INCOME APPROACH

By:
Er. N K Rajkumar
Ph:9844066471

BASIC APPROACHES TO VALUE

BASIS OF VALUE (IVSC)

Statement of fundamental measurement assumptions of a Valuation
Approach to Value is one of the most important aspect in a Report

CLASSIFICATION OF PROPERTIES:

Basis of benefits derivable from ownership

Investment property : Produce direct monetary benefits to the owner. Acquired purely for earning
expectancy

Non Investment Property : Use and or consumption by the owner : Acquired mostly for self use

Ex : House, Public properties

CLASS-MARKETABILITY:

Income producing marketable properties

-All investment properties

Non-Income Producing Marketable properties

-Self occupied house/shop/office/industry.

Non-Income Producing Non-Marketable properties

-Public buildings, Religious properties

Benefits from a Property:

1. Self use or consumption.

2. Income flow in the form of rent/lease amount.

3. Income in future in the form of capital gain.

Investment Property :

• Income flow in the form of rent/lease amount

• Income in future in the form of capital gain.

Non Investment Property

• Self use or consumption.

Income in future in the form of capital gain

Economic Principles in Valuation :

There are 4 attributes to Value in an asset:

1. Utility

2. Demand

3. Scarcity

4. Transferability

There are physical, Legal, Economical and Sociological factors which have an impact on Value.

Economical factors have significant effect on value

Pertinent to understand the economic principles that affect the value

Investment Property :

• Income flow in the form of rent/lease amount

• Income in future in the form of capital gain

• Principle of Anticipation

Non-Investment Property

• Self use or consumption

• Income in future in the form of capital gain

• Principle of substitution
Primary kinds of Value:

Classification Value Characteristics Kind of Value

Utility Owner Value

Investment Prop Marketability Market Value

Self Liquidity Investment Value

Utility Owner Value

Marketable NIP
Marketability Market Value

Service Property
Utility Owner Value
NINM

Valuation Process:

• There are different approaches to value based on the Economic principles that are associated
with the property :

• Normally there are three approaches to value based on

• Comparable Sales(Market)

• Income &

• Cost of acquisition

• We will see them in detail a little later

PRINCIPLES AFFECTING VALUATION:

1. Principle of Anticipation

2. Principle of Balance

3. Principle of change

4. Principle of competition

5. Principle of conformity

A. Principle of Progression

B. Principle of Regression

6. Principle of consistent use

7. Principle of Contribution

8. Principle of External factors

9. Principle of increasing & decreasing returns

10. Principle of Substitution

11. Principle of Supply and demand

12. Principle of Surplus productivity

PRINCIPLES OF ANTICIPATION :

• Principle of Anticipation: Buyers buy properties for future benefits. They actually buy the
present worth of future benefits.

• Principle of anticipation refers to a rule on which the current value of a property depends.
According to this principle the value of the property depends on the anticipated utility or
income that will accrue to the property owner in the future.

• The principle says that value rises using anticipated benefits (money or amenities) to be gained
from a property in the future.

PRINCIPLES OF SUBSTITUTION:

The principle of substitution states that the upper limit of value tends to be set by the cost of acquiring
an equally desirable substitute, assuming no untimely delays. A prudent investor would pay no more for
an income-producing property than it would cost to build or purchase a similar property.
PRINCIPLE OF PROGRESSION :

The principle of progression states that the value of less expensive properties will increase when more
expensive properties come into the area.

• The idea behind this principle is, the price of a property escalates with an increased perceived
value of a location.

• The notion that a smaller house's value will be enhanced if it is near larger, fancier houses.

PRINCIPLE OF REGRESSION:

This is the opposite of progression principle. The price of a property decreases with a reduced perceived
value of a site.

The belief that a larger and more expensive dwelling will lose value if it is located near smaller low-
priced dwellings.

PRINCIPLE OF CONFORMITY:

The principle of conformity states that conformity to land use objectives contributes to economic
stability in a residential community. This is why homes are built in the same style as the other
properties in that same area, because the values will go up.

