VALUATION

METHODS

Mr. Nimasha Sugathadasa

02.10.2024
 Learning Outcome
AT THE END OF THE SESSIONS, YOU SHALL BE ABLE TO;

• UNDERSTAND THE THREE APPROACHES AND FIVE

METHODS OF VALUATION
AGENDA • UNDERSTAND THE KEY TERMS RELATED TO THE
INVESTMENT METHOD OF VALUATION

• UNDERSTAND THE FUNDAMENTALS OF THE INCOME

APPROACH AND INVESTMENT METHOD OF
VALUATION
 (i) Market Value
Fundamental measurement
assumptions that underpin a (ii) Market Rent
valuation.
(iii) Investment Value/Worth
They provide a framework for
BASES OF determining how the value of an (iv) Equitable Value
VALUE : asset or liability is assessed and
are essential for ensuring that (v) Synergistic Value
IVS 104 the valuation is consistent,
relevant, and appropriate for its (vi) Liquidation Value
intended purpose.
(vii)Replacement Value

(viii)Fair Value
 • Estimated Amount
• Exchange
“The estimated amount for which the
• Valuation Date
property should exchange on the date • Willing Buyer and Seller
of valuation between a willing buyer • Knowledgeable and
MARKET and a willing seller in an arm’s length
Prudent Parties

VALUE transaction after proper marketing

•

•
Absence of Compulsion
Arm’s Length
Transaction
wherein the parties had each acted
• After Proper Marketing
knowledgeably, prudently and without
compulsion.“ • Highest and Best Use
• Transaction Costs
Source: RICS, 2012: 27
Assumption
 The estimated amount for which a • Estimated Amount
property would be leased on the • Valuation Date
valuation date between a willing • Willing Lessor and
Lessee
lessor and a willing lessee on
MARKET appropriate lease terms in an arm’s
• Appropriate Lease Terms

RENT length transaction, after proper

• Arm’s Length
Transaction
marketing where the parties had • Proper Marketing

each knowledgeably, prudently and • Knowledgeable and

Prudent Parties
without compulsion • Absence of Compulsion

Source: RICS, 2012: 31

 Value of an asset to a particular owner
or prospective owner for individual
INVESTMENT investment or operational objectives.
VALUE This definition highlights that
•

•
Subjective Nature
Contrast with Market
Value
Investment Value is not a measure of
• Use in Performance
market value but rather reflects the Measurement

specific benefits of ownership to the

current or potential owner, which may
differ from those of a typical market
participant.
Source: IVSC, 2013, page 8; IVSC,
2013, para 36, page 20
VALUATION
APPROACHES
AND METHODS
VALUATION APPROACH & METHODS
• A valuation approach refers to the overall manner in which the valuation task is
undertaken to determine the value of a particular asset or liability. It
encompasses the general strategy or framework that guides the valuation
process.

• Valuation method refers to the specific procedures or techniques used to

assess or calculate the value.

There are Three Approaches, Five Methods of

Valuation
VALUATION APPROACHES
Market Approach Income Approach Cost Approach

This approach involves comparing This approach is based on the This approach indicates the
the subject asset with identical or capitalization or conversion of value of an asset based on
similar assets for which price present and predicted income the cost to create or replace
information is available, such as (cash flows) to produce a current it, under the premise that a
purchaser would not pay
recent sales or market capital value. more than the cost to obtain
transactions. an asset of equal utility.
Property generates income for its
Value bases its opinion of value on owner, that income, or potential
what similar properties (otherwise for income, helps to
known as “comparables”, or substantiate, calculate or How much a property would
“comps”) in the vicinity have sold identify the market value of the cost to replace (meaning,
rebuild) after subtracting
for recently. property
accrued depreciation
VALUATION METHODS
Comparable Method Compares the subject property to similar recently sold
properties, adjusting for differences.

Investment Method Focuses on income-generating properties, estimating value

based on expected returns (capitalization rate).

Profit Method
Suitable for specialized properties where trading profits
dictate value.

Suitable for Properties with Development Potential, value

Residual Method
land by subtracting costs from the final development value.

