1.00 Chief Accountant of a multinational company instructed a valuer to revalue companies assets, viz. factory buildings and plant and machineries installed in the factory. When valuer asked about revaluing land, the chief replied “Land is not to be revalued as land is of leasehold tenure from Government”. Valuer had great difficulty in explaining and convincing chief that though land is with leasehold tenure, as Lessee of land, the company held very high value interest in land which is called value of Lessee’s interest in the land. Said value was many times more than Book Value of land.
1.10 A well known industrialist invited a valuer to value his factory buildings and large leasehold land in city area of Mumbai. Valuer after examining his title deeds said I can not value this property because value of entire property to you is zero. Industrialist was shocked and said you joking ? Valuer replied “I am not joking. I have examined Lease Deed of the land of this running factory and the lease term has expired three years ago and there is no renewal clause in lease. More over lease provides that on expiry of lease, land with factory buildings would vest with Lessor at free of cost. As you hold no rights in property now, the value to you is ‘Nil’.
1.20 A very senior and experienced valuer once raised a question about share of Lessor’s right and share of Lessee’s right in total value of a leasehold land. He further said Courts have given different rulings such as 50 : 50 share, 60 : 40 and 30 : 70 share in total value of land for Lessor’s interest in land and Lessee’s interest in land respectively and hence the question. Correct answer to this query would be that the provisions or terms of lease deed would decide share or value of right of Lessor and Lessee’s interest in the land.
2.00 All these practical field examples, indicate that there is tremendous ignorance about value of the rights of the interest holders, in the leasehold property.
2.10 In order to understand the proper valuation of interests in leasehold land, we will have to go to the basics. We must first understand different types of leases, lease terminology and interpretation of the provisions and clauses in different types of leases.
3.00 Lease contracts is executed between land owner and land occupant. Land owner is called the ‘Lessor’ where as land tenant or the land occupant is called the ‘Lessee’. Some times the property is sub leased, in such a case land occupant is not Lessee but ‘Sub Lessee’. Rights of different interest holders in leased property are as under :-
Lessor : He is the owner of the land or land with building. He gives away possession of his property for use of tenant (Lessee), on rent and on certain terms and conditions. Lessor holds right to receive ground rent and right to reversion of land.
Lessee : He is the tenant of the property of Lessor. He holds in leased out property, in accordance with the terms and conditions set out in the lease agreement. Lessee has right to erect buildings on plot and right to receive rent from such buildings.
Sub Lessee : Some times under lease agreement rights are given to Lessee to sub let the property to third person. This sub tenant is called Sub Lessee. Main Lessor in such a case is called Head Lessor. Right of Sub Lessee is similar to Lessee i.e. receive rent from the building erected on the plot.
3.10 There are basically four types of lease.
(i) Building lease.
(ii) Occupational lease.
(iii) Sub Lease.
(iv) Lease for Life.
3.20 Building Lease : This type of lease are most common in which open land is given on lease for construction of a building. Lease period may be 40 years, 60 years, 99 years or 999 years. Term of 99 years or 999 years is called perpetual lease. In this type of lease, ground rent for land use in paid by Lessee to Lessor and rent from building on the plot is received by the Lessee.
3.21 Many a times, in addition to annual rent, Lessor takes initial premium from the Lessee. This is like an advance lease rent for full period of lease. Annual lease rent in such cases is reduced correspondingly. In Government agency lease, such as M.I.D.C. lease, full premium amount is initially charged and annual lease rent is fixed at token sum of Rs.1/- per year only. However in private leases total rent is bifurcated in two parts. Advance rent (Initial premium) and annual rent.
3.22 Some of these leases have a provision of term renewal clause. If lease term is 99 years, it is renewed for further term of 99 years at revised rent or same rent. In some other lease, there is a clause which requires surrender of building constructed on the plot by Lessee to Lessor, free of cost, on maturity of lease. Value of rights of Lessor and Lessee would all depend on these clauses and terms of lease.
3.30 Occupational Lease : This lease is for use of land and building together. It can be land with building or ownership flat, ownership office or even shop. Ownership of land and building both are with the Lessor. These are rented out for short term period of 3 years, 5 years or 10 years. There is generally a provision of increase in rent after one year or two years interval. In India these types of leases are less for residential premises due to Rent Control Act. However such lease is very common for the commercial premises.