Conformity is important in commercial areas also. The stores in an area should appeal to the
same types of people in order to be successful. For example, it is no mystery why you tend to
see Annapoorna & Anandhas near each other more often than not. They tend to appeal to the same
type of clientele-hungry people. So having both near each other makes a great deal of sense. There is a
reason there is a food court in the mall.

PRINCIPLE OF CONSISTENCY:

The principle affirms that when improved land is in a state of transition to another HABU, it cannot be
appraised with one use allocated to the land and another to the building or other improvements. The
use of all real property components during an appraisal must remain consistent

(They should be in conformity with zoning regulations).

OTHER PRINCIPLES:

Principle of Balance :

Maximum Value is maintained through balance.

Principle of Change :

A value today is Valid only for today.

Principle of competition:

Excess Profit breeds ruinous competition.

Principle of External factors :

Things nearby can influence value.

Principle of HABU

Focus on use that will produce greatest return.

Principle of Increasing/Decreasing Returns:-

More is not necessarily better.

Principle of Supply and Demand:-

Market forces are always at work.

Principle of Surplus Productivity:-

Net income flows to the land.

APPROACHES & METHODS:

• Approach means to advance towards our destination.

• Method is the way of doing things or step by step procedure.

• Approach is a broader concept.

• Method is narrower concept.

• More than one method under every approach.

• Approach is MACRO/METHOD is Micro.

• Approach & Method are not the same & have different meaning.

Different Approaches:

Market and Economics Based Approaches:-

• There are 3 approaches which are market based approaches generally used globally.

• The other 2 approaches are Economics based approaches

1. Profit approach &

 2. Land Residual approach

• These two methods do not take into account the TIME VALUE OF MONEY (DCF Technique).

• Since the effect of these factors on Market Values is significant in emerging markets such as
India, the use of the these methods is not recommended.

APPROACHES TO VALUE:

• Cost Approach provides an indication of value using the economic principle that a buyer will
pay no more for an asset than the cost to obtain an asset of equal utility whether by purchase
or by construction.

• Income Approach provides an indication of value by converting the future cash flows to a
single current capital value.

• Market Approach provides an indication of value by comparing the subject asset with identical
or similar assets for which price information is available.

Other Approaches to Value:

• Benefit Approach : Dams, Bridges, Highways etc.,

• In this approach benefit to the society as a whole is assessed to find out present worth of the
property. Social benefit in terms of saving in time and man hours is considered in this approach

• Common Sense Approach – not dealt in any of the books.

• “Common sense which is a cluster of life’s experiences is often more dependable than the rival
facts presented by warring litigants” Justice Chandrachud – CJ CB – Olga Telis case vs BMC 1985
3 SCC 545.

INCOME APPROACH:

1. Rental Method of Valuation (Yield Method)

2. Profit Method (Capitalisation of earnings Method or Investment (analysis) Method)

3. Discounted Cash Flow Technique (Method)

Income Approach: 3 Methods.

Market Approach: 5 Methods

(Market approach 4 techniques each under Direct & Indirect Methods).

Cost Approach: 5 Methods.

We need to be thorough in 19 methods in order to do valuation of Real property.

We have many methods to arrive at a fairly accurate value for different purposes.

Approaches and methods depend on the purposes, importance of the assignment, nature of property
& availability of reliable data and accuracy warranted, stakeholder need.

Appropriate Approach:

INDIA

o 50% of housing stock rented. Income approach should be on top of the list

o Next Factories and Bungalows pledged as securities – normally done under

o Cost approach ( not by income approach) or Market Approach

o Even for IT - cost approach is adopted

o Cost approach cannot be relegated to last

o It is an important approach

o Land & ownership premises are obviously valued by Market Approach

o Ownership & possession

Land is fully developed & building fully tenanted .

Land is fully developed & building partially tenanted and partially owner occupied.

Land is partially developed with surplus FSI with rented building is in one side.

Land is partially developed with surplus available FSI. Only vertical development possible over exg
rented portion below.

Land is only partially developed but rented (old).

