ODA BULTUM UNIVERSITY

INSTITUTE OF LAND ADMINISTRATION

Department of Land Administration and surveying

PROPERTY VALUATION (LaAd3083)

Handout
UNIT 1: PROPERTY VALUATION

1.1 Introductions

Property valuation is necessary for a number of public and private functions in the sector,
including state disposal of land, compensation for state acquisition, taxation of land, and
determination of the value of collateral assets. Determination of the value of collateral assets is
critical to the health of the financial sector, because overvaluation can create large, hidden
exposures in loan portfolios.

Valuation, in countries where valuation system is sufficiently developed, provides accurate

information for a government to pay just compensation, for individual property sellers and
purchasers to receive and offer reasonable price, for a commercial real estate market, so financial
intermediaries use highly discounted, partial values as security. The lack of robust valuation
standards opens the way for corruption in land acquisition through expropriation for public
purpose, in estimation of property for collateral purpose etc.

In Ethiopia, there are no well-established valuation standards which are used to value land and
attached properties expropriated for different public purposes. Hence, as a land administration
student, this course enables you to grasp important concepts and techniques of valuation in your
future work and career.

The major concern of this unit will, therefore, be to explain:

 An overview of what constitutes of value
 The factors that affect value
 Property and Property Rights

Land, in an economic sense, is defined as the entire material universe outside of people
themselves and the products of people. It includes all natural resources, materials, airways, as
well as the ground

Land and its products have economic value only when they are converted into goods or services
that are useful, desirable, paid for by consumers, and limited in supply.

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Real Estate, Real Property and Personal Property

Real estate: because of its magnitude, plays a key role in shaping the economic condition of
individuals, families, and firms. It can substantially influence a family’s ability to finance its
education, health care, and other important needs. Changes in the value of real estate can
dramatically affect the wealth of business and their capacity to grow.

Similarly, real estate resources can greatly affect a community’s ability to attract and support
profitable business activities, as well as to provide secure, convenient, and affordable living
environments for its citizens. The adequacy of the housing stock, as well as the public
infrastructure, including roads, bridges, dams, airports, schools, and parks, all affect the quality of
life in a region.

The legal definition of real estate includes the following tangible components. Land is

 All things that are a natural part of land, such as trees and minerals
 All things that are attached to land by people, such as buildings and site improvements.
 In addition, all permanent building attachments (for example, electric wiring, and heating
systems) as well as built –in items (such as cabinets and elevators) are usually considered
part of the real estate. Real estate includes all attachments, both above and below the
ground.

Real Property: includes all interests, benefits, and rights inherent in the ownership of physical
real estate. A right or interest in real estate is also referred to as an estate. Specifically, an estate
in land is the degree, nature, or extent of interest that a person has in it. The total range of
ownership interests in real property is called the bundle of rights. Imagine a bundle of sticks
where each “”stick” represents a distinct and separate right or interest.

The value of a real estate bundle of rights is a function of the property’s physical, locational, and
legal characteristics. The physical characteristics include the age, size, design, and construction
quality of the structure, as well as the size, shape and other natural features of the land. For
residential property, the locational characteristics include convenience and access to place of
employment, schools, shopping, health care facilities and other places important to households.

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 The locational characteristics of commercial properties may involve visibility, access to
customers, suppliers, and employees or the availability of reliable data and communications
infrastructure. The physical and location characteristics required to provide valued real estate
services vary by property.

Real estate is the physical land and appurtenances affixed to the land. Real estate
is immobile and tangible..
Real Property: includes all interests, benefits, and rights inherent in the
ownership of physical real estate.

Real estate is property. The term property refers to anything that can be owned, or possessed.
Property can be a tangible asset or an intangible asset. Tangible assets are physical things, such as
automobiles, clothing, land, or buildings. Intangible assets are non-physical and include
contractual rights (example, mortgage and lease agreements) financial claims (example stocks
and bonds), interests, patents or trademarks.

Personal property: It includes movable items of property that are not permanently affixed to real
estate. Personal property is not endowed with the rights of real property ownership. Examples:
furniture and furnishings not built into the structure such as refrigerators and freestanding
shelves, bookshelves and window treatments installed by a tenant that, under specific lease terms,
may be removed at the termination of the lease.

Trade Fixture: Unlike fixtures, which are regarded in law as part of the real estate, trade fixtures
are not real estate endowed with the rights of real property ownership. They are personal property
regardless of how they are affixed. A trade fixture is to be removed by the tenant when the lease
expires unless this right has been surrendered in the lease.

Examples of trade fixtures:

 Restaurant booths
 Gasoline station pumps
 Storage tanks

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  Fitness equipment in a health club etc

Criteria for distinguishing between personal property and fixtures:

 The manner in which the item is affixed: Generally an item is considered personal
property if it can be removed without serious injury to the real estate or to itself. There are
exceptions to this rule.
 The character of the item and its adaptation to the real estate: Items that are specifically
constructed for use in a particular building or installed to carry out the purpose for which
the building was erected are generally considered permanent parts of the building.
 The intention of the party who attached the item: frequently the terms of the lease reveal
whether the item is permanent or is to be removed at some future time.

