Department of Estate Management and Valuation

Faculty of Management Studies and Commerce

University of Sri Jayewardenepura

Subject : Principles of Valuation

Subject Code : EMV 2377
Subject Coordinator : Dr. (Mrs) T G U Perera
Lecturers : Dr. (Mrs) T G U Perera
Tutor : Mr Nimasha Sugathadasa
Year/Semester : Year II Semester II
Number of Credits : 03
Number of Lectures : 30
Total Lecture Hours : 45
 Learning Outcomes of Today’s
Lecture
 Students should be able to understand the Fundamentals of the
Contractor’s method of Valuation, Residual Method of Valuation,
and Profit Method of Valuation

 Students should be able to understand the key terms related to

the Contractor’s method of Valuation, Residual Method of
Valuation, and Profit Method of Valuation
Residual Method of
Valuation
 Hypothetical Development Method / Development appraisal

 This Method of valuation is used to value lands with development

potential
 New development - Where new buildings are to be created on
previously undeveloped land
 Redevelopment - Where existing buildings on vacant sites are to be
replaced by new structures.
 Refurbishment - Where existing buildings are to be substantially
converted or modernized.
 Residual Method of Valuation can be used:
 To identify the residual value after the potential development
 To find the site value of a land with development potential.
 Where the land value is already known, it can be used to find
the developer’s profit.
 To determine the viability of the development
 This method of valuation is based mainly on two assumptions
 The optimum development is known.
 It is possible to estimate the cost of development accurately.
 Assessment of value by the Residual Method.
 Estimate the gross development value (GDV) - the value of the property
after the property has been developed.
 Estimate the total cost of development - building costs, professional
fees, advertising and legal fees, cost of short-term finance etc.
 Subtract the cost of development and developers profit from the GDV
 This will leave a residual figure - Total amount available to purchase
the land.
 The residual figure shows the amount available to purchase the property in
its unimproved state reflecting development potential.
The equation for the Residual Method

Value of the property in its undeveloped state reflecting the

development potential (Residual figure) =

GDV – Cost of Development + Developers Profit

Estimating price of land (with development potential) under the Residual
Method
A = Gross Development Value
B = Cost of development
1. Site preparation
2. Building costs
3. Professional fees
4. Finance costs
5. Contingencies
C = Developer’s Profit
Total cost = B + C
Residual value = A – (B + C) (PV in n years @ r%)
GDV

 GDV arises from the sale of the developed property

 Inthe residential property – the price will be based on the comparison
method
 Commercial property – GDV will be the estimated market value or price
that will be obtained on sale and will be estimated using income
approach/ investment method valuation as well as the comparative
method of valuation
 GDV takes different forms such as a rental value, sale price of completed
buildings, or developed land blocks
 This amount is not receivable until the work is completed or nearly to be
finished
e.g.
You are required to value freehold interest in premises in Maharagama town.
This property consists of an obsolete house now vacant and to be demolished
for redevelopment. Permission has been given to build a shop. The shop is
expected to let at Rs. 75,000 per month net and the resultant investment
should sell on the basis of a 6.5% return (In this example GDV is the Freehold
value of the property).

Full rental value of shop / Net Income (Rs. 75,000 * 12) = Rs. 900,000 p.a
Y.P in perpetuity @ 6.5% = 15.38 Y.P
GDV (Rs. 900,000 p.a * 15.38) = Rs. 13,842,000
Cost of building/ Construction cost

If the site is planned for a construction, then cost of construction has to

be estimated.
These estimates are normally based on the prevailing costs of building
per square foot or per square meter of the gross internal floor area
(GIF).
As the scheme details become more advanced it may be appropriate to
prepare a priced specification or a bill of quantities and may need to
consult a Quantity Surveyor
e.g.:
Shop F.A. 1000 sqft. (GIF) @ Rs. 3000/- per sqft. = Rs. 3,000,000
Professional fees