3.40 Sub Lease : In this type of lease, Lessee has right to sub-let property as per terms of lease agreement. Lessee therefore grants sub-lease for a period which is one year less than period of main lease. If main lease is for 99 years period, sub-lease has 98 years period. Again lease rent fixed under sub-lease is always more than the lease rent payable by Lessee to the Head Lessor under principal lease. Under sub-lease, possession of property is with Sub Lessee only yet there are three parties interested in the total value of the property viz. Head Lessor, Lessee and Sub Lessee. Value of rights of each one will depend on rental value and terms of principal lease and sub-lease.
3.50 Lease for life : Under this type of lease, period of lease is directly linked
(co-terminus) with the future life span of the Lessee. On the death of Lessee the lease comes to an end. This type of lease is not common in India.
4.00 Terms – Conditions – Covenant : There is always a clause in all types of lease that if Lessee commits a breach of any of the terms and conditions of the lease, the lease would be determined (terminated) by the Lessor immediately i.e. before maturity date of lease. It is therefore necessary for a valuer to study various types of terms and conditions normally provided in lease document.
4.10 Some of the important terms and conditions stated in lease are as under :-
Lease Term : Date of commencement and date of termination of lease.
Renewal Clause : Date of notice for renewal, first term in year and renewal
Period, provision of revision of rent, if any.
Amount of Rent : Fixed Annual Rent or monthly rent or ground rental i.e.
increased rental after fixed period of intervals, say 10 years or 20 years.
Lessor’s Covenant : Responsibility of land tax payment.
Lessee’s Covenant : Payment of building tax, building insurance, repairs and
upkeep of property, timely payment of lease rent.
Right for Assignment : Right to sub-lease the property, on condition or without
any condition.
Restrictive Covenant : Not to alter building or change user of the land.
Vesting Back Land Clause : Under this clause it is provided that the Lessee would, on maturity of the lease period, demolish the building erected on the Lessor’s plot and would handover possession of open vacant land to the Lessor or return land with building free of cost of Lessor or surrender back land with building to the Lessor but Lessor will be required to pay mutually agreed amount to the Lessee for the building.
5.00 Depending upon lease conditions, value of interest of Lessor and Lessee would change.
5.10 Value of Lessor’s interest in property normally consists of two parts.
(a) Capitalised value of ground rent income for unexpired period of lease.
(b) Present value of the right of reversion of the property (Land or land with building) at the expiry of lease period.
5.20 Value of Lessee’s interest in the property may consist of one or two parts.
(a) Capitalised value of net rental income receivable from the building, for unexpired period of lease. As Lessee would lose the building on maturity, provision for recoupment of capital invested in building should be made by selecting dual rate table.
(b) If the plot is not fully developed but is under utilized, in such a case, the Lessee would also hold interest equivalent to the present worth of the unutilized land.
6.00 Following examples would explain how rights of Lessors and Lessees has to be estimated in case of leasehold property.
6.10 Example-1 : M.I.D.C. leased 1800 Sq.Mts. land for industrial use in 1972 by charging full premium at the rate of Rs.400/SM. Lease period was 95 years renewable for further 95 years period. Lease rent was fixed at Re.1/Year. Lessee constructed factory building (area 950 Sq.Mts.) in 1972. Lease provides that in case of Sale (Assignement), Lessee shall pay 10% of unearned increase in land value to Lessor. Calculate value of right of Lessor and Lessee as on 2006, if replacement cost of factory in 2006 was Rs.8500/Sq.Mt. and land value in 2006 was Rs.5,000/Sq.Mt.
Solution-1 : (A) Value of Lessor’s interest : There is no right to reversion of factory building to M.I.D.C. Due to renewal clause, it is a perpetual lease and reversionary value of land will be negligible. The lease rent is only Re.1/Year and hence its capitalized value also will be negligible. Lessor’s interest in land value would be therefore restricted to claim of 10% unearned increase in land value.
Unearned increase = 1800 x (5000 – 400) = Rs.82,80,000/-
Value of Lessor’s Right = 0.10 x 82,80,000 = Rs.8,28,000/- … (a)
(B) Value of Lessee’s interest :
Total value of land = 1800 x 500 = Rs.90,00,000/-
Value of Lessee’s interest = Total value – Value of Lessor’s interest.
