Land Value = 1000 @ 50,000/SM = 500,00,000
BLDG DRC. = 0.5 × 500 × 24000 = 60,00,000
Total Value = 560,00,000
Land Value = 500,00,000
= 60,00,000
Total Value = 560,00,000
1.00 Most of Practicing Valuers are familiar with the Chaotic conditions prevalent in Real Estate Market in Indian towns and cities. There are innumerable known and unknown forces operating in Real Estate Market which includes Demand and Supply aspect, Black Money aspect, Paying Capacity aspect, Builders connected with Mafia Dons, Imprudent Purchasers paying fancy prices, Dual interest rates in market, Second hand concept etc.
1.10 Valuer may find following chaotic conditions and confusing picture of Real Estate Assets in any city of India.
1.20 Two side by side flats on same floor of the building both having 800 SQFT area are sold in same month. Flat A fetched Rs. 20 Lacs and adjoining Flat B fetched Rs. 2 Lacs only. Flat A was vacant and Flat B was occupied by tenant protected by Rent Control Act and paying rent of Rs. 1200/M. No part of the world you will find 960 % price difference in two side by side flats on the same floor.
1.30 A shop ( 100 SFT area ) in shopping centre near station was sold for actual price of Rs. 60 Lacs. However sale document was made for 20 Lacs only and Rs. 40 Lacs was paid in cash. Purchaser offered shop for Bank mortgage. Bank’s valuer valued shop at Rs. 48 Lacs only by allowing for black money factor operating in market.
1,40 There were two adjoining plots each having 1000 SM area. Both plots were sold in same month. Plot A fetched Rs. 60 Lacs and adjoining Plot B fetched Rs. 15 Lacs. Plot A was free hold and plot B was leasehold yielding rent of Rs. 10,000/Month with 50 years unexpired lease period.
1.50 Valuer took search of sales of flats in a locality. For the relevant locality , during the required period, he came across 3 documents as under.
Sale ‘A’ in Feb 2016 : Flat 850 SFT sold for Rs. 21.25 L
Sale ‘B’ in Mar 2016 : Flat 750 SFT sold for Rs. 11.25 L
Sale ‘C’ in Mar 2016 : Flat 800 SFT sold for Rs. 16.00 L
All flats are in new building with similar specification. All flats were sold at uniform rate of Rs. 2500/SQFT. However local broker informed that sale ‘A’ is with 100% white money, sale B was with 40% black money and sale C was with 20% Black money.
How would valuer know black money portion in sale price by reading sale document ?
1.60 Three flats in three new buildings in same locality were available for sale. Carpet area of each flat was 800 Sq.Ft. However Super builtup floor area and sale price of each flat were different as detailed below.
Builder ‘A’ quoted salable area of flat at 1040 Sq.Ft. & sale price of Rs. 31.20 Lacs.
Builder ‘B’ quoted salable area of flat at 1120 Sq.Ft. & sale price of Rs. 33.60 Lacs.
Reputed builder ‘C’ quoted sale area at 1200 Sq.Ft. & sale price of Rs. 36.00 Lacs.
This gives loading factor of 30%,40% and 50 % respectively. In case of shops some builders charge loading factor as high as 100 % of the actual carpet area. Poor valuer is confused and he does not know what loading factor he should adopt while estimating value of subject flat in the same locality .
1.70 There would be such innumerable confusing situations and instances that the valuer has to face every day in his practice. It is commendable that valuers in India do excellent work by estimating fair market value in spite of such chaotic market.
1.80 To overcome such chaotic market conditions and to develop expertise in valuing properties in such chaotic Real Estate Market, it is necessary for valuer to educate himself of various market forces and some fundamental principles of valuation.
2.00 As early as in July 1948 justice Viscount Simon of House of Lord held that “ Even if asset is difficult to value, none the less it is of a money value. Hence the best possible valuation must we made. Mathematical certainty is not demanded nor indeed it is possible.”
2.10 During past several years the situation has not changed. Valuing asset has still remained very difficult to value. Unfortunately clients and Banks have started expecting mathematical precision in valuation of Real Estate. To counter Act to their expectations following court judgements can be cited.
2.20 In 1971, in Hays will Trusts Case, Justice Thomas held that “ It has been established time and again in these courts, that there is a range of price, in some circumstances wide, which competent valuers would recognise as the price which property would fetch if sold in the open market.”