1.2. Concepts of Value

Distinctions among Price, Cost, and Value

Specific real estate markets are defined on the basis of various attributes:

 Property type
 Location
 Income-producing potential
 Typical investor characteristics
 Typical tenant characteristics

Other attributes recognized by those participating in the exchange of real property. The market
for, single-family residences selling for birr 750000 in a well-defined area and the market for
super market building located near the central business district are examples of specific real
estate market.

Price: the amount a particular purchaser agrees to pay and a particular seller agrees to accept
under the circumstance surrounding their transaction.

Cost: the total money expenditure for an improvement (structure); applies to production, not
exchange (price).

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Value:

1. The monetary worth of a property, good, or service to buyers and sellers at a given time.

2. The present worth of the future benefits that accrue to real property ownership.

1.3. Appraisal Institute Definition

Valuation is the process of estimating the value real property using different methods. In 1993 the
Appraisal institute adopted the following definition of market value.

The most probable price which a specified interest in real property is likely to bring under all the
following conditions:

1) Consumption of a sale occurs as of a specified date.

2) An open and competitive market exists for the property interest appraised

3) The buyer and seller are each acting prudently and knowledgeably

4) The price is not affected by under stimulus

5) The buyer and seller are typically motivated

6) Both parties are acting in what they consider their best interest

7) Market efforts were adequate and a reasonable time was allowed for exposure in the open
market

8) The price represents the normal consideration for the property sold, unaffected by special
or creative financing or sales concessions granted by anyone associated with the sale

Use Value

The realities of current real estate practice frequently require appraisers to consider other types of
value in addition to market value. One of these, use value, is a concept based on the productivity
of an economic good.

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Use value is the value a specific property has for a specific use. In estimating use value, the
appraiser focuses on the value the real estate contributes to the enterprise of which it is a part,
without regard to the highest and best use of the property or the monetary amount that might be
realized from its sale. Use value varies depending on the management of the property and
external conditions such as changes in business operations.

For example, a manufacturing plant designed around a particular assembly process may have one
use value before a major change in assembly technology and another use value afterward.

Real property may have a use value and a market value.

Investment Value

While use value focuses on the specific use of a property, investment value represents the value
of a specific property to a particular investor. Investment value is the value of a property to a
particular investor based on those people (or entity’s) investment requirements. In contrast to
market value, investment value is value to an individual, not necessarily value in the market
place.

Investment value reflects the subjective relationship between a particular investor and a given
investment. It differs in concept from market value, although investment value and market value
indications sometimes may be similar. If the investor’s requirements are typical of the market,
investment value will be the same as market value. When measured in finance, investment value
is the price an investor would pay for an investment in light of its perceived capacity to satisfy
that individual’s desires, needs, or investment goals. To render an opinion of investment value,
specific investment criteria must be known. Criteria to evaluate a real estate investment are not
necessarily set down by the individual investor; they may be established by an expert on real
estate and investment value, i.e. an appraiser.

Going –concern Value

A going concern is an established and operating business with an indefinite future life. For
certain type properties (e.g., hotels and motels, restaurants, manufacturing enterprises, athletics
clubs, landfills), the physical real estate assets are integral parts of an ongoing business. The

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market value of such a property (including all the tangible and intangible assets of the going
concern, as if sold in aggregate) is commonly called its going-concern value. See the figure
below. Appraisers may be called upon to develop an opinion of the investment value, use value,
or some other type of value of a going concern, but most appraisals of going-concern value relate
to market value.

Traditionally, going-concern value has been defined as the value of a proven property operation.
The emerging definition of the term highlights the assumption that the business enterprise is
expected to continue operating well in to the future; in contrast, liquidation value assumes that
the enterprise will cease operations. Going-concern value includes the incremental value
associated with the business concern, which is distinct from the value of the real property. The
value of the going concern includes an intangible enhancement of the value of the operating
business enterprise, which is produced by the assemblage o the land, buildings, labor, equipment,
and the marketing operation. This assemblage creates an economically viable business that is
expected to continue. The value of the going-concern refers to the total value of the property,
including both the real property and the intangible personal property attributed to business
enterprise value.

Assessed Value

Assessed value applies in ad valorem taxation and refers to the value of a property according to
the tax rolls. Assessed value may not conform to market value, but it is usually calculated in
relation to a market value base.

1.4. Types of Real Property

 Fee Simple Estate: all interests, benefits, and rights inherent in the ownership
 Leased Fee Estate: an ownership interest held by a landlord
 Leasehold Estate: an ownership interest held by the lessee
 Life Estate: Total rights of use, occupancy and control limited to the lifetime of a
designated party.
 Easement: A conveyance of use, but not ownership

1.5. Factors that affect Value

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 Utility: ability of a product to satisfy a human want, need or desire

 Scarcity: supply relative to demand

 Desire: wish to satisfy a human need

 Effective Purchasing Power: ability of an individual or group to purchase

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 UNIT 2: THE VALUATION PROCESS

Under this section you will learn about the meaning of valuation process, the approaches to value,
and definition of the Appraisal problem. In addition to this you will also be introduced about
intended use of the Appraisal, Identification of the characteristics of the property, Data collection
and property description, Final Reconciliation of value indications and Report of defined value.