= Rs.90,00,000 – Rs.8,28,000 = Rs.81,72,0000/- … (b-1)
Replacement cost of factory building :
950 Sq.Mts. @ Rs.8,500/Sq.Mt. = Rs.80,75,000/-
Depreciation for 34 years age = 0.9 x 80,75,000 x 34/60 = Rs.41,18,250/-
Depreciated value of factory :-
Rs.80,75,000 – Rs.41,18,250 = Rs.39,56,750/- … … (b-2)
Value of Lessee’s interest in property (b-1) + (b-2) :
Rs.81,72,000 + Rs.39,56,750 = Rs.121,28,750/-
Say Rs.121,29,000/- … … (b-3)
It will be seen that in this case, value of Lessor’s interest is hardly 6.39% and value of Lessee’s interest in property is 93.61% of total value.
6.20 Example-2 : Under a private lease, 1500 Sq.Mys. land was leased in 1967 for a period of 60 years with lease rent of Rs.4000/Year. Lessee constructed a residential building and rented out tenements to tenants, which yielded net rental of Rs.50,000/Year. Calculate value of Lessor’s interest and Lessee’s interest in the property as on year 2007. There is a lease condition that on maturity of lease, building will vest with Lessor free of cost. Rent Act is applicable.
Solution-2 : (A) Lessor’s interest in 2007 is two fold.
* Right to receive lease rent income for 20 years more.
* Right to receive house rent income after 20 years. (Due to Rent Act, house tenants can not be ejected).
(i) Capitalised value of lease rent income at 8% for 20 years period.
4,000 x 9.818 = Rs.39,272/- … … (a-1)
(ii) Capitalised value of house rent income at 8% in perpetuity.
50,000 x 100/8 = Rs.6,25,000/-.
Present value of this right (Defer value at 7% for 20 years) :
6,25,000 x 0.2584 = Rs.161,500/- … … (a-2)
(iii) Total value of Lessor’s interest : Rs.39,272 + Rs.161,500
= Rs.2,00,772/- Say Rs.2,01,000/- … … (a-3)
(B) Lessee’s interest in the property is only one. Right to receive house rent for 20 years more. As Lessee would lose rental income after 20 years, we must provide for
Redemption of capital invested in house also (Duel rate to be used). Capitalised net income at 8% and also providing redemption of capital at 3% for 20 years period, we get value of Lessee’s interest :
Rs.50,000 x 8.531 = Rs.426,550/- Say Rs.4,27,000/- … (b)
In this case, value of Lessor’s interest is 32% and value of Lessee’s interest is 68% in total value of the property.
6.30 Example-3 : In a small town, land was leased for construction of Cinema in 1980. Lease period was 30 years and lease rent was fixed at Rs.40,000/Year. Lessee constructed cinema and started running the same himself. Net income from cinema in year 2006/2007 is Rs.2,50,000/Year. Calculate value of the Lessor’s interest and also value of the Lessee’s interest in the property as on 2007. The lease deed provides that cinema with machinery would vest with Lessor free of cost on muturity of lease i.e. in the year 2010.
Solution-3 : (A) Value of Lessee’s interest is only to run cinema and earn income for 3 years more. As this income would cease after 3 years, we must provide for redemption of capital also. Capitalising net income at 12% and allowing for redemption of capital at 3% or 3 years period, we get : Value of Lessee’s interest :
250,000 x 2.255 = Rs.5,63,750/- Say Rs.5,64,000/- … (a)
(B) Value of Lessor’s interest is two fold :
* Right to lease rent income for 3 years.
* Right to cinema income after 3 years due to reversion clause.
(i) Right to lease rent income at 8% for 3 years :
40,000 x 2.577 = Rs.1,03,080/- … … (b-1)
(ii) Right to cinema income after 3 years would last for another 30 years. (Future life of cinema building in 2010). Hence capitalizing net income at 12% for 30 years period and allowing for redemption of capital at 3% we get : Value of Lessor’s interest in cinema :
Rs.2,50,000 x 7.091 = Rs.17,72,750/-
Present worth of this capital sum is determined by deferring value at 8% for 3 years period = 17,72,750 x 0.7938 = Rs.14,07,208/- … … (b-2)
(In this, reversionary value of land is ignored due to profit rental for 30 years after 2010).
Total value of Lessor’s interest :
Rs.1,03,080 + Rs.14,07,208 = Rs.15,10,288/-.