Used for Unique properties, valuing them based on

Contractor’s method replacement cost minus depreciation.
INVESTMENT METHOD OF
VALUATION
INTRODUCTION
• The method is used for properties held as • Valuers have two primary methods for the
investments, valuing them based on rental investment valuation: the traditional method and
income and future capital returns the discounted cash flow (DCF) approach. The
traditional method focuses on current rents and
• Rent is considered a key income stream, and values, implicitly accounting for future rent
properties may be freehold or leasehold increases through the yield. In contrast, the DCF
approach explicitly forecasts growth and values the
property based on market yield.
RENTS AND OUTGOINGS
• Income from Real Estate/Property is called Rent Outgoings:
• In estimating the market value of a property from an
investment point of view, the valuer must first determine its General (Conventional)
market rent • Repairs and maintenance
• Immediate repairs
• An important difference between property and other forms • Annual repairs
of investment is that regular expenditure is needed to • Future repairs, depreciation and sinking fund
maintain, insure, manage and, when let to secure tenants; all • Insurance
such expenses are referred to as outgoings. • Fire and disaster
• Where the property is owner occupied, the owner is • Management
responsible for meeting all these costs. • Rates/Council tax
• Where the property is let, the lease specifies who is liable Other Outgoings examples,
for each outgoings, subject only to any statutory • VAT
requirements. • Voids
• FRI- Full Repair and Insurance- landlord passes all the
outgoings to the tenant by means of FRI
YIELD
• The use of income approach the valuer must determine the yield
• Yield is the rate of return that buyers at the valuation date are
seeking in relation to the particular interest in that type of property, of
that investment quality, in that location.
• Yield needs to be based on comparable transactions
• The valuer is interested in why investors require investment A to
yield 6%, investment B 3% and investment C 12%.
• Yield required by the investor would depend on;
• The security and regularity of the income
Higher security and regular income lead to lower
• The security of the capital required yields. For example, if an investment
guarantees capital and regular payments, a minimal
• The liquidity of the capital
yield is expected.
• The cost of transfer (Cost of buying and Selling)
Higher the risk …higher the yield/rate of return
 Yield and Return on Investment is it
YIELD the same or different? (More will be
Gross Yield = Annual Rent / Property Value x 100 explained in Real Estate finance)

• Net Yield = (Annual Rent – Operational Costs or outgoings)/ Property

Value x 100
• Years purchase (YP) is Years Purchase (YP) is the multiplier used to
convert the annual income into the total capital value of a property.
• It is the reciprocal of the Yield. (YP = 1/yield)

Conventional Standards

• Residential 3-5%
• Commercial 5-7%
• Office 8-10%
• Agricultural 10-14%
• Industrial 10-12%
TRADITIONAL INVESTMENT METHOD OF
VALUATION
Example:
Freehold Property
Value the freehold interest in a factory that has
• The principle of the income approach is : just been let on the open market at the full

Net income x Year’s purchase = Capital/ Market value market rent of Rs.100,000 per annum.
Comparables indicate an all risks yield of 8%
• Freehold interests are perpetual and therefore, incomes from freehold will apply.
property will also be perpetual.
For leaseholds: Valuation
Net profit rent × Years purchase dual rate tax adjusted = Capital value Net income = Rs. 100,000 p.a.
(also known as lease value on assignment). × YP perp @ 8% = 12.5
Market value = Rs. 1,250,000
INVESTMENT APPROACH (CONVENTIONAL)

Leasehold let at market rent

Freehold let at market rent
ILLUSTRATIONS
• What net income will be required if A wishes to invest Rs 1,000,000 in shop
premises and requires a rate of return of 6% on the capital to be invested?

Rs 1,000,000 * 6/100 = Rs 60,000/=

• If net rent of a residential building is Rs 5000 which the investor has invested
Rs100,000/=. Calculate the years purchase.