Definition:

 The valuation process is a systematic set of procedures an appraiser follows to provide

answers to a client’s questions about real property value.
 Process has many uses
 provides a framework for estimating market value (or other types of value)
 provides a model for performing
 market research
 analysis of data
 applying appraisal techniques

 provides a checklist for appraisers and users of appraisal services

 complies with the Uniform Standards of Professional Appraisal Practice

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 The Valuation Process

Definition of the Problem

Identification Identification Use of Definition of Date of Description Other
of real estate of property appraisal Value value of scope of limiting
rights to be estimate appraisal conditions
valued
Preliminary Analysis and Data Selection and Collection
General Specific Competitive Supply and Demand
Region, City, Neighborhood Subject and Comparables The Subject Market

Highest and Best Use Analysis

Land as though vacant Property as improved

Land Value Estimate

Application of the Three Approaches

Cost Sales Comparison Income Capitalization

Reconciliation of Value Indications and Final Value Estimate

Report of Defined Value

Basically valuation process has seven steps. Theses are

1. Definition of the Problem: The first step in the valuation process is the development of a
clear statement of the appraisal problem. This sets the limits of the appraisal and eliminates
any ambiguity about the nature of the assignment. under this stage the following activites are
done.
 Identification of client
 Intended (proposed ) users
 Intended use of appraisal
 Purpose of appraisal (including definition of value)
 Date of opinion (estimation ) of value

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  Identification of characteristics of property (including location and property rights to be
valued
 Extraordinary assumptions
 Hypothetical conditions Two dates for each report: date of the opinion and date of the
repor
2. . Preliminary Analysis and Data Selection and Collection

a. Plan the Work Schedule

b. Selection and Collection of Data

i. General Data

1. Economic, Governmental and Environmental forces

ii. Specific Data

1. Subject property: Land and Improvements

2. Comparable Data:

a. Land & Improved Sales

b. Rental and Capitalization Rate Data

c. Competitive Supply and Demand Data

i. Identification of the subject’s market

1. Geographic, Property Type and category

2. Potential Users, Potential Buyers

3. Highest and Best Use Analysis

 It is the reasonable and profitable use that will support the highest land value as of the
date of value.”
 Criteria of highest and best use

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  Legal Use
 Physically Possible
 Financially Feasible
 Maximally Productive
4. Estimate land value
 The five primary methods used by appraisers for land values are:
 Sales Comparison, Allocation, Extraction, Land Rent Capitalization, Land Residual and
Subdivision Development. We will see each method in chapter three of this course.
 Some Physical factors that affect land value is Size, Shape, Width, Depth, Type of Lot
and Topography
 Some legal factors that affect the values of land are Legal Entity, Zoning Environment
like Protection, Laws rules and regulations, Use Restrictions Utilities & Municipal
Services and Level of Taxes

• Some the propose land value estimation are

 Sale and Purchas (transaction )

 Financing and insurance

 Land Leasing

 Government Actions like expropriation

 Agriculture

 Court Actions
5. Application of the three approaches: using this three methods we can estimate the value of
the property.

There are three conventional approaches for estimating the value of real estate: the cost approach,
the sales comparison approach, and the income capitalization approach.

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 1. In the cost approach, value is estimated as the current cost of reproducing or replacing the
improvements (including an appropriate entrepreneurial incentive or profit) minus the
loss in value from depreciation plus land or site value.

2. In the Sales comparison approach; value is indicated by recent sales of comparable

properties in the market.

3. In the income capitalization approach, value is indicated by a property’s earning power,

based on the capitalization of income. The income capitalization approach is the
dominant approach when estimating the value of any income producing type of property.
It assumes a property’s value is determined solely by its expected future cash flows.
Thus, the income approach is les appropriate as the value of a property depends more on
non monetary (or partially monetary) future benefits as with owner-occupied homes,
public auditoriums, or public arenas, or public marinas.

6. Reconciliation of Value Indications and Final Estimate of Value

– Result in 3 different value indications

– Which one is right?

– Appraiser needs 1 value estimate

• All Approaches to Value:

– Consider market information

– Rely on judgement and careful analysis

– Simulate market participant behavior

– Result in a slightly different answer because market information is not perfect and
our ability to analyze it is not perfect

7. Report of Defined Value

 Uniform Standards of Professional Appraisal Practice

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  Three Types of Report Formats
o Self-Contained.
o Summary.
o Restricted
 Supplemental Standards
o Code of Professional Ethics & Standards of Professional Appraisal Practice of the
Appraisal Institute

Intended use of the appraisal: the manner in which a client will employ the information
contained in an appraisal report.
Definition of Value: A written statement specifying the type of value to be estimated; must
be included in every appraisal report..
Date of the opinion of value: The date for which an opinion of value is valid. The sale of a
property may be negotiated months or even years before the closing or final disposition of the
property. In this case, an adjustment for changes in market conditions between the date the
contract is signed and the effective date of value may be appropriate.