Only Rental Method is applicable

Rental portion : Income Approach

Occupied : Market Approach

Rented Portion : Income Approach

Surplus FSI : Market

Approach/Income Approach

Rented Portion : Income Approach

Surplus FSI portion : Market Approach /Income Approach

Income method may not be applicable.

Development Method (total demolition and HABU applied).

Terminologies – IVS 2013:

1. Real Estate

2. Real Property

3. Fair Value

4. Market Value

5. Market Rent

6. Investment Property

7. Investment Value

8. Cost approach

9. Income Approach

10. Market Approach

REAL ESTATE & REAL PROPERTY:

• Real Estate : The Land and all things that are a natural part of the land eg trees, minerals and
things that have been attached to the land

Ex: Buildings, site improvements and all permanent building attachments,

Ex: Mechanical and electrical plant providing services to a building that are both below and
above the ground – Physical.

• Real Property : All rights and benefits related to the ownership of the real estate – Legal.

FAIR VALUE, MARKET VALUE :

• Fair Value : Estimated price for the transfer of an asset or a liability between identified
knowledgeable and willing parties, that reflects the respective interests of those parties.

• Market Value : Estimated amount for which an asset or liability should exchange on the
valuation date between a willing buyer and willing seller at an arms length transaction after
proper marketing and where the parties had each acted knowledgeably, prudently and without
compulsion.
MARKET RENT:

The estimated amount for which a property would be leased on the valuation date between willing
lessor and willing lessee on appropriate lease terms at an arm’s length transaction after proper
marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

Investment Property and Investment Value:

• Investment property : The property i.e. Land or a building or part of a building or both, held by
the owner to earn rentals or for capital appreciation, or both, rather than for -

A. Use in production or supply of goods or services or for administrative purposes or

B. Sale in the ordinary course of business

Investment Value : The value of an asset to the owner or a prospective owner for individual
investment or operational objectives

REAL ESTATE Properties – Classification:

• Based on Marketability:

• Income fetching Marketable Properties

• Hotels, Cinemas, malls, petrol pumps, industrial properties, leased land

• Non-income fetching but marketable

• Self occupied house, flats, shops, factories, freehold land

• Non-income fetching but non-marketable

Govt buildings, Fire station, museum etc .

TIME VALUE OF MONEY:

• The time value of money (TVM) is the concept that money available at the present time is
worth more than the identical sum in the future due to its potential earning capacity. This
core principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.

• TVM principle explains how time affects monetary value.

• TVM is relevant and important

Why there is Time Value of Money

• Purchasing power: Because of inflation, Rs 100,000 can be used to buy more goods and services
today than Rs 100,000 in 10 years from now.
 • Opportunity Cost : A rupee received today can be invested now to earn interest, this can result
in a higher value in the future.

• Risk Vs Return: If you are giving your money to be used by another person / company, that
means you are taking the risk associated with it, which is known as ‘default risk’ (you may or
may not get back your payments). So, you expect return / interest to compensate the risk.

Compounding & Discounting:

Compounding & Discounting :

• Discounting and compounding are two sides of the same coin. Both are used to adjust the value
of money over time. They just work in different directions:

• Compounding: The method uses to know the future value of a present amount.

• Discounting: Process for determining the present value of the amount to be received in the
future.

• Compounding uses compound interest rates while discount rates are used in Discounting.

Future Value from Present Value :

• FV = PV x ( 1+r)n

Present Value from Future Value :

• PV = FV/ (1+r)n

Applicability of Income Approach:

This method is applicable for those properties which are held as investments. The owner of the
Investment Property gives the right to occupy to a tenant or tenants by way of a lease. In other words,
this method can be reliably used for Tenant occupied properties where the tenant pays a rent to the
owner

TERMINOLOGIES:

LEASE RENT:

The amount in terms of money charged by the land owner (lessor) to the tenant (Lessee) for use of land
owned by him under specified terms and mutually agreed lease terms and conditions. It can be monthly
or annual rent.

It is also called ground rent.

It may be fixed for the entire lease period or may increase at fixed intervals of years or may be reviewed
at the time renewal. The same words lessor and lessee are also used for letting out built up premises
also.