In addition to the actual costs of building, professional fees are also

payable. The membership of the development team depends on the
nature and scope of the development. The fees payable depend on
the circumstances but usually vary between 8% and 14% of the
building costs with 12% as the average.

e.g.
12% of Building cost = Rs. 3,000,000/100*12
= Rs. 360,000
Ancillary cost/ Miscellaneous items

 Since all sites are heterogeneous, having unique characteristics may

require some ancillary cost
Ex –
Site clearance and preparation cost
Filling uneven lands
Expenses for planning requirements
Fees charged by respective local authority
Cost of Finance

 Considerable sums of capital need to be spent on the carrying out

of development. Normally this money is raised from banks or other
lending institutions. The cost of borrowing money which will be
repaid on the completion and sale of the development is the
interest charged at an agreed rate.
 Even if the developer is able to provide money from his own
resources, the prevailing borrowing rate should be adopted in the
valuation as this is the opportunity cost of the capital.
 This method assume, the developer run such project using
borrowed money
 Money to be borrowed related to two items: building cost and land
cost
 Land cost – will be incurred at the start and interest runs for the
whole period of development
 Building cost – money required for building works will only be needed
in stages, so as a rule of thumb, it is assumed that whole of building
money is borrowed for half of the development period.
 When the details of development are known clearly, it may be
necessary to change the rule of thumb
 Cost of finance may include ancillary cost, contractors cost,
professional fees
E.g. Development period is assumed to be one year and finance is available at
18% per annum. And site preparation cost is estimated at Rs. 75,000

Interest on building costs and professional fees for 6 months at 18% per annum
Rs. 3,360,000 * 18 * ½ = Rs. 302,400
100

Cost of finance for site preparation for one year at 18%

Rs. 75,000 * 18 = Rs. 13,500
100
Cost of Finance = Rs. 302,400 + Rs. 13,500 = Rs. 315,900
Developers Profit

 Allowance must also be made for developers profit. This is

remuneration for the enterprise of the developer, as the development
operation will be of a fairly speculative nature.
 The developers profit is the return for his expertise and the reward for
the risks he takes, and there is no fixed rule for the calculation of this
figure.
 It is sometimes calculated as a percentage of GDV, sometimes as a
percentage of building costs
 Profit margin may vary due to type of the project, market demand,
availability of competitive projects, location of the subjected project,
risk of the development
 Generally between 15-20 percent is taken as the developer’s profit

 GDV = Rs. 13,842,000

 Developer’s profit @ 15% of GDV = Rs. 2,076,300
 Total net income = Rs. 900,000 p.a
 Capitalize @ 6.25% rate of return = 15.38 Y.P
 GDV (Rs. 900,000 p.a * 15.38) = Rs. 13,842,000
 Less Cost of development
 Building costs = Rs. 3,000,000
 Professional fees = Rs. 360,000
 Site preparation cost = Rs. 75,000
 Interest = Rs. 315,900
 Developer’s profit = Rs. 2,076,300 = (Rs. 5,827,200)
 Residual figure (future value) = Rs. 8,014,800
 Residual figure = Rs. 8,014,800
 P.V. of one rupee in one year at 18% = 0.8475
 Residual figure/Surplus available for land = Rs. 8,014,800 * 0.8475
= Rs. 6,792,543
 A Critique of the Residual Valuation Method

 This method contains many variables which all are based on estimations,
as with estimations, one person’s opinion may differ from another
 In that sense, small changes in variables such as the rent, initial yield,
construction costs, finance rate and building period, etc. will result in a
wider range of answers.
 This variability is the method’s weakness, but it is acceptable as long as
the estimations are done by experts with special knowledge of these
estimations. Reduces any possible errors.
 This issue has been explored a number of times by the Lands Tribunal in
cases as far back as First Garden City Ltd. Vs. Letchworth Garden City
group in 1966.
 The outcome from these cases has been that the residual method
should only be used as a last resort when direct comparison was
not an option.
 When direct comparable projects are rarely for many mixed use
developments or those containing different combinations of
housing tenures or which may simply be unique architectural
designs – this can be applied.
 Although the residual model is logical in it’s approach to the
valuation of undeveloped property, it is open to a high degree of
error,
 The GDV may be incorrectly assessed.
 Building costs or costs of short-term finance may be affected by
external events, whilst any delay in the development schedule
(due to complications in obtaining planning permission,
interruptions due to weather conditions, or an unsuccessful
marketing campaign) is likely to have serious financial
implications, especially where the cost of short-term finance is
high.
 Although the residual valuation can be expressed in a form of a
simple equation, difficulties may arise in accurately estimating the
component parts of the equation
 Accuracy relies on good application of techniques and the
knowledge and experience of the valuer.
The Profit Method
 This method is used to estimate the Rental Value