Divided interest: An interest in part of a whole property, e.g., a lessee's interest

Undivided interest: Fractional interest without physical division into shares.

Public Restrictions on ownership

In countries where properties are privatized, Private ownership of real property rights is
guaranteed by the Constitution but is subject to certain restrictions.

. The four restrictions laid by the power of the government on private property are:
1. Taxation
2. Eminent domain
3. Police power
4. Escheat

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Taxation is the right of government to raise revenue through assessments on goods, products, and
rights. The Constitution effectively precludes the federal government from taxing real property
directly; the right to tax property is reserved for state and local governments.

Eminent domain is the right of government to take private property for public use upon the
payment of just compensation. This right can be exercised by a government agency or by entity
acting under governmental authority such as a city municipality, woreda district, etc.
Condemnation is the act or process of enforcing the right of eminent domain-i.e., the taking of
private property for public use,

Police power is the right of government through which property is regulated to protect public
safety, health, morals, and general welfare. Advanced countries use restrictions on building
codes, air and land traffic regulations, health codes, and environmental regulations are based on
police power.

Escheat is the right of government that gives the state or a local government (e.g., township or
municipality) titular ownership of a property when its owner dies without a will or any statutory
heirs

Taxation: The right of government to raise revenue through assessments on

.
valuable goods, products, and rights
Eminent domain: The right of government to take private property for public
use upon the payment of just compensation. The Fifth Amendment of the U.S.
Constitution, also known as the takings clause, guarantees payment of just
compensation upon appropriation of private property.
Police power: The right of government through which property is regulated to
protect public safety, health, morals, and general welfare.
Escheat: The right of government that gives the state titular ownership of a
property when its owner dies without a will or any ascertainable heirs.

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 Leased fee: An ownership interest held by a landlord with the rights of use and
occupancy transferred by the lease to others. The rights of the lessor (the leased fee
owner) and the lessee are specified by contract terms contained within the lease.
Leasehold: The interest held by the lessee (the tenant or renter) through a lease
transferring the rights of use and occupancy for a stated term under certain conditions.
Market rent: The rental income that a property would probably command in the open
market; indicated by the current rents that are either paid or asked for comparable space
as of the date of the appraisal.
Contract rent: The actual rental income specified in a lease.

UNIT SUMMARY

Land, in an economic sense, is defined as the entire material universe outside of people
themselves and the products of people. It includes all natural resources, materials, airways, as
well as the ground. All air, soil, minerals and water is included in the definition of land.
Everything that is freely supplied by nature, and not made by man, is categorized as land.

Real estate is the physical land and appurtenances affixed to the land. Real estate is immobile and
tangible. The legal definition of real estate includes the following tangible components:

 Land

 All things that are a natural part of land, such as trees and minerals

 All things that are attached to land by people, such as buildings and site improvements.

In addition, all permanent building attachments (for example, electric wiring, and heating
systems) as well as built –in items (such as cabinets and elevators) are usually considered part of
the real estate. Real estate includes all attachments, both above and below the ground.

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Real Property: includes all interests, benefits, and rights inherent in the ownership of physical
real estate. A right or interest in real estate is also referred to as an estate. Specifically, an estate
in land is the degree, nature, or extent of interest that a person has in it. The total range of
ownership interests in real property is called the bundle of rights. Imagine a bundle of sticks
where each “”stick” represents a distinct and separate right or interest.

Personal Property: It includes movable items of property that are not permanently affixed to real
estate. Personal property is not endowed with the rights of real property ownership. Examples:
furniture and furnishings not built into the structure such as refrigerators and freestanding
shelves, bookshelves and window treatments installed by a tenant that, under specific lease terms,
may be removed at the termination of the lease.

The valuation process begins when the appraiser agrees to take an assignment and ends when the
conclusions of the appraisal are reported to the client. Each property is unique, and opinions of
many different types of value can be developed for a single property. The most common
appraisal assignment is performed to render an opinion of market value. The valuation process
contains all the steps appropriate to this type of assignment.

The valuation process is accomplished through specific steps. The number of steps followed
depends on the nature of the appraisal assignment and the available data. Research begins after
the appraisal problem has been defined and the scope of work required to solve the problem has
been identified. The analysis of data relevant to the problem starts with an investigation of trends
observed at the market level international, national, regional, or neighborhood. This examination
helps the appraiser understand the interrelation ships among the principles, forces, and factors
that affect real property value in the specific market area.

Real property ownership involves not only the identification and valuation of a variety of
different rights but also the analysis of the many limitations on those rights and the effect that the
limitations have on value. Some limitations on ownership, such as eminent domain, are public
while others such as deed restrictions are private. Holding a form of ownership in real property
equates to having an interest in that real property.

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UNIT 3: METHODS OF SITE VALUATION

3.1.Methods of site valuation

The following five basic methods were used to determine the value of a given site. These are:

1. Sales Comparison

2. Allocation

3. Extraction

4. Land Rent Capitalization

5. Land Residual method

Site is valued as though vacant and ready for its legal optimum, of highest and best, use.
Appraisal techniques, numbers and formulas may be used to provide a foundation for judgment;
but never a substitute for judgment. The market decides how much a site is worth or market
value; “The market talks and the appraiser listens!”