1. Rack Rent

2. Virtual Rent

3. Head Rent

4. Profit Rent

5. Contractual rent

6. Standard Rent

7. Market Rent

8. Concessional rent

9. Monopoly rent

PROBLEMS:

(A) Return on Investment

Example – 1

A fully rented and fully developed house is sold for Rs.3,50,000.00. On inquiry it is learnt that total
rental income from the house is Rs..42,000.00 / Yr. Property taxes are Rs.10,000.00 per six months.
Other expenses are 20 % of Gross Rent. Calculate Rate of Return available to the purchaser.

(Ans. – 3.88 % per year)

Example – 2

An investor purchased a 5 bedroom flat in Mumbai at the cost of Rs.5 Crore. He licensed it to a
multinational company for a total license fee of Rs.1,20,000.00 / Month. In addition an interest free
security deposit of Rs. 1.00 crore was also taken. Society maintenance charges are Rs.65,000.000 / Qr. If
8 % interest is available in market for refundable security deposit, calculate rate of return on investment
to the investor. Rent control Act is not applicable to the subject property.

(Ans. – 3.96 % p. a.)

ANNUITY:

Net annual Payment (ROI) for the capital invested in an immovable property or any other form
of investment.

Ex: Rent from land or house, interest on bank FD or yield on government security

CAPITALISATION:

Process of finding out the amount required to be invested at the present time, desiring to acquire the
right for benefit or profit receivable in the future.

Rate of capitalization : it is the rent.

Rate of Capitalisation : It is a rate of return at which an investor is willing to invest his capital to get
future benefits (income).

SINKING FUND :

Annual recurring fund required to be set aside every year, for a given period of time, at a given rate of
interest, to recoup the capital invested in a property, interest or return from which would cease after a
given period of time.

There are situations when the return from an investment or an invested asset will cease. Or other wise
the income is terminable at a given point in time in the future : (Expiry of a Lease term for a lessee ) In
such cases the lessee should have saved a portion of his income to recoup the initial capital invested
besides the return on investment.

So he need to set aside an amount (SF) to recoup the Capital invested. This is called ASF

Remunerative Rate of Interest & Recoupment Rate.

BASIS OF THE APPROACH:

Value of an asset is a function of its utility.

The approach assumes that the value of the property is based on the future cash flow that the property
is expected to generate.

It works on the Principles of Substitution and Anticipation.

To understand the approach we need to study the rent Theory

Rent Theory – David Ricardo

“Rent is that portion of the produce of the earth which is paid to the landlord for use of the original and
indestructible powers of the soil.”
Rate of Capitalisation:

Rate of Return at which an is willing to invest his capital to get future benefits.

Ex: A person invests Rs. 1 Lakh in an FD in a bank @8%

8% is the Cap Rate

Similarly if an investor yields 8% on his investment in a rented house property by way of rent, 8% is the
rate of Capitalisation

Rate of Return at which an is willing to invest his capital to get future benefits.

Ex: A person invests Rs. 1 Lakh in an FD in a bank @8%

8% is the Cap Rate

Similarly if an investor yields 8% on his investment in a rented house property by way of rent, 8% is the
rate of Capitalisation

STEPS:

➢ Collect Market data & other sources for genuine instances of comparable rentals of comparable
properties in the locality.

➢ Inspect the property to be valued and comparables and check veracity of data collected.

➢ Make local enquiries

➢ Check if the comparables are fair (low or excessive or maintainable)

➢ In case excessive calculate standard /maintainable rent /market rent.

➢ If rent is too low make suitable adjustments.

➢ Now arrive at the Gross Maintainable rent for comparables.

➢ Arrive at the Net Maintainable Rent after deducting outgoings.

➢ the yield rates for the comparables and fix the Cap rate for the subject property after
adjustments.

➢ Find out the applicability of RC Act for subject.

➢ Calculate the Outgoings.

➢ Capitalise the net receivable income for period of flow of rental income.

➢ Deduct major outstanding liability including cost of immediate repairs.

 ➢ Estimate the final Value.