 For certain properties with the element of Monopoly (due to

unique location, legal status, or planning permission)

 e.g.: properties that require license to carry out business

such as cinema hall, meat stall, petrol filling station, a
racecourse, amusement park

 used to value business where accounts are available and

the comparative method cannot be applied easily due to
lack of satisfactory evidence (comparable). E.g.: theaters,
cinemas, hotels
 Base of this method – the rental value depends on the
earning capacity of a property

 The value to the occupier approach is adopted

 The valuation based on the audited accounts of a business

 The approach based on the economic theory that rental

value of a property is a function of its earning capacity,
productivity of profitability
 The basic assumption of this method – this kind of business
is run by a hypothetical tenant. So, the rental value is
estimated assuming that if a rational tenant run the
business how can the rental value could be derived

 Valuer should clearly identify the receipts and the costs

 The receipts – all the direct and indirect (additional)

income should be taken into consideration
Calculation
 Estimate the gross profit (GP) that can be earned by the
business in the property

 All expenses are deducted from GP (excluding any rent or

loan interest payment on the property)

 The resulting figure is called “Divisible Balance”

 Divisible Balance includes the amount available for

tenant’s share and the landlord’s share

 Deduction of tenant’ share form divisible balance leaves

the surplus for payment to the landlord in the form of
Annual rent
 Divisible balance – tenant share can be considered as
60% of Divisible balance and 40% as share of landlord,
in some cases, this can be 50/50
Simplified Model of Profit Method

 Estimated gross earnings Rs. 220,000

 Less – Purchase of goods Rs. 120,000
 Gross profit Rs. 100,000
 Less – Working expenses (Excluding rent) Rs. 70,000
 Divisible Balance/ Net Profit Rs. 30,000
 Less – Tenant’s share
 Interest on Capital Rs. 5,000
 Remuneration Rs. 15,000 Rs. 20,000
 Rent Payable to Landlord Rs. 10,000 p.a
 The rent derives from accounts, can be capitalized to
arrive at an opinion of open market value

 Capital Value (CV) = Net income P.A * Y.P (assume, rate of

return 6%)

 CV = Rs. 10,000 * 16.67

= Rs. 166,700
Special Note

 The valuer normally examine the last complete set of

accounts produced before the date of valuation with the
preceding three years accounts – aim to determine the
reasonable level of profit that can be expected in future
reflecting past trends and fluctuations

 Determination of profit should be from a tenant of

reasonable competence could make from the occupation
of the property
Contractor’s Method of
Valuation
 Cost Approach

 Apply for properties that are designed and used for special
purposes to meet specific requirements

 Examples – temples, churches, town halls, schools, public

libraries, hospitals, universities

 These cases have no sales in the market and no comparable

 Valuation of Existing use of these properties may be required for

Financial reporting purposes, rating purposes, compulsory

acquisition.
 Economic principle of the Approach

 Buyer will not pay more for an assets than the cost to obtain
an asset of equal utility, whether by purchase or construction

 The price required by a body owning such properties is the cost

of providing equivalent alternative accommodation

 Used to estimate Capital value and Rental value

Equation for Contractor’s method to find the
reinstatement value (Replacement cost method)

 Value of Land and Building = Value of the site, assumed vacant

with demand for next best use (e.g. opportunity cost) + Cost of
the building
Capital Value