1. Sales Comparison Approach

• Based on idea that value is indicated by actual sales prices of similar sites.

• Accomplished by comparing the appraised site to other similar, competitive, comparable

sites which have recently sold.

• Comparison adjustments are made to the price for differences;

– positive (+) when subject is superior

– negative (-) when subject is inferior

2. Allocation (%)
 Used to establish land value when the numbers of vacant land sales recently is
inadequate.

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  Investigate market standard ratio; what % that site represents of the total price
 Example: from the market typically find:

o Total Property 100%

o less (-) improvements 80%

o equal (=) site 20%

 Then apply the site % to the total property values typical of subject type and location to
find estimated contribution of the site.

3. Extraction

Extraction is a technique in which land value is extracted from the sale price of an improved
property by deducting the value contribution of the improvements, estimated at their depreciated.

Land value = total price – depreciated value of the improvement

Example, assume an appraiser is estimating the value of the land under an aging, deteriorated
automobile service garage that was recently sold for Birr 575,000. No vacant lots have been sold
in the market area recently. The appraiser estimates the cost of the improvement at Birr 200,000
and its total depreciation at 80%, estimate land value using extraction method.

• Depreciated cost of the improvement= 200,000*0.08 = 40,000.

Land value = 575,000 - 40,000 = 535,000 by the extraction technique

4. Land Rent Capitalization

• Used when a property is producing fair market income under a ‘land lease’ and a market
capitalization rate can be derived from the market (sales of land leased at time of sale)

• Land value = NOI / capitalization rate

• Example: subject is under land lease with fair market rent:

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 – Annual Income to owner after all expenses (such as insurance and real property
tax): $10,000

NOI

– Capitalization Rate (RL) from market: 10%

– Indicated Land Value = I/R or: $10,000  0.10 = $100,000

5. Land Residual

Used when a total property total market net income is known or estimated, and land and building
capitalization rates may be found in the market.

Land value = land residual (NOI – total income to building ) / total market return

For example: if we find a 2% recapture, or “return of” rate and 8% “return on” investment in the
market, and …

Net Operating Income: $100,000

Less income to the Building: 35,000

Residual to the land: $ 65,000

Land Value: (V=I/RL); $65,000  0.08 = $812,500

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 UNIT 3 THE SALES COMPARISON APPROACHES.

Seal comparison approaches is a valuation technique in which the value of the subject property is
determined by comparing the properties recently sold in the market to the subject property. In
this approach it is assumed that the subject property will be sold for an amount similar to the
adjusted price of the comparable properties. The sales comparison approach is preferable to
determine the value opinion of the subject property provided that there are sufficient recent and
reliable market data on properties that are similar to the subject. The appraiser should have
recently sold sales data of comparable since change in market situations may degrade the validity
and applicability of older data. It is the easiest approach of estimating the value indication when
market data is available. It is required, in using this approach, to know the subject property, the
neighborhood, city and the region where the property is located. It is not advisable to use sales
comparison approach when there is shortage of market data on comparable. In addition to these,
it cannot be applicable for estimating the value of special purpose properties such as museum
since it is difficult to get market data on comparable. Rather the cost method is preferable for
estimating the value opinion of such properties as you studied in the previous unit.

In this approach the appraiser has to verify the market date obtained and fully understand the
behavioral characteristic of buyers and sellers involved in property transaction. It is also
mandatory for the appraiser to recognize and investigate the strength and weakness of the data
compiled and the degree at which comparative analysis has been carried out in the sales
comparison. Prior sales or listings of the subject or the comparable sales used in an appraisal
may help to validate the current data. For instance, if an appraiser finds a comparable sale that
was reportedly sold for 500,000 birr this year but a historical research shows that the same
property was sold last year for only 250,000 birr, he/she ought to spend his/her time in
investigating the probable causes a 100% increase in sale price of the property in one year
difference. In most markets, if a property sold for 500,000 birr this year, 480,000 birr before one
year, and 250,000 birr before four years, property valuation experts would have little fear that the
current data was reported incorrectly.

An appraiser uses sales comparison approach when there is

 Availability of accurate and complete data on comparable

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  Recent sales

 Similarity of comparable

 Stability of local market conditions, regional and nation economic factors

1. Principles in Sales Comparison Approach

Supply and demand

The price of real estate is determined by the interaction of market demand and market supply of
real estate assuming that there are many buyers and sellers that act for maximizing their interest.
The demand for a property can be estimated considering the number of potential buyers of a
property, their purchasing power, taste and preferences since these factors affect the demand for
a property. Similarly, an appraiser may consider the existence of vacant properties as well as
properties that are being constructed, converted or planned to be constructed in order to
determine the supply of a property in the market.

The price of a subject property and comparable properties may be changed if there are changes in
factors that affect demand and supply of properties. In addition to these, the activities of lenders
also affect the prices of a property as several property buyers are financed by borrowing from
banks. A decrease in bank interest rate makes the market active and thus price of properties will
be increased.