➢ Gross Income

➢ Gross Monthly Rent

➢ Other incomes

Outgoings :

1. Property Tax

2. Land Revenue

3. Ground Rent

4. Annual Repairs

5. House Insurance

6. Collection & Management expenses

7. Upkeep & Service

8. Vacancies and bad debts

9. Sinking Fund

10. Life of the Building

Analysis of Sale:

To arrive at the Cap rate we need to obtain market info from Sale Instances/rental comparables
available in registrar’s office

Cumbersome

Veracity of the sale value

Physical verification

Collection of rental data

Outgoings

GI and NI to be computed accurately

From the Sale value and NI, Cap rate is obtained.

Precautions:

For Sale instances from Registry :

If the property has surplus FSI suitable adjustments need to be made.

Only Fully developed fully rented property can only give correct yield rate.

In case of shops and flats its not difficult. Reliable Market information will be available. Society
maintenance will give total outgoings.

Limitation of Rental Method:

Reliability depends on the reliability of Cap rate

Even 1% variation in Cap rate will lead to a 8 to 10% variation in value.

There are two rates of return for rented properties

The RC properties (8 to 10%) and Non RC properties. (4 to 6%) This can create lot of confusion while
arriving at the correct Cap Rate.

RC methods not suitable for Non investment properties like schools, temples & Public buildings.

Normally RC method gives too low a value ignoring the intrinsic value of land & buildings

Self occupied – notional rents – may not reflect true

Under utilised FSI – RC cannot reflect true value.

Other methods to be used additionally

If Actual rent is more than Standard Rent there will be anomaly in fixing the GI and NI and the rent
becomes not maintainable.

The presence of Pugri, Salami, Goodwill etc makes the adoption of RC impractical in significant cases.

Where RC is in force.

In RC areas, Reversionary value is considered nil and hence value computed is far less.

For RC properties, future rent is assumed in perpetuity irrespective of the building condition.

LEASE HOLD PROPERTIES:

Lessor, Lessee, Sub-Lessee, Lease for Life,

Ground Rent, Rack Rent, Profit Rent,

Premium
Types of Leases:

Building Lease and Occupational Lease.

Terms & Conditions and Covenant

Lease term, renewal clause, Amount of rent

Lessor’s covenant, Lessees covenant,

Rights of sub lease, Rights of assignment,

Restrictive covenant,

Vesting Back of Land clause.

TERMS-CONDITIONS-COVENANT:

Covenant

An agreement, contract, or written promise between two individuals that frequently constitutes a pledg
e to do or refrain from doing something.

The individual making the promise or agreement is known as the covenanter, and the individual to wh
omsuch promise is made is called the Covenantee.

Valuation Lease hold Properties:

In a Lease hold property there are two interests which require Valuation depending upon lease
conditions and rights of Lessor and Lessee :

Lessor’s interest:

Capitalised value of lease rental receivable for the unexpired period of lease.

Present Value of the right of reversion of land & building on maturity of lease period.

Market value of the rights of the lessor to waive any of the restrictions imposed under the lease.

In case of premium paid initially, virtual rent may also be required to be considered for arriving at
Lessor’s interest.

Valuation Lessee’s Interest:

Capitalization value of profit rent for the unexpired period if sub-let.

If not sublet for own use (res/com/ind/)-value of depreciated present worth of structures built...
If plot not fully developed (under utilised), profit rental for untilised land till the maturity to be
considered in valuation.

In case premium is paid, rent equivalent of the premium to considered to find the lessees’ interest and
appropriately capitalised.

Profit Rent = Rack Rent – Actual ground rent – rental equivalent of premium.

Unearned Increase in VALUES:

State/local auth/quasi Govt./ give land for development to individuals/entrepreneurs & companies / on
long lease.

Full initial premium and token lease rent Re.1 per year.

Premium is generally low in view public interest for development /employment / under developed
areas.

Ex:- Industrial development.

Unearned Increase Clause

When the lease holder sells his right he earns profit. St Govt has 50% share in the profit.