2.30 In 1981, in case of K.P. Varghese, supreme court held “ It is well known fact that the determination of fair market value of a capital asset is generally a matter of estimate based to some extent on guess work and despite the utmost bonafides, the estimate of Fair Market Value is bound to vary from individual to individual. The postulate underlying sub section (2) of the act is that the difference between one honest valuation and another may range up to 15%.”
2.40 In 2011, in case of Trishla Jain Supreme Court held “ More often than not, it is not possible to fix compensation with exactitude or arithmetic accuracy.”
2.50 The sum and substance of these court ruling is that in field of valuation 5 + 5 could be 9, 5 + 5 could be 10 and 5 + 5 could be even 11. Clients and banks must be told clearly that precise valuation of the property is not possible. Value is an estimate of likely price of the property in the market. Estimated value & likely receivable actual price of property in the market may vary by 15% or even 30%.
3.00 Valuers while valuing property must keep in view several aspects such as :
( i ) Fundamentals & principles of valuation.
( ii ) Market forces like Demand and supply and Black money aspect.
( iii ) Time factor.
( iv ) Purpose of valuation.
( v ) Selection of Appropriate Method.
The following examples will explain importance of each one.
3.10 Fundamental Principal of Valuation is that “ Full Right Full Value – Less Right Less Value – No right No Value.” Valuer must examine right of a person in the property. Lessee may have 10% right or 90% right, free holder may have 100% right, co – owner may have 50% right or only 20% right.
3.11 In one case industrialist was running factory for 30 years with 54000 SQFT factory/godown on 11450 SQYD plot and was earning net profit of Rs. 35 Lacs/Year. Valuer valued the property at NIL Value. It was 30 years lease and lease had expired. As per lease terms factory & plot vested back to Lessor. Lessees right had extinguished. Hence there was no right to the occupant and hence NIL value of the property.
3.12 LIC accepted application of an applicant for purchase of flat ( Area 900 SFT ) on 7th floor in building under construction. Agreement to purchase indicated price of flat at Rs. 68 Lacs. Panel valuer was asked by L.I.C. to report present stage value of the flat. As only plinth work was done on site , the Valuer reported Nil value stating that 7 th floor flat is not yet constructed. This is not correct. Under purchase agreement, applicant obtained right to receive flat within a period of one year. He also acquired right on undivided share in land say 100 SQMT area. Valuer ought to have valued said undivided share of land say at Rs. 40 L and 10% plinth work at Rs. 2 Lacs. Total value at Rs. 42 Lacs. This is the value of right of flat purchaser in building under construction at plinth stage.
3.13 Sometimes borrowers flat- bungalow – hotel gets destroyed due to flood or due to defect in design or poor workmanship. Valuer is called to value such security. As flat was in building which has collapsed /destroyed , some valuers are of opinion that the value of the borrower’s flat is zero , because subject flat does not exist anymore. This view is not correct. What we value is right in the property and not physical property itself. Even after collapse of the building, flat owner/ borrower , held two rights in the said property .
( i ) Right in undivided share of land.
( ii ) Right to rebuild the new construction.
These rights are substantial and value cannot be zero.
3.20 Valuers must have feel of the Real Estate Market. In Buyers Market prices fall as demand is less. In Sellers Market prices rise as demand is more and in stable market prices remain same. It is not difficult to know market trend. Brokers will tell you whether it is Boom period or Slump period. Number of Documents registered every month at registers office will also indicate if sales are increasing or decreasing. This information is now available on line for some of the states in India.
Apart from demand and supply factor valuer should also know overall economic condition of the country. If stock market is collapsing investors will be tempted to invest in Real Estate and prices will rise in the Real Estate Market. Valuer must also keep a track on black money force operating in Real Estate Market. In some area it may be as high as 80 % cash payment (Black Money) , where as in some other areas it may be as low as only 30 % or less cash payment in the transaction. Appropriate weightage must be considered for this market force. For Bank Valuation this is very important.
3.21 In Surat cloth market a shop of 200 SQFT was to be valued for Bank Mortgage. Prevalent Rate for shop was 100 Lacs but comparable documents were for Rs. 20 Lacs only. Rs. 80 Lacs was paid in cash i.e. as Black money. Such shop can be valued by two different methods.
Option- A : Out of many shops some may be on rental occupancy . If market rent is Rs. 150 /SQFT , value the subject shop on Rental method by assuming probable rental :
Value of Shop = 200 × 150 × 12 × 100 = Rs. 72 Lacs. 5
Option- B : Valuer can Discount True value of Rs. 100 Lacs by 30% of the difference between actual value and agreement value. In present case difference is Rs. 80 Lacs hence total value should be discounted by Rs. 24 Lacs.