Substitution

The sales comparison approach is based on the economic concept of substitution that a
knowledgeable and prudent person would not pay more for a property than the cost of acquiring
an equally satisfactory substitute. This implies that, within a suitable time frame, the values of
properties that are considered to be close substitutes in terms of location, utility and desirability
will tend to be similar, and the lowest price of the best alternative tends to establish market
value. In this approach buyers compare a number of competitive listings and choose the one that
they like best based on the list prices and features. Sellers usually determine their price according
to the observation that they have on what buyers have paid for similar property in recent sales.

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This principle indicates the situation that the reliability of sales comparison approach shall be
degraded unless there are substitute properties for the subject in the market.

Balance

It is clear that market price of a property is determined by the interaction of market demand and
market supply of a property in market economy. The market achieves its equilibrium at this point
(point of intersection). Shift in any of the factors that affect market demand (for instance
population, purchasing power, consumer taste) or factors which determine market supply (like
construction of new buildings) of a property definitely disturbs this equilibrium.

In addition to this, the relationship between land and improvements and relationship between the
property and the environment has to be in balance so that the value of the property can indicate
the optimum market value.

Externalities

As it is known, there are several external factors that affect the value of the property. Some
factors affect value of the property negatively and others may affect it positively. It is clear that
the value of a property may vary depending on the condition and lighting of the street, the
availability of transportation facilities, the adequacy of police protection, the enforcement of
municipal regulations, and the proximity to shopping and restaurant facilities. For example, a
property near to the drug addicted area has less value than those far from it and a property which
is located near to a lake side with nice view has higher value.

2. Procedure for Sales Comparison Approach

1. Research the market for information on sales and listings: - It is the first step of sales
comparison approach. In this step an appraiser ought to gather data on:
 Sales
 Contract
 Offers to purchase
 Listing of comparable properties

23
The data collected from completed transaction and conducted at arm’s length are considered as
the most reliable source of value indicator as conclusions must be market driven. Initially,
appraisers research the prices, real property rights conveyed, financing terms, motivations of
buyers and sellers, dates of the property transaction, and costs incurred immediately after
purchase. Next to this, an appraiser should observe each properties location, physical and
functional condition, economic characteristics, use and non-reality components of value.
Appraisers can obtain these data from different sources such as
 Buyers and seller of real property
 Brokers
 Public records
 Professional data companies
 Other appraisers
 Real estate periodicals

2. Select relevant units of comparison

Appraisers commence systematic analysis of estimating the value of the property after collecting
and verifying sales data. The units that will be compared must be similar. Therefore, each sales
price should be stated in relevant units of comparison. Units (elements) of comparison are used
to facilitate comparison of the subject property with the comparable properties. Units of
comparison are generally specific to a particular market. For instance, the price per square foot
of gross building area including land is the relevant unit of comparison in some markets. In other
markets, the price per square foot of net building area may be considered as a unit of
comparison. Units of comparison may be:

 Physical units of comparison such as price per square meter of gross building area and
pries per square meter of net building area

 Income units of competition such as potential gross income multiplier (PGIM), effective
gross income multiplier (EGIM) and net income multiplier (NIM).

Therefore, an appraiser should select appropriate unit of comparison to reach at good value
opinion of the subject property.

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3. Analyzing and adjusting comparable sales

In this step an appraiser should observe the difference between the comparable sales properties
and the subject property using the elements of comparison and then adjust the sales price of each
property to reflect how it differs from the subject property and to provide an indication of value
for the subject property. Adjustment can be made either to total property price or to appropriate
unit of comparison. Adjustments for property rights conveyed, financing condition of sales, date
of sale, and expenditures made immediately after purchase are usually made to the total sales
price. The adjusted price is then converted in to a unit price and adjusted to other elements of
comparison. The following are the basic elements of comparison that appraisers should consider
in estimating the value of a subject property using the sales comparison approach.
 Real property right conveyed
 Financing terms
 Conditions of sale
 Expenditures made immediately after purchase
 Market conditions
 Location
 Physical characteristics
 Economic characteristics
 use (zoning)
 Non-realty components of value such as furniture’s and fixtures those are typical of
presently.

4. Reconciliation of Value Indications in Sales Comparison Approach

Reconciliation is the last step of valuation in sales comparison approach when there is two or
more value opinions estimated from market data. These different value estimates are reconciled
into range of values or a single value estimate referred to as point estimate. In doing this,
appraisers have to consider the strength and weakness of each value indication estimated,
observe the reliability and appropriateness of the market data compiled and the analytical
techniques used. In sales comparison approach, reconciliation may involve two levels of
analysis. The first level of analysis includes the derivation of value indication from the adjusted

25
price of two or more comparable properties expressed in terms of a single unit of comparison. A
second level of analysis is needed when an appraiser defines two or more value estimates of the
subject property expressed in different unit of comparison. For example, value opinion estimated
based on the area method and assessment value method must be reconciled into arrange of value
of a single value indication for the sales comparison approach.