Rs 5,000/100,000 = 5% , Example:
Value the freehold interest in shop premises in a
Years Purchase = 100/5 = 20 secondary location. The premises
comprise a shop on the ground floor with flat
• If shop premises produce a net income of Rs 8,000/= p.a. and if the appropriate above, let recently to a single tenant
rate of return is 8% then the capital sum (value) would be at Rs. 300,000 p.a. exclusive on IRI (Internal
Repairing and Insuring) terms for 15 years with
Rs 8,000 * 100/8 = Rs 100,000/= five-yearly rent reviews. The rent is at MR.
ALL RISKS YIELD
The all-risks yield may be defined as one that reflects implicitly all future benefits and disadvantages of the investment.
ARY vs DCF: The ARY (All-Risks Yield) method capitalizes current rents at a yield that reflects expected future growth,
while the DCF method explicitly forecasts future cash flows and discounts them at a target rate of return.
Gap Between ARY and Return: ARY captures future rental income and capital growth implicitly (indirectly included). The
difference between ARY and the actual target return represents the expected or implied rental growth.
Sensitivity of ARY: Small changes in factors like rental income, risks, and market conditions can greatly affect the
property value using ARY.
Practical Use of ARY: ARY is useful when there’s a steady supply of comparable evidence, making it easier to adjust
yields based on market transactions.
Challenges with ARY:
• Lack of comparable evidence in cases where properties are rarely traded.
• Greater variability in investment properties (e.g., location, tenant quality, lease conditions).
• Difficulty in valuing properties with complex leases, variable income streams, or over-rented situations.
 DCF METHOD
• The Traditional (ARY :All-Risks Yield) method capitalizes current rents at a yield that reflects expected future
growth, while the DCF method explicitly forecasts future cash flows and discounts them at a target rate of
return.
• Which property types DCF method can be applied to?
Applied to value equity, business/firm, and income producing properties
• What brings estimated future values to present values
DF will reflect market and property specific risk. Target rate or discounting factor by extracting sales evidence
from market sales, yield construction (Risk-free rate + Risk premiums), through opinions based on experience,
financial techniques – WACC & CAPM or published data
• What is the time horizon for cash flow estimation?
5, 10 to 25 years
 DCF METHOD
• DCF models project future cash flows (e.g., rents, void periods, expenses) and discount them using a specific
target rate of return. DCF explicitly accounts for risks, growth potential, and depreciation, unlike ARY which
handles these implicitly.
• It allows for more detailed consideration of various investment factors, making it useful for complex properties
or when limited comparable market data exists.
• DCF requires assumptions about future rents, market growth, void periods, and renewal options. The target rate
of return and discount rates can be subjective and are critical to the outcome.
• By separating inputs like growth rate and discount rate, DCF poses the risk of overestimating or underestimating
property value.
• DCF is widely recognized, with guidance provided by institutions like the RICS, offering a robust tool for
evaluating complex investment properties.
DCF METHOD PROVIDES THEINTRINSIC VALUE
What Is Intrinsic Value? Key Variables:
intrinsic Value is the estimated worth of an asset following
Rent: The current and projected rental income
the objective analysis of its fundamentals and internal data –
generated by the property.
without reliance on external factors such as prevailing
market price
Rental Growth Rate: The expected increase in
Intrinsic value measures the value of an investment based on rental income over time, based on market trends.
its cash flows. Where market value tells you the price other
people are willing to pay for an asset, intrinsic value shows Target Rate of Return: The rate of return an
you the asset's value based on an analysis of its actual investor expects to earn from the investment,
financial performance. used to discount future cash flows to their
present value.

Exit Yield: The yield expected at the end of the

investment period, used to estimate the
property’s value when it is sold or at the end of
the holding period.
 EXAMPLE
• Commercial property has a net annual income of Rs 100,000 per month. This net annual income is expected to
grow at 3% per annum. The terminal value of the property after 5 years is estimated at Rs 20,000,000. The
discount rate applicable is assumed to be 10%. Value the property using the DCF method of valuation

Y1 Y2 Y3 Y4 Y5

Cash Flow 12,000,000 12,360,000 12,730,800 13,112,724 13,506,105

Terminal Value 20,000,000

33,506,105,72

D.F @ 10% 0.909 0.826 0.751 0.683 0.621

Value 10,908,000 10.209.360 9,560,830 8,955,990 20,807,291

Rs. 60,441,471
 EXERCISE
A freehold property investment was let recently at Rs.1,200,000 per annum (receivable annually in arrears) on a
15-year FRI lease with five-year rent reviews. Assuming an initial yield of 8% (from comparable evidence), a target
return of 12% (risk-free rate 9%, market risk 2%, property risk 1%), an implied annual growth rate (calculated
above) of 4.63% and a holding period of ten years after which a sale is assumed at an exit yield equivalent to
today’s ARY, the valuation
DCF MODEL

Terminal/ Exit Value

NPV discounted at ARY
REFERENCES
• H M Premathilaka (2016).
Property Valuation
Principles. Department of
Estate Management and
Valuation, University of Sri
Jayewardenepura
• Shapiro, E., Mackmin, D.
and Sams, G., 2019.
Modern methods of
valuation (11th edition).
Taylor & Francis
THANK YOU
Mr. Nimasha Sugathadasa
Email: nimashasugathadasa@[Link]
Department of Estate Management & Valuation
University of Sri Jayewardenepura