Value of the Shop by this method = Rs. 100 L – 24 L = Rs. 76 Lacs
This approach though not very scientific is based on market trend concept.
30% rebate is considered for tax liability to convert Rs. 80 Lacs black money into white money. It is logical to assume that prospective purchaser will be ready & willing to pay Rs. 76 Lacs for asset which is worth Rs. 100 Lacs in market. This would be fair market value of property for Bank Mortgage. However distress value of such shop under Public Auction could be hardly Rs. 65 Lacs only.
3.30 Time factor is very vital for valuation. Depending upon date of valuation, value changes . For Capital Gain Tax value is required as on 1-4-1981 or subsequent date if the purchase is later than April 1981. Valuer has to find out market trend during said period. For Bank mortgage, current market value is required. It should be remembered that present value may not be same when the account turns to be NPA after 3 or 5 years period.
3.40 Valuers must realise that all sale transactions taking place in Real Estate Market are not indicative of Fair Market price. Market is flooded with sales taking place due to different reasons and aspirations of buyers or sellers. Sale price may be Distress Value as seller had to sell property for daughter’s marriage. Sale price could be Special value which is higher than the F.M.V. because purchaser was determined to purchase the flat at any cost due to his desire to stay close to his brother having flat in said building.
There are many imprudent and reckless purchasers in the market. They pay fancy prices for different reasons. In big cities where many redevelopment projects are going on, a builder would buy over one flat in 40 or 50 years old building , by paying even 100 % extra price than its real worth. In one case builder paid Rs. 125 Lacs to acquire occupancy right of the sitting tenant of the flat, in an old building, against possession of the premises, even without the permission and consent of the landlord for the transfer of the tenancy rights. This new trend and the latest technique of the builders is known as “ANCHORING THE PROPERTY” Once builder is in possession of even a single flat in the building ,he can easily pressurise other occupants/tenants / landlord for the redevelopment project in his favour.
Sale price in the document could be Speculative value by the investor/purchaser who thought that prices in locality will rise by 50% in next year. Price could be Prestige value as flat purchased was next to flat of celebrity. Valuer has to therefore make proper enquiry before relying even on documented sale transactions.
3.50 Value of property changes with the purpose for which value is required . A residential bungalow could have four different values on same day.
Sale Purpose Rs. 540 Lacs.
Insurance Purpose Rs. 40 Lacs.
Taxation Purpose Rs. 4 Lacs.
Auction Purpose Rs. 400 Lacs.
4.00 Valuers must know fundamental difference between COST and VALUE.
4.10 * A bungalow built with total “ COST ” of Rs. 120 Lacs may have ‘ VALUE’ of Rs. 160 Lacs after 2 or 3 years.
4.20 * A dream resort house ( 16900 SFT ) at Khandala was built at cost of Rs. 430 Lacs. On completion the valuer valued it for Rs. 266 Lacs only. Reason was that 6500 SQFT area was unauthorisedly built and that portion was estimated at Nil Value by the valuer . In this case Rs. 430 Lacs is COST and Rs. 266 Lacs is VALUE.
4.30 * An assesee purchased land at cost of Rs. 2 Lacs and constructed building at cost of Rs. 8 Lacs. Total cost was Rs. 10 Lacs. Whole building was let out to the tenants for Rs. 4000/Month. Valuer valued it at Rs. 3.50 Lacs only. Due to Rent Act protected tenants, and frozen rent, VALUE of the property was less than actual COST.
5.00 There are three basic approaches available to valuers to value any property.
Income Approach : Rental Method – Profit Method
Cost Approach : Land and Building Method
Market Approach : Sales Comparision Method
5.10 These methods are tools of valuer to estimate value of the property.
Normally Rented properties are valued by Income Approach.
Bungalows and factories are valued by Cost Approach.
Ownership flats, offices, shops are valued by Market Approach.
However there are no hard & fast rules or watertight compartments in selection of any one of these three Methods.
Facts and Circumstances of the case may demand estimating value of owner occupied bungalow by Rental Method instead of Land and Building Method.
5.20 An industrialist constructed palatial bungalow in small village ( Population 5000 Person ) at cost Rs. 152 Lacs ( Cost of 5000 SM Land : Rs. 2 Lacs & Cost of 600 SM bungalow : Rs. 150 Lacs ). When property was offered for collateral security, Banks valuer valued it at only Rs. 9 Lacs. Poor farmers had no paying capacity to buy but 4 tenants could use it on nominal rent of Rs. 6000/Month between these prospective 4 tenants. Valuer valued it on Rental method instead of Land and building method. As there was no demand and no paying capacity for huge capital investment, Commonsense Approach of valuer was to change methodology and estimate value on Income Approach.