3. Selection of Comparable Sales

Every property has its own unique feature that makes it different from others. As a result, it may
be difficult to get a recently sold property that is completely comparable to the subject property.
Thus, an appraiser should collect data that are as similar as possible to the subject in time of sale,
location and other essential characteristics.

There is no specific number of comparable that is considered to be right for every appraisal. The
number depends on the comparability of the sales to the subject property. Three comparable
properties may suffice for estimating the value opinion of the subject property if they are

 very similar to the subject property

 located nearby the subject property and

 very recently sold

However, large number of comparable is deemed to be necessary when the sales are assumed to
be less comparable or the appraiser has less confidence in the reliability of the information
obtained about the sales.

The sales price of a property has to fulfill three different conditions to be taken as appropriate
comparable. These are:

 Competitive property

 Open market transaction

 Recent in time of sale

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Competitive property

A property sold before and considered as comparable should be a reasonable substitute for a
potential buyer looking at the subject property. A competitive property has to be located in the
area where the potential purchaser needs to buy a property. It should be similar to the subject
property in size, shape and other features to satisfy the need of the purchaser. A competitive
property should request the same group of buyers. In economics, this group of buyers is called
submarkets. The features such as family size, age, and economic status can be used to recognize
the different submarkets in the case of residential property. Each group of buyers has its own
need of housing. The housing need of a household with large family size is quite different from
that of with small family size. Thus, two bed room houses would not usually qualify as
appropriate comparable for a four bed room house in determining the value opinion of the
subject property.

Open market transaction

The second condition that the sale has to fulfill to be taken as comparable is that the sale must be
an open market transaction. This means the transaction must be arm’s length. Otherwise, it
cannot be qualified as comparable. A seller should have the possibility of exposing to several
potential buyers to have a market determined price. An appraiser, therefore, has to consider the
unusual conditions, which could distort the market price of a property, in testing whether the
sales have been undertaken in an open market transaction. An appraiser must avoid a sales price
of a property which not arm’s length transaction. If the sale is deemed to be so beneficial in
estimating the value opinion of the subject, an appraiser has to carefully scrutinize the
transaction and make interview the participated in the transaction.

Recent in time of sale

The third condition that a sale has to fulfill to be considered as comparable is that the property
must be sold recently. In property appraisal, the date of sale refers to the date on which the
parties were committed to the contract. The most recently sold property is preferred to be more
comparable than the previously sold one. As it has been discussed previously, supply and
demand of a property can be changed through time due to change in factors which affect them.

27
Thus, this change has to be considered in selecting comparable sales. Suppose that there is
announcement that a major factory would be built in certain area. The sales data of the property
sold in that area before this announcement is unlikely to be taken as comparable for the
estimating the value of a subject property after the announcement. Change in market attitude
may shift the price of a property. The long lasing shortage of gasoline could increase the value of
properties near to public transportation routes. It is necessary to consider the general market
trends (such as inflation or deflation) when selecting the most recent sales as comparables. The
reason is that such trends may affect the sales price of properties even if the local conditions
affect more than the national one.

Analyzing and Adjusting Comparable Sales

It is a rare case that the comparable properties are identical to the subject property, particularly
for nonresidential properties. Thus, the determinants of property value such as location, physical
attributes such as size, layout and configuration, quality and condition of accommodation and
legal factors such as ownership type and lease terms need to be quantified, adjusted and
reconciled in determining the value opinion of the subject property using the sales comparison
approach.

After collecting the sales data of comparable properties, it is possible to undertake adjustments in
several ways. One can apply quantitative and qualitative adjustment techniques to minimize the
differences between the subject property and the comparable properties. These two different
methods can be used separately or in combination. They are complementary to each other.

An appraiser can apply mathematical techniques to make quantitative adjustments. However, it is

necessary to examine the qualitative relationship through direct comparison of market data and
analysis of market trends provided that they cannot obtain enough quantitative data that can
support quantitative adjustment. Adjustment can be made either on total property prices or on
appropriate units of comparison. It is usual that adjustments for

 Property rights conveyed

 Financing terms

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  Conditions of sale

 Date of sale and

 Expenditures made immediately after purchase are applied to the total sales price. And
then the adjusted sales price is changed into a unit price and adjusted for other units of
comparison like location and physical characteristics.

Elements of Comparison

As it has been discussed previously, comparable sales come from the market place. As a result,
these data show not only the value of the property but also the condition of sales transaction. The
critical feature of both the sales transaction and property involved in the sale are called elements
of comparison. Each of the basic elements of comparison must be analyzed to determine whether
an adjustment is required. If sufficient information is available, a quantitative adjustment can be
made. If there is insufficient support for a quantitative adjustment, the element can be addressed
using qualitative analysis.

The following are the most commonly used elements of comparison.

Real property rights conveyed

Real property rights might be the sole subject of the contract when they are being sold. The
appraiser, therefore, has to initially make sure that the sales price of the comparable property can
be applicable to the property rights that are similar to those being appraised before using the
price of comparable sales in sales comparison analysis. It is necessary to carefully observe and
identify whether they may require certain adjustments before using them as comparables.

