in older or earlier developed areas which almost become more
or less central or prominent location areas, increase with expansions of
urban areas. This value of capital invested in real estate increases i.e.
appreciations and is known as ‘Capital Appreciation’

Investments in residential and commercial properties in India yield interest

at the rates varying from 4% to 5% and 6% to 9% respectively which are
lower than that yielded by Govt. bonds, since investments in real estate
enjoy the benefits of Capital appreciation and of guard against capital
erosion.

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1.6 CHARACTERISTICS OF PROPERTY MARKET

1.6.1 Market

The economic term market refers to a group of buyers and a group of

sellers who are in communication with each other for purpose of
transaction and both of whom are willing and able to buy and sell at a
price. Competition among buyers and sellers acts as mechanism
controlling supply and demand and prices. Under conditions of perfect
competition in an open market neither buyer nor seller are able to
influence prices by their individual decisions as in the case of monopoly.
Perfect competition is facilitated due to comparability and possibility of
substitution among the products mainly resulting from standardization and
possibility of increasing/adjusting supply and demand by various means.

1.6.2 Property Market

Property market differs from market of other commodities in various

characteristics due to which conditions of perfect competition are hard to
obtain in a property market. These special characteristics are –

1) Heterogeneity and lack of standardization

No two properties are identical and differ from each other in many
respects which acts as a constraint on comparison and substitution
and hence conditions of perfect competition are almost absent.

2) Total supply of land is fixed

Total supply of land in all area is fixed and land cannot be

transported from one place to another as in the case of other
commodities. Converting use of land say from agriculture to non-
agriculture, from residential to commercial etc. may be possible but
it is time consuming.

3) Inelasticity of supply

Supply of land/property cannot be increased or decreased easily

and quickly to match demand.

4) Effect of various legislations

Various legislations like Rent Control Acts, Town Planning Acts and
Development Control Rules, Land Ceiling Acts etc. affect use,
quality and intensity of use, occupancy, transferability of landed
properties constraining condition of perfect competition.

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 5) Imperfect and Inadequate Information

Lack of correct and adequate information about transactions

contributes to imperfect competition. Such inadequacy of
information is mainly due to –

a) Method of conducting transactions: Most of the

transactions in the real estate market, except open auctions,
are conducted privately and adequate and correct
information about transactions is not easily available.

b) Various rights and interests: Various rights and interests,

ownerships, tenures, etc. such as freehold, leasehold etc.
are being transacted which make comparison difficult.

c) Non-availability of adequate and reliable information :

Information available from authentic sources like records of
Registrar’s and Sub-Registrar’s Offices needs to be
supplemented by conducting inquiries during site inspection
for many reasons, such as obtaining correct information
identifying witnesses for proof of transaction in the Court,
etc.

The nature of real estate market and its special characteristics have effect
on market values of properties and therefore form the primary base for
estimating fair market values of properties.

1.7 PROPERTY CLASSIFICATION, VALUE CHARACTERISTICS, VALUE

INGREDIENTS AND PRIMARY ELEMENT OF VALUE

1.7.1 Property classification Value characteristics

Investment property - Monetary yield to the owner

(similar to interest earned)

- Marketability

- Recovery of invested capital

Marketable non- - Usefulness to the owner without

Investment property direct monetary yield

- Marketability

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 - Non-recovery of original cost in
general

Service property - Usefulness to the owner without

direct monetary yield

- Non-marketability

- Non-recovery of original cost in

general

Property classification Primary element of value

Investment property - Investment value

Marketable non-
investment property - Market value

Service property - Owner value

1.7.2 Only in the case of investment property, there is the expectation of

recovery of the invested capital. This recovery comes from
monetary returns.

1.7.3 Ingredients of investment property :

* Utility
* Marketability
* Self-liquidity

1.7.4 A marketable non-investment property has only two value

ingredients

* Utility and marketability

1.7.5 Service property has only one value ingredient – utility which
produces the value to the owner.

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1.7.6 The following table gives a total picture:

Investment property Utility Owner value

Marketability Market value
Self-liquidity Investment value*

Marketable non- Utility Owner value

Investment property Marketability Market value*

Service property Utility Owner value*

* Primary element of value

Methods of valuation

A. Investment analysis method of valuation:

Investment analysis method of valuation is used to measure value

of investment property. This method consists of forecasting the
earning expectancy of the subject property as a series of net
monetary returns calculated from the valuation date to the
estimated end of life of ownership and working out the present
worth of this series at a rate per cent (yield rate) commensurate
with the relative risk involved.

B. Sales analysis method of valuation:

The market value of marketable non-investment property is

measured by the sales analysis method of valuation (market
approach). This method consists of formulating the relationship
between the value elements of, and the prices paid for, properties
which are identical, equivalent, or otherwise comparable to the
subject property, in order to forecast its most probable buy-self
price.

C. Cost-summation method of valuation:

In some cases, the ‘owner value’ of a tangible service property can

be measured by the cost-summation method of valuation. This

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 method consists of estimating what the current cost of producing
the subject property would be and then applying an appropriate
depreciation factor(s).

1.7.8 Approaches to Valuation: Conclusion

It would be seen that the three approaches to valuation are not

exclusive of each other. In income approach fair market rents of
similar properties sold and of the property to be valued are
estimated by market approach i.e. by comparison. In cost
approach fair market value of land is estimated by comparison with
similar lands sold i.e. by market approach. It is therefore,
considered appropriate to discuss the market approach first, ahead
of Income approach and Cost approach.

All the three approaches to valuation involve comparison of various

legal, physical, social and economic factors/aspects of comparison,
as also of advantages/merits and disadvantages/demerits arising
out of these various factors. In order to ensure that none of those
factors and their advantages and disadvantages are over looked or
lost sight of, it is advisable that a valuer should first step in the
shoes of the client and think about the problem i.e. of property and
its fair market value from all aspects. Therefore, he should step in
the shoes of the party on the other side and think about the
property consider advantages and disadvantages and fait market
value of the same property from the other angle of view. Thinking
from points of view of both (or all) sides will ensure better and fairer
estimation of market value of a property.

Lastly but not the least, since value is an estimate of what price
ought to be, fair market value is always ‘ESTIMATED’ and is never
worked out, calculated or arrived at (mathematically) or done, fixed,
decided etc. (indicating final decision). Fair market value is always
‘estimated’.

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