 Supposition – no purchaser would pay more for an existing

property than the sum of the cost of building a similar site and
constructing a new building with similar utility and written down to
reflect the physical, functional, environmental and locational
obsolescence of the actual building

 The cost of a new building must be depreciated

 The differences between new building and the subjected
property reflects
 Age (estimate the remaining economic life)
 Comparative efficiency
 Functionality

 Running cost
 This approach is also called Depreciated Replacement Cost Method (DRC
Method)

 Value Estimate (VE) equals the Land Value (LV) plus the replacement cost
of the new building (RC) minus the amount of depreciation (d)

 VE = LV + RC – d

 LV = estimate by means of the sales comparison approach

 RC = estimate by multiplying the number of square feet of the building
by the replacement cost per square foot
d = the loss of value of the subject when compared to a new property
Depreciation

 Three types of depreciations

 Physical deterioration
 Functional obsolescence
 Economic obsolescence

 These three types of obsolescence may be difficult to isolate –

overlaps and coalesce

 Need careful consideration without double count

 Physical deterioration
 wear and tear over the years, which may be combined
with a lack of maintenance.
 Functional obsolescence - the design or specification of the
asset no longer fulfils the function for which it was originally
designed.

 An example - a building that was designed with specific

features to accommodate a process that is no longer carried
out. the asset is no longer fit for purpose.

 In other cases the asset will still be capable of use, but at a

lower level of efficiency than the modern equivalent, or may be
capable of modification to bring it up to a current specification.
 The depreciation adjustment will reflect either the cost of
upgrading or, if this is not possible, the financial consequences
of the reduced efficiency compared with the modern
equivalent.

 Advances in technology - A machine may be capable of

replacement with a smaller, cheaper equivalent that provides a
similar output, or a modern building may be more efficient
because of superior insulation and modern services.
 Another example - legislative change. In the industrial sector an
existing plant may be incapable of meeting current
environmental regulations, or in some cases the product it was
built to produce is now illegal.

 In the service sector, the need for occupiers to comply with

current regulations on health and safety or disabled access
may also give rise to differing degrees of functional
obsolescence.
 Examples of economic obsolescence is where over-capacity in
a particular market reduces the demand and therefore value
for the actual asset, regardless of how modern or efficient it may
be.

 In the industrial sector, falling commodity prices have seen

periods when excess market capacity has made the production
of commodities such as oil or steel uneconomic. During such
periods, this would have had a significant impact on the
demand, and therefore on the value, of specialised facilities
used to produce these products.
Calculation of Depreciation
 Three methods of depreciation calculation
 Straight line depreciation
 Reducing balance
 S-curve approach
 Straight line depreciation
 Most commonly used method
 Same amount is depreciated for each year of the asset’s life
 Thismethod assumes – assets depreciate at a constant rate from
the new to the end of its life
 The average annual percentage rate of depreciation = 100/
total life (building or machine)
 Example –

10 years old building with an estimated 30 remaining years of life,

the average annual percentage rate of depreciation is,
100/ 40 = 2.5%

Applying this rate to 10 year old building, gives accumulated

depreciation of
2.5% @ 10 years = 25%
 The weakness of this method is

 the very simplistic assumption of the uniform erosion of the asset’s

value over its total life, compared with the equivalent
replacement asset.

 The assumption is clearly correct at two points in the life – the

beginning and the end – but it would be entirely fortuitous if it
were correct at any intermediate point, which is when a valuation
is most likely to take place. However, this effect may be mitigated
by frequent valuations.
Reducing balance
 Assumes a constant percentage rate of depreciation from the
reducing base.
 more depreciation is at the beginning of an asset's lifetime and
less is charged towards the end
Example -

Year Depreciation Depreciated value Value at the end of the

year
1 10,000 * 20% 2,000 8,000
2 8,000 * 20% 1,600 6,400
3 6,400 * 20% 1,280 5,120
S-curve approach

 This considers as most realistic method

 Assume – assets depreciate slowly in the early years of the

asset’s life, then depreciate faster in the middle years and
depreciation slows down in the latter years

 However, some assets, such as plant, may have a different

depreciation pattern (high at first rather than low).
 It is normally accepted that the S-curve realistically represents
the pattern of depreciation over the life of most assets, the
percentage for any given year will depend on decisions made
as to the rates of depreciation at different times and when these
change.