5.30 A Giant developer company purchased 400 Acres of land at Gurgaon for Rs. 400 Crores in 2008. For Bank mortgage purpose value was required in year 2012. Developers Chartered Accountants estimated value at Rs. 12000 Crores by DCF Method ( Income Approach ). Bank’s valuer valued it at Rs. 1600 Crores only by Sales Comparision Method ( Market Approach ) .
5.40 In 1979, in case of V.C. Ramchandran, Karnataka H.C. held “ If there are
more than one valuation of same property, the one which is reasonable and nearer to correct
market value, alone should be accepted ”.
6.00 Selection and application of most appropriate method of valuation in a given case alone is not sufficient. Valuer must also be vigilant enough to consider various factors and forces existing in Real Estate Market. Proper weightages should be given in valuation for all these factors. It is seen that some market forces do exist in the market and they affect the value of the property but they are never considered in proper manner while estimating value of the property.
Following aspects are required to be considered by the valuer.
Income Approach : Duel yield rates prevalent in Market.
Cost Approach : Demand/Supply factor on building component.
Market Approach : Second hand concept operating in Market.
These are discussed in greater details in following paras.
6.10 INCOME APPROACH
There are two sets of yield rates simultaneously operating in Real Estate Market in every city of India. This is perhaps unique in whole world. Valuers know very well that rate of capitalization is very important factor in fixing market value of income yielding property. On some properties expected yield rate is 3% to 5% where as on some other properties expected yield rate is 8% to 10%. This duel yield rate has evolved because of Indian Legal system.
Properties given on Leave & Licence are governed by provisions of Indian Easement Act. Rent can be increased after Licensed period. Investors call it “ APPRECIATING ASSET ” and hence are happy with low return of 3% to 5%.
Properties given on Rent are governed by provisions of Rent Control Act. Rent is frozen and cannot be increased. Investors call it “ DEPRECIATING ASSET ” and hence expect high return of 8% to 10%.
6.11 Following field examples will explain how valuer should give proper weightage for this market force by selecting proper rate of capitalization in a given case.
6.12 An ownership flat is Licensed at net sum of Rs. 40,000/Month.
License period is 3 years.
Sol : Rental yield is capitalized at 4%
Value of flat = 40,000 × 12 × 100⁄4
= Rs.120 Lacs
After 3 years flat could be sold with vacant possession for say Rs. 170 Lacs ( 42% rise/3years ) Equitable yield to investor is = 4% + 14% = 18%/year .
Hence investors call such licensed property as an Appreciating Asset.
6.13 An old rented building yields net rent of Rs. 15000/Month. Rents are frozen.
Sol : Capitalise rent at 9%.
Value of Property = 15000 × 12 × 100 9
= Rs. 20 Lacs.
Such rent controlled property with the frozen rent is considered Depreciating
Asset and hence higher rate of capitalization is adopted.
7.00 COST APPROACH
International Valuation Standard Council ( IVSC ) is of view that cost approach is market based and it does not consider demand and supply aspect of the market. IVSC therefore recommends this approach to valuation for non marketable properties like Church, Temple, Museum. Though IVS norms prohibits use of Cost Approach for Bungalows and factories, yet in India, 60% of Bank Valuations are done by valuers by applying Cost Approach i.e. Land and building method of valuation.
7.10 It will be proper for valuers to consider IVSC objection and allow weightage for demand and supply in valuation. In this method Land & building are valued separately and then added together to arrive at final value. Land is valued by comparable sales method which fully considers demand & supply. However on building value component this aspect is not considered. Valuer must start new trend by allowing weightage ( positive for boom period and negative for slump period ) on building component value.
7.20 Following example will indicate how this weightage can be considered in valuation. A property has 1000 SM land and 500 SM built up bungalow which is 30 years old. Land rate is Rs. 50,000/SM and Replacement cost is Rs. 24000/SM.
( A ) Value as per present convention
Land Value = 1000 @ 50,000/SM = 500,00,000
BLDG DRC. = 0.5 × 500 × 24000 = 60,00,000
Total Value = 560,00,000
Land Value = 500,00,000
= 60,00,000
Total Value = 560,00,000
( 50% depreciation for 30 Years Age )
( B ) Value as per New Trend
Allow 15% Positive weightage as demand is more and it is seller’s market.
