Session 1

Valuation of Properties:
Investment Approach
Ramakrishna Nallathiga
Associate Professor
NICMAR University - Pune
Structure
• Introduction
• Concept of Perpetuity
• Application of Method
• Investment income
• Determination of Income
• Determinants of Income
• Factors Affecting Income
• Investment yield
• Determination of Yield
• Yield from investments
• Special Aspects of Property Investment
• Factors Affecting Yield
Introduction
• Valuation is a process of ‘careful estimation of the
worthiness of the landed property’
• While there are several approaches to the valuation of
real properties, one important approach taken towards it
is the ‘investment approach’
• Under this approach, real property is viewed akin to any
financial asset i.e., real property, like a financial asset,
also fetches a return on investment made to acquire it
• Investment approach is more appropriate to those
properties that are acquired primarily with an intention to
rent/ lease, which include commercial properties
 Perpetuity
• Valuation under the investment approach considers the
real property as capable of generating a ‘net income’ on
perpetual basis and gives a ‘return or yield’ on the
investment made
• An underlying assumption is that both ‘net income’ and
associated ‘yield’ remain constant over time due to lease/
rental contract structure of letting real properties
• Therefore, the value of real property is essentially the
value of ‘perpetuity’ or ‘perpetual asset’, which is akin to
the value of financial asset like bond that also yields
‘perpetual income’ over a very long term
Approach
• Investment method of valuation essentially treats real
property as an investment asset with an expected
return on it as ‘income’ due to rent/lease
• Therefore, the net income flow (either potential/
realisable or actual) from the property becomes an
important means of valuation of the real asset
• Subsequently, we attempt to capitalise the ‘net
income’ of such asset by using appropriate ‘yield’
(also termed as ‘rate of return’ or ‘interest rate’ in
other similar contexts like projects and lending)
Valuation of Perpetuity
• In simple terms, the value of perpetuity is
Value = [100/yield] * annual rental income
Where, yield is the income return on Rs 100
• Or, Value = [1/i] * annual rental income
Where, i is the yield/rate of return as %
• Alternately,
Value = Y.P. * annual rental income
Where, Y.P. Is Year’s Purchase of Perpetuity
Application of Method
• This valuation method is applicable to those
properties that are either given on rent/lease (either
short or long term) or owner occupied for short term
• It is applicable when there is sufficient rental evidence
available for similar class of properties in the property
market; also, it is for those properties without any
latent/hidden development potential
• It is the ‘Valuer’ who has to find ‘net income or net
potential income’ and choose an appropriate ‘yield’ for
the subject property under valuation
Determination of Income
• In the case of properties that are already let out,
rental income or rental value as per rental contract is
the income from property
• However, depending upon the circumstances, the
subject property may be let either ‘at’ or ‘above’ or
‘below’ the ‘full market rent/value’
• Accordingly, the rental income can also be termed as
‘unsecured income’ or ‘secured income’
• The income from real property (actual or potential) is
measured in net terms i.e.,
Net Income = Gross Income – Outgoings
Determinants of Income
• Rental value or income from real property is
influenced by the rental market forces of demand and
supply operating on landed property

• On the demand side, rental value depends upon population

growth, economic activity, income levels, infrastructure
investments and inflation

• On the supply side, rental value depends on peculiarities of

land (non-transferability), geographical fixity,
planning/development controls and legislations impacting on
supply e.g., rent control legislation
Factors Affecting Income
• The ‘Net Income’ from real property will depend upon
the following factors that lead to ‘outgoings’, which are
deducted from the gross rental income
• Vacancy/ Voids
• Maintenance/Service Charges
• Repair expenses
• Recurring (regular)
• Capital (restoration)
• Municipal taxes
• Professional charges
• Brokerage, insurance, legal
 Determination of Yield
• The ‘income yield’ (or, return on investment) on property is
governed by the operational aspects of capital markets,
which the valuer needs to know
• Any capital investment is made with the objectives of
obtaining:
• Flow of income
• Gains from transfer
• Two major classes of investment exist in the capital
markets:
• Fixed income instruments
• Variable income instruments
Yield of Fixed income
instruments
• Fixed income instruments like bonds, debentures and
government securities provide a fixed income as
defined/ promised by them at the time of floatation
• The income yield of such instruments remains
constant and they are exchanged more or less at the
same face value in secondary market, if exists
• The current yield may vary if they are exchanged at
above or below the original capital/ price in secondary
market; the current yield will accordingly rise or fall
Yield of Variable income
instruments
• Variable income instruments like equity shares do not
offer any fixed income and the dividend income
depends upon the performance of issuing firm
• However, the equity shares may be sold in market at
a value either more or less than their issue/face value,
therefore, the yield varies widely
• Firms with attractive business proposition will
generate more income and generate more prospects
of the rise in value of share capital; they are acquired
by equity market participants at a value premium
Yield from Investments
• Investment in any income instruments is made with an
expectation of income but investors would like to
secure their capital as well as income
• As inflation further reduces the money value of
income, thereby makes it not secure in real terms
• For absolutely safe investment, both physically and in
real terms by the way of capital appreciation, the
investor is, therefore, prepared to accept low income
yield
• Low income yield is not bad but it is reflective of
appreciation potential or safety of the asset
Yield from Investments
• In other terms:
• Greater the security of capital in real terms lower
the yield for capitalisation
• Greater the security of income in real terms and
regularity of income, lower the yield for
capitalisation
• Greater the liquidity of the investment, the lesser is
the yield acceptable
• Lesser the cost of transfer, lesser is the yield
acceptable
Factors Affecting Yield
• The ‘Yield’ from property will depend upon the
following factors
• Security of the asset
• Risks associated
• Inflation rate
• Operating laws
• Liquidity condition
• Transaction costs
• Information imperfections
Special Aspects of Property
Investment
• Property market investments are integrated with other
investment/capital markets
• Investment in real property, however, is different from
investment in security market
• Lot of costs and hazards of management are associated
with landed property (therefore justifying higher
investment yield)
• Laws operating (rent controls), poor liquidity and high
transaction costs affect expected yield
• Imperfect information/knowledge of property markets also
raise the expected yield
References
• S Datta (2004), Valuation of Real Properties, Eastern
Law House Publishing, Kolkata
• Chapter 4: Investment Method of Valuation