Valuation of Real Estate

The grand structure of valuation of real estate stands on four basic pillars which are Value, Benefit, Security and Interest in a property to be valued.

Value

Value is often mistaken as ‘Market Value’, but both market and value are entirely two different concepts. Value is neither inherent in a thing, commodity or a property in itself. Value of anything, articles/goods, assets etc. is due to the ‘utility’ of the final product produced by various ingredients and labour. It arises out of the utility/usefulness of the final product. Value of a building or asset is attributable to the utility in terms of the benefits, tangible or in tangible; one can derive by purchasing/acquiring and putting a building to use. An object, goods, property/asset is considered to be useful or having utility when its possession and use ultimately results, directly or indirectly, in saving of time/energy or in recoupment of energy. An object, goods or asset etc. which saves more time and energy is considered to be more useful and therefore more valuable. The utility and benefit are thus the functions of time and energy saved or recouped by a person per unit of time i.e per hour. Value can be therefore be defined as “The cost of time and energy saved or energy recouped by a person due to possession and use of a thing, an object etc. including a property during or over the estimated remaining/future life of an object, property etc. as on the relevant date, limited by the saving capacity or affordability of a person concerned.”

Market value has been defined by the International Valuation Standards Committee (IVSC) as “An estimate of what price ought to be in a transaction between an able, willing and prudent buyer/purchaser and able, willing and prudent seller/vendor at an arm’s length.” Cost of a thing, goods, property etc. usually comprises of two factors – cost of production which includes cost of raw materials, labour and interest on capital either owned or borrowed and cost of making the product available in the market i.e cost of transport, cost of distribution including commission, taxes etc. The cost of supply of a thing, goods, property etc. in the market can be adjusted according to the demand at a price in the market.

Benefit

Seeking ‘Benefit’ – both tangible and/or intangible is the first and foremost basic and universal instinct of human being. Benefit may take several forms – like in business it may be in form of net profit, in any investment it may be in form of net annual returns, in purchasing it may be in form of goods, property etc. In real estate or property benefit takes the form of net annual rental income and annual equivalent of capital appreciation and protection against inflation. The fair market value of a property is estimated by capitalizing the net annual rental income at the appropriate rate of interest depending on the security offered by the investment in the concerned property.

Security

The concept of ‘Security’ is the same all over the world irrespective of place, town, city or country/nation. The criteria for security of investment in any form can be stated as Safety of capital – The capital invested should be safe where the investor should be satisfied with annual income at lower rate of interest if the capital is absolutely safe. If it is not safe and there remain some element of risk, the investor will require the annual income at the higher rate of interest. Hence, the rate of interest expected is in the inverse proportion to the security and in the same proportion with the risk factor. Next comes the liquidity of capital which means the possibility of the amount of capital invested being recovered or getting back either fully or partly with minimum difficulty. Such eventually occurs at the time of resale of a thing, goods, property etc. or in case of distress sale etc. Next is the safety and regularity of income which are concerned with receiving the amount of annual income and timing of receiving income. The timings can be daily, weekly, quarterly, half yearly or annually etc. In residential properties and commercial offices regularity of income depends on the quality of the occupants i.e tenants, lessees etc. In case of commercial shops income fluctuation depends on type of shop i.e on the commodity sold or service offered. Thus higher the regularity of income, lower will be the rate of interest for annual income and vice-versa. The income from investment is also expected to be received with minimum efforts. Income from the investment if received at the door steps like that from government securities, fixed deposits etc. or dividends from companies etc. the investor will require annual income from his investment at lower rate of interest while the converse is also true. In the case of any investment, including the investment in real estate, the rate of interest expected to be yielded by the investment i.e the rate of interest for capitalization of net annual income/net profit etc. is in the inverse proportion to the security and in the same proportion to the risk factor. Higher the security, lower will be the risk factor and the investor will be satisfied with the annual income at the lower rate of interest. Inflation though has virtually no effect on the rate of interest yielded by investment in a property. With increase/decrease in the rate of inflation, the capital value of the property increases/decreases.

A Valuer needs to clearly understand, before proceeding to estimate market value of a property, the subject matter of the valuation i.e what exactly the valuer is suppose to value. The general perception is that a valuer has to estimate market value of any asset which is a physical entity like land and buildings. In the case of valuation of any property, exceptions being that of any religious buildings, public buildings etc. which are neither sold nor normally let out for rent, a valuer is required to estimate not the market value of a physical asset which is a physical entity, but the market value of the interest in a property i.e interest of the owner, occupier etc. in the property which is a legal-economic entity. Even according to the provisions of the Land Acquisition Act only a person having ‘interest’ in the land under acquisition is entitled to claim compensation for his ‘interest’ in the land being acquired.