This charge by lessor is called Premium for unearned increase. It is a charge on the property and is
deduction from total value of the property.

Example:

Land area leased : 1500 Sqm : Yr 1965 – 99yr

Monthly Rent : Rs. 1000

Lessee constructed res bld and rented out flats 1966

Rent received : Rs. 5500 pm

Outgoings : n40%

Calculate Lessor’s interest, Lessees interest

Prevalent market rate of return 7%

Value of Lessor’s interest : Lessor’s GAI x 100/R

Gross Annual Income : 1000 x 12 = Rs.12000

Lessor’s interest = Gross Annual Income x 100/R :

 Rs.12000 x 100 / 7 = Rs.1,71,428

Value of Lessees interest:-

Gross Annual Income = Rs.5500 x 12 = Rs. 66000

Outgoings @40% = Rs. 26400

Ground Rent = Rs. 12000

Total = Rs. 38400

Net Annual Income = Rs. 27,600

AT (7+1)% Value of lessee's interest

= Rs.27600 x 100 / 8 = Rs. 3,45,000

Profit Method:

This is the third method under income approach as it considers the income (profit) from the property as
a business.

There are properties which are commercial entities which means immovable asset as well as a business
component.

Hotels, Cinemas, multiplex theatres, Petrol pumps shopping malls, Warehousing & cold storage etc.

These can be valued using cost method. But these properties are run by a management to derive
income.

Hence LB method is not appropriate. IA is useful

Measure of Investment:-

Any investment made will generate cash outflows & cash inflows over periods of time. Since
money has time value, all cash flows must be recorded with reference to time. To aid evaluation &
assessment for a project (or investment) certain techniques have been developed by to measure the
investment worth of an (investment or) project.

The following are the Appraisal Techniques:-

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

NPV:
Example:

In the following investment proposed, the investor would like to know the minimum sale price
‘X’. You are requested to know to advice him.

Cost of ready-made House Rs. 2,00,000/-

Improvements Rs. 1,50,000/-

Rent yea for consecutive 5 yrs is Rs. 30,000/- P A

(Payable at the end of even year)

Sale price at the end of year Rs. X

Capital Gains Tax to be paid at the time of sale Rs. 60,000/-

Target rate is Rs. 12% P A.

Solution:
Time Details Cash Flow R N Discount Present
(Year) (C) Per years Factor (D) Value
(-outgoing Annum D= 1 , P= C x D
+ incoming) (1+R) n
Rs
Rs.
0 Cost of House - 2,00,000 0.12 0 1 - 2,00,000
0 Improvements - 1,50,000 0.12 0 1 - 1,50,000
1 Rent Year 1 + 30,000 0.12 1 0.89286 + 26,785
2 Rent Year 2 + 30,000 0.12 2 0.79719 + 23,916
3 Rent Year 3 + 30,000 0.12 3 0.71178 + 21,353
4 Rent Year 4 + 30,000 0.12 4 0.63552 + 19,066
5 Rent Year 5 + 30,000 0.12 5 0.56743 + 17,023
5 Sale Value +X 0.12 5 0.56743 + 0.5743 X
5 Capital gain tax - 60,000 0.12 5 0.56746 - 34.046
Net Present - 2,75,092
Value + 0.56743 X

The minimum sale price X of the house will be obtained when the total present value P as calculate
above is Zero, so that a 12% target rate is maintained.

∴ - 2,75,902 + 0.56743 X = 0

OR X = Rs. 275902 = Rs. 4,86,231/-

0.56743
 So, Sale Price X = Rs. 4,86,000/-

Internal Rate of Return (IRR)

The IRR is the actual return obtained from an investment. Here the internal rate, i.e. ‘R’ is to be
calculated. So that all future discounted receipts & discounted payments are equal at this point the NPV
will be zero.

Where there are several investment opportunities those investments with IRR below the target
rate will be rejected, of those with an IRR greater than the required rate of return. The investment with
the highest IRR will be preferred. The IRR may be calculated by trial & error and by interpolation.

Prepared by:
Er. N K Rajkumar
Ph:9844066471
Email:[Link]@[Link]