 In the absence of empirical evidence in support of these inputs,

the exact pattern of the curve may depend on subjective inputs
and may be no more relevant than the other methods
discussed.

 Requires considerable data to create S-curve, if data exists, this

is a best method for depreciation
Example – A public library has to be valued for
financial accounting purposes

VE = LV + RC – d
 Land extent of the public library is 0A-01R-35P and Market value of similar size in the
area is about Rs. 200,000 per perch.

Land value (LV): 75P @ Rs. 200,000 p.p = Rs. 15,000,000

 The building is 20 years old and in good condition, covering a floor area of 5,000 sqft.
the current cost of construction of a similar building in the area is about Rs. 4,000 per
sqft. The economic life of the building can be estimated as 80 years

Replacement cost of new building (RC):

F.A 5000 sqft @ Rs. 4,000 per sqft = Rs. 20,000,000

D = 100 *age of the building
Economic life of building
= 100 * 20
80
= 25%
_____________________________________________________________________________

VE = LV + RC – d
VE = Rs. 15,000,000 + (Rs. 20,000,000 – Rs. 5,000,000)
= Rs. 30,000,000
Contractor's Method of Valuation
(Rental Value)
 Assumed that the property is owned by a hypothetical landlord who
wishes to let it and there is a hypothetical tenant who is willing to pay
rent in order to occupy it.

 Although the parties to this transaction are hypothetical, the property

is real and the valuer’s concern is therefore with the rental value of
the actual property.

 This may be used for properties such as oil refineries, chemical works,
Steelworks, shipbuilding yards, public sector buildings that cannot be
valued by other methods which are rarely let in the market
 This method should be used as the last resort where
comparative, investment and profit methods cannot be
applied

 There are lots of arguments and criticism about the validity and
reliability of this method

 Net rental value = rate percent of the effective capital value

 Generally, 4% of land value, 6% of depreciated cost of
building, 8% of depreciated cost of machinery equals the net
annual rent of a property)
Example – Rental value of a Factory building

 Lets assume, land value of the factory building is Rs. 15,000,000 (use comparative
method)
4% as Net rent of land value = Rs. 15,000,000 * 4% = Rs. 600,000
 Let assume, Depreciated replacement cost of the building as Rs. 12,000,000
6% as net rent of depreciated building value = Rs. 12,000,000 * 6% = Rs. 720,000
 Let assume, depreciated value of the machinery is Rs. 4,000,000
8% as net rent of machines (4,000,000 * 8%) = Rs. 320,000
_______________________________________________________________________________
Total Net Rent (Annual) = Land rent + Building rent + Rent for machines

Total Net Rent (Annual) = Rs. 600,000 + Rs. 675,000 + Rs. 320,000
= Rs. 1,640,000
Total Net Rent (Annual) = Rs. 1,640,000

Add- 20% of gross income for annual out goings (R, R, I, M)

= Rs. 410,000
Annual rent = Rs. 2,050,000
_______________________________________________________________________
Note
Total net rent here = 80% = Rs. 1,640,000
So, Annual rent with 20% outgoings = Rs. 1,640,000/80*100
= Rs. 2,050,000
Reference
 Shapiro, E., Mackmin, D. and Sams, G., 2019. Modern methods of
valuation (11th edition). Taylor & Francis.
 Premathilaka, H M., 2016. Property Valuation principles. Department
of Estate Management and Valuation, University of Sri
Jayewardenepura.
 RICS professional standards and guidance, UK Depreciated
replacement cost method of valuation for financial reporting 1st
edition, November 2018
Thank you…