Say Rs.15,10,000/- … … … (b-3)
In this case, value of Lessor’s interest is 72.80% and value of Lessee’s interest is 27.20% in total value of the property.
7.00 The above examples are for building leases. In occupational lease also some times we come across controversy about proper market value of Lessor’s interest and Lessee’s right in the property. Rental value of the premises go on changing in the Real Estate Market depending upon demand and supply and prices of Real Estate. However once premises are leased out, benefit of rental increase in subsequent year, is not available to Lessor. Similarly benefit of reduction, if any, in rental rate in the market, in subsequent year, is not available to Lessee, as he is bound by agreed rental value during lease period. This variation sometimes results in situation where market value of leased flat is either higher or lower than its real worth as vacant premises.
7.10 Example-4 : An investor purchased 5 bed rooms flat having an area of about 2500 Sq.ft. area, in the year 2005, in Mumbai, at the cost of Rs.5 Crore. Owner leased the flat to multinational company for a lease of Rs.120,000/Month for 5 years period. Rs.1 crore interest free deposit was also taken. Society maintenance charges were Rs.65,000/3 months. Calculate fair market value of flat on 2007, if ruling rate of flat in locality is Rs.30,000/Sq.ft. Expected rental yield on investment in flat, in the year 2007 is 5% and market yield on other sound investment is 8%.
Solution-4 : Normally value of flat as vacant would be :
2500 x 30,000 = Rs.7,50,00,000/-
However flat is leased and hence vacant possession is not possible for another 3 years. Value of Lessor’s right in flat is two fold.
* Rental income for 3 years.
* Right to receive back flat after 3 years.
(a) Capitalised value of rental income is as under :
Gross Annual Rent = Rs.120,000 x 12 = Rs.14,40,000
Add : Interest at 8% on security deposit of 1 Crore = Rs. 8,00,000
Total Annual Income = Rs.22,40,000
Less : Society maintenance : Rs.65,000 x 4 = Rs. 2,60,000
Net Annual Yield = Rs.19,80,000
Capitalising net receivable yield at 5% for 3 years period :
Value to Lessor for rent : 19,80,000 x 2.723 = Rs.53,91,540/- … (a)
(b) Value of reversion of flat is worked out by deferring present value as vacant at 8% for 3 years period. Value to Lessor for reversion of flat :-
Rs.7,50,00,000 x 0.7938 = Rs.5,95,35,000/- … … (b)
Total value of flat (Value to Lessor in 2007) :
Rs.53,91,540 + Rs.5,95,35,000 = Rs.6,49,26,540/- Say Rs.6.49 Crore. … (c)
7.11 Though market value of flat with vacant possession is Rs.7.50 Crore, its sale value, in 2007, in market, is only 6.49 Crore. This is because expected rental yield for such a flat has increased to about Rs.312,500/Month at 5% yield vis-à-vis Rs.120,000/Month fixed two years back. Expected yield rate in 2005 was hardly 3% on value of the flat, due to less demand for rental flat in the market in 2005.
7.12 If expected rate of return in market was 5% in 2005 and if it had fallen to 3% in year 2007 due to less demand, value of flat would have been more than its sale price in the market with vacant possession in 2007.
8.00 Today, due to Globalisation and open economy, money supply in Stock Market, Real Estate market and even in Commodity Market is much more than the money respective market can absorb. This is the reason of boom period in all market. Expected rate of return on investment in sound security like real estate, or estimating fair yield rate on risky investment like stock market, is anybody’s guess. Yield rate has become volatile in every market.
8.10 It will be seen from above stated examples, how important it is for a valuer to select proper rate of capitalization to arrive fair market value of leased property. But the sad story is that due to current volatile capital market, it has become very difficult for an experienced valuer or even a Banker to predict fair yield rate expected by an investor say after six months.
8.20 Due to volatile capital market and inflation, Reserve Bank issues various directives to financial institutions from time to time. Let us hope that the Reserve Bank attempt to control and monitor money supply in the capital market succeeds. In spite of tremendous money supply in the market, if Reserve Bank can bring down inflation rate in our country, all the executives responsible for achieving such magnificent success, will be blessed by the common men of our country.
16-2-2007 For Kolkata Seminar
Mumbai. For IOV/ MUMBAI
Articles on Valuation of Real Estate 