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 are you joking ? Valuer replied “No, I am not joking. I have examined Lease Deed of the land of this running factory unit 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 of this large property to you is Nil”. It was a different storey that value of the same property to the lessor, on the same day , was in millions.
1.20 A very senior and experienced valuer once raised a question about correct 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 25 : 75 share in total value of land for Lessor’s interest in land and Lessee’s interest in land respectively . In case of Krishi Utpadan Mandi Samiti V/s Bipin Kumar (2004) 2 S.C.Cases 283, Supreme Court approved 25:75 share between Lessor and Lessee. This confusion is because of valuers mistake. Valuers do not present correct facts before the court. Correct answer to this query about share is that the share of two parties wholly depends on the provisions or terms and covenants in the lease deed .Unexpired period of lease and vesting back of land and building to Lessor would decide share or value of right of Lessor and Lessee’s interest in the land.
2.00 Above referred practical field examples, indicates 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 contract 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 interest 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 G.I.D.C. or 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 or clause for renewal of lease period for the second term. If first lease term is for 99 years, it is provided in the lease clause for renewal of lease period for the second term of 99 years at revised rent or at same lease rent. In some other lease, there is a clause which requires surrender of building constructed on the plot by the Lessee to the Lessor free of cost, on maturity of the lease. Value of rights of Lessor and Lessee would all depend on these clauses and terms of lease provided in the lease agreement.
3.30 Occupational Lease : This lease is for use of land and building together. Such lease could be for the plot of land with whole building or merely for the ownership flat, ownership office or even a ownership shop premises in the building. Ownership of land and building both continue to remain with the Lessor. Only occupational rights are given to the lessee under occupational lease. These are leased 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. Leave and license agreements prepared as per provisions of Indian Easements Act are more popular for the residential premises. However occupational leases as per Transfer of property Act 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 is normally for 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 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 number of years and
renewal Period if any, and provision for the revision of rent.
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 certain conditions or without any condition.
Restrictive Covenant : Not to alter building or change user of the land.
Vesting Back of Land Clause : This is a very important 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 back to the Lessor . Many leases provides that on maturity of lease the lessee would hand over or return land to the Lessor along with the building free of cost to the lessor. There could be a provision that the lessor will be required to pay mutually agreed amount to the Lessee for the building erected on the plot. All these provisions would change value of shares of two parties.
5.00 Depending upon lease conditions, value of interest of Lessor and value of the interest of the 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 1976 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 1976. 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 2010, if replacement cost of factory in 2010 is Rs.8500/Sq.Mt. and land value in 2010 is Rs.5,000/Sq.Mt.
Solution : (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 , if any, will be negligible. The lease rent is only Re.1/Year and hence its capitalized value also will be negligible. However Lessors do hold interest in the value of the property in form of right to levy differential premium at the time of sale ,transfer or assignment. This 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 5000 = 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.Mts. land was leased in 1970 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 2010. There is a lease condition that on maturity of lease, building will vest with Lessor free of cost. Rent Control Act is applicable to the tenants in the building.
Solution: (A) Lessor’s interest in 2010 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 (Terminable Income) , we must provide for Redemption of capital invested in house also (Duel rate table 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)
It will be seen that 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 1983. 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 2009/2010 was 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 2010. The lease deed provides that cinema with machinery would vest with Lessor free of cost on muturity of lease i.e. in the year 2013.
Solution: (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 (Terminable Income), 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 2013). 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 2013).
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 as high as 72.80% and value of Lessee’s interest is 27.20% only 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 in the market , as vacant premises. For the same reasons value of interest of Lessor and Lessee also will substantially change due to changes in the prevalent market rental during the lease period. 7.10 A very interesting case of city of London in this regard is worth study . A landlord (Lessor) wanted to let out his commercial premises when rentals were considerably rising. He offered the large office premises in his building to a prospective lessee tenant (who was fully aware of the market that the rentals are going up) at a slightly lower rent than prevalent rental . Long lease period was agreed by both the parties. However lessor put one special condition that in the event of lessee vacating the premises before agreed term/period he will pay damages/compensation to the landlord (Lessor). The tenant (Lessee) agreed to this condition because according to his calculations the rentals were to go up further and not fall down . But, in reality it so happened that in a short span of one year rentals went down by 50% i.e. the next door identical premises were available at 50% of rent paid by him. The lessee tenant could not vacate the premises as the benefit of 50% rent was less than the damages required to be paid to landlord in the event of premature vacating of the premises as per the terms of lease contract. Thus sometimes situation arises in rented/leased properties when value to the lessor, value to the lessee and value to the market with vacant possession are all different. Rights held by each will determine the value of the premises to him.