Land Value 1000 @ 50,000/SM = 500.00,000
BLDG DCR = 60,00,000 × 1.15 = 69,00,000 Total Value = 569,00,000
The enhanced value is hardly 1.6% more of total value and is of no significance.
7.30 Valuers should therefore not hesitate to start new trend of considering weightage on Building Component Value, as it would then be in Line with International Valuation Standards and Value will be wholly market based.
8.00 MARKET APPROACH
Under market approach most popular method is Sales comparision method for valuing ownership premises.
8.10 In this method several factors of the property which bring about changes in value of the property are considered by the valuer and appropriate weightages are also considered to account for the effect of these factors, while comparing sales . Final values are estimated after adjustment in value is done for these factors.
8.20 Major factors for comparision and adjustment considered by majority of the valuers are : Time factor, Location factor, Age factor, Size factor and Specification/Amenities factor.
8.30 It is seen that one major factor or market force which operates in Real Estate Market but is not considered by the valuers is the purchasers dislike for second hand products i.e. second hand assets like premises in old buildings.
8.40 Second hand factor is wrongly mixed up and clubbed by valuers with Depreciation aspect or Age factor or Obsolescence factor.
8.50 This lacuna can be very well understood by following field example. It is common knowledge of valuers that rate of ownership premises in newly constructed building with ready possession is much higher than rate of premises in next adjoining building which is 20 to 30 year old. If a flat in new building in locality is available at rate of Rs. 16000/SQFT, flat in adjoining 30 years old building may fetch rate of Rs. 10,000/SQFT.
Now if we consider depreciation for 30 years age deduction will be Rs. 1200/SQFT. This means that flat in 30 years old building ought to be available at rate of Rs. 14800/SQFT. But it is not so. There is a clear gap in figures to the tune of Rs. 4800/SQFT. This cannot be attributed to obsolescence or specification difference. It has to be due to purchasers dislike for old premises i.e. second hand concept. This gap as found in metropolitan area of Mumbai may not be so wide in other cities and smaller town. In smaller cities gap may be much less than 30 % as in above example. However the fact still remains that there remains some left out gap (Spillover) even after allowing for the depreciation. This is nothing but secondhand effect or one may call it a type of obsolescence effect.
8.60 Above example shows that there is a need for thorough research on this aspect. There is also a need for a consensus amongst valuers on issue that “ Second hand ” factor is quite different from depreciation or obsolescence aspect.
8.70 It is possible that there exists two distinct and separate depreciations.
( i ) “ Cost Depreciation ” : This can be linked with Age factor and specification difference of the building.
( ii ) “Value Depreciation” : This can be linked with ‘ Second hand ’ factor or customers dislike for old premises ( Oldage Phobia) and liking for brand new asset (Novelty Philea).
9.00 Justice Hand, great federal judge of USA stated “ I am not slave of precedents. I think law must grow and change to meet needs of men. New conditions may rob old concepts and even old principles of their formal meaning , so that old ideals and even traditional principles call for new applications. Better perception of the true meaning of the basic ideal also may call for new developments.”
10.00 Though Justice Hand is talking about new conditions and new applications, what is expected from valuers by the clients and banks is very simple and fundamental. These clients expect that their property/mortgaged security should sell at a price equal to the value reported by the valuer. These clients are least bothered, by which method the valuer has arrived at the final estimated value.
11.00 Valuers must always remember following basic aspects of Valuation.
* That there is a range of prices of the property. Depending upon sellers urgency OR purchaser’s bargaining power , price of the property would change.
* There is a BOOM period and SLUMP period in the Real Estate Market. Valuer must be aware of the current market trend.
* Valuer must be reasonable and rational in his approach to valuation. Commercial wisdom of the valuer is accepted even by the courts. If valuer discounts real value of the property by 30 % or more to account for Black Money force existing in the market, court is likely to accept your discounted value.
* Valuer must never forget golden rule of valuation that :
“ PROPERTY MUST SELL AT REPORTED VALUE”
12.00 Indians have got best brains in the world . With their talent and intelligence Indians have excelled in each and every field, world over. However we Indians are worst in Research. Though we are capable of doing excellent research work, yet we hardly find any Indian involved in research work on his own.
Lot of Research work is required to be undertaken by the valuers by study of various known and unknown market forces prevalent in Real Estate Market, in order to prove and establish new concepts and modified principles of valuation.
23-5-2016
Articles on Valuation of Real Estate 