8.00 The properties which are yielding controlled rent from the tenants is an altogether different valuation assignment. Great care has to be taken in working out net receivable future flow of the rental income from the property. As all the tenants are protected by the provisions of Rent control Act, neither the tenants could be ejected nor can the old frozen rent can ever be increased. However some of the states have tried to pacify the rigours of the Rent Control Act by introducing some amendments.
8.10 Government of Maharashtra enacted Rent Control Act 1999 ( Effective from 31-3-2000).U/S 11 of Act it is provided for increase of 4 % / year in the basic rent. Under section 3 , protection of rent act is withdrawn for the public limited cos having paid up capital of Rs. One crore. U/S 56 landlord is permitted to charge premium (Pugdi) from the tenant while inducting him in the premises for the first time as well as at the time of transfer of tenancies. Tenants are also permitted to take such sum at the time of surrender of tenancy.
These provisions calls for special approach to valuation of rented properties . Future flow of rental income has to be increased at the rate of 4 % per year. In case of limited companies contractual rent and controlled rent both have to be ignored and only prevalent market rental has to be taken as basis of income flow. However great care has to be taken for interpretation of sec. 56 (i) provision (Legalising of taking Pugree/Premium by the tenant for surrender of tenancy ) for the purpose of valuation. No value accrues to landlord or tenant unless both agree for transfer of tenancies in writing and such document is duly registered with the registrar. Banks can not advance loan against tenancy rights by considering it as a legal asset of the tenant due to sec. 56 (i) of Rent Control Act of 1999.
8.11 Gujrat government has also came out with a very good amendment to the Rent Control Act, in the year 2001. As per section 4(1) (a) of the Gujrat Amendment Act 2001, the provisions of the act shall not apply for a period of 10 years from 5-9-2001, to any premises constructed on or after amendment of act in2001. Sec. 4 (1) (b) says that the Act shall also not apply for 10 years to the existing premises which is self occupied or vacant on 5-9-2001 and is let after such date.
These provisions though extremely good for the people of the state , it provides great difficulty to the valuer in interpretation of these provisions for the purposes of valuation.
As the act provides, these provisions are valid only upto Sept. 2011.Now if current rent is based on market rentals and in the year 2011 the premises will fetch only controlled standard rent, then how will the valuer estimate future flow of income from such a property ? We may however make an assumption that Government is most likely to extend these provisions for the further period of 10 years in the public interest. Value of the property will drastically fall if market rental gets converted into controlled rent in the year 2011. 8.12 Another very important factor to be considered in the valuation of rented properties is about adoption of correct rate of capitalization. There is so much confusion and chaos on this issue that hardly two valuers will ever agree on this point. On one side , one group of valuers say that rate of capitalization for rent controlled properties should be higher than yield rate from gilt edged security. Taking yield rate at 7.50 % in 2010, rate of capitalization ought to be at least 9 % as per this group. On the other hand other group of valuers say that our research and market survey indicates that investors are satisfied with 4 % to 6% yield on their investments in residential rented properties. Now, as valuer , we know very well that a reduction of even 1 % in the rate of capitalization will increase the value of the property by atleast 12 %. Hence adopting 6 % as rate of capitalization instead of 9 % will increase the value of the rented property by 50 %. More thorough research is therefore required on this vital issue.
It will not be surprising if research study results indicate that 9% yield is proper rate for rent controlled properties yielding frozen rent and 4 % yield rate is proper for rental income which are based on market rentals and for the properties falling out side purview of Rent Act. (Leave and licence contract under Easement act. )
9.00 Due to Globalisation and open economy, money supply in Stock Market, Real Estate market and even in Commodity Market in the year 2010 was much more than the money respective market could absorb. This was the reason of boom period in all market in the year 2010. But see what happened in January 2011. Foreign investors started withdrawing their investment from stock market. There was liquidity crunch and Banks wanted their money back from Real Estate Giants . Suddenly market started falling . This indicates how markets can turn volatile overnight. As boom period or slack period cannot be predicted by any one like wise it is very difficult to predict correct rate of yield on an investment. Expected rate of return on investment in sound security like G-sec or 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. Even an experienced banker can not predict future yield rates.
9.10 Due to volatile capital market and inflation, Reserve Bank of India issues various directives to financial institutions from time to time. Let us hope that the attempt of the Reserve Bank to control and monitor money supply in the capital market succeeds. In spite of controlling supply of money in the market, Reserve Bank may or may not be able to bring down inflation rate in our country. Let us hope that sincere efforts of all the executives responsible for controlling inflation, results in a grand success. Common men of our country would certainly bless these executives if they achieve such magnificent success of controlling and bringing down the rate of inflation in our country.
19-1-2011
MUMBAI. (Rewritten FOR WORKSHOP AT MANGALORE ON 18/19 March 2011)
Workshop not Held.
( Written on 28-9-2010 for SURAT SEMINAR of 16-10-2010 by CVSRT )
Articles on Valuation of Real Estate 