Financing terms

It is clear that the terms of the sale can affect the selling price of a property. For instance, a
lender may participate in government sponsored low income home buyer program and grant
below market interest rate loan to buyers. In another case, the purchaser of a comparable
property may have assumed an existing mortgage at a favorable interest rate. In both cases, such
a favorable financing situation may allow buyers to pay a somewhat higher purchase price to get

29
below- market financing. Therefore, a price adjustment ought to be made to indicate the situation
before using the sales price for comparison purpose. Downward adjustment is usually made
when such financing occurs. Below-market rates are sometimes extended to individuals who
have substantial bank accounts and are therefore especially creditworthy. The appraiser needs to
investigate if these arrangements will affect the sale price of the property.

Conversely, interest rates at above-market levels often result in lower sale prices which need
upward adjustment.

Condition of Sale

As it is known, a forced sale or a desperation purchase can cause unequal bargaining power
between buyers and sellers. It is usual that personal relationship may cause a transaction price
lower than the market value of the property, as where a parent sales property to a son or
daughter, one member of a family may sell a property to another at a reduced price, or a buyer
may pay a higher price for a property because it was built by his ancestors. A developer may pay
more than market value for lots needed in a site assemblage because of the plottage value
expected to result from the greater utility of the larger site. A sale may be transacted at a below-
market price if the seller needs cash in a hurry. These situations affect transaction prices. Such
transactions are not considered as arm's-length transactions (that is fairly negotiated transaction).
Thus, an appraiser has to check each comparable sale whether it was an arm’s- length transaction
between buyers and sellers who have relatively on equal position to bargain.

Great care must be given for using non-market conditions of sale as a comparable. The
circumstances of the sale must be thoroughly researched before an adjustment is made, and the
conditions must be properly described in the appraisal. The adjustment task has to be well
supported with reliable data. Otherwise, the sale cannot be taken as comparable and it should be
eliminated from the list of comparables.

Some arm's-length sales may show a typical motivations or sale conditions which is different
from the usual market situation due to

 unusual tax considerations

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  lack of exposure on the open market or

 the complexity of expropriation proceedings

Thus, the condition of sale should be adjusted before using the data of such sales for comparison
purpose.

Expenditures made immediately after purchase

A buyer who has sufficient knowledge concerning a property under consideration usually
includes the expenses that he/she is going to made after purchase in the price of the property
since they will increase costs for the buyer. These expenditures are:

 costs to cure deferred maintenance

 costs to demolish and remove any portion of improvements

 costs to petition for a zoning change

 costs to remediate environmental contamination

Such costs are not actual costs but they are anticipated cost expected by the buyer and the seller.

Market conditions

We have discussed that in sales comparison approach, the comparable sales used in estimating
the value opinion of the subject property are historical data collected from different sources. That
means the transaction may have been taken place yesterday, several months or years ago. It is,
therefore, important to recognize that the general market condition may have changed since the
transaction occurred in using the data to determine the current value estimate of the subject
property. Changes in market condition may be emanated from change in general price level
(inflation or deflation), change in local condition of supply and demand, a change in investors'
perceptions, changes in income tax laws and other economic factors. Market conditions that
change over time needs to be adjusted. Adjustment in the market condition is referred to as time
adjustment. In this case, time is not the cause of the adjustment rather it is a measure of the
adjustment. For instance, if there is appreciation of a property value, it can be the causes of the

31
adjustment and time can be the measure of the adjustment. The adjustment to change in market
condition is usually made in percentage of the previous price and it is applied to the prices after
adjustment is made on property rights, financing terms, condition of sale, and expenditure after
sale.

Location

As you remember in your property market study, the three most important factors that affect
property value are: location, location and location. A location adjustment is required when the
location of the comparable properties is either superior or inferior to the location of the subject
property which is a usual case. Factors such as the condition and quality of the nearby properties,
the availability of utilities and transportation, the proximity to trouble and hazards should be
noted during location analysis. If a location difference is higher for a sale, it cannot be qualified
as comparable in sales comparison approach. Location differences are often the most difficult
elements of comparison since they are difficult to quantitatively measure the buyer’s subjective
impression of the environment. Most comparable properties in the same market area have similar
locational characteristics, but variations may exist within that area of analysis. For example, a
property with a pleasant view of a park has different location advantage than a property located
two blocks away with a less attractive view. The nearest property to the subject is more
preferable for estimating the value opinion of the subject property in comparison method.

Therefore, adjustments for location are needed to minimize the differences of comparable data
with the subject in estimating the value of the subject property using sales comparison approach.

Physical characteristics

This adjustment is usually done to include the difference in sales price which come from the
physical difference in between the subject property and the comparables. It includes differences
in lot size, structure size, desirability of floor plan, architectural style, type of construction,
condition of property, material, presence or absence of various features such as garage, fire
place, swimming pool and etc. Thus, an appraiser has to adjust (upward or downward depending
of the factors considered) for the differences created due to the above factors.

32
Economic characteristics

It incorporates all features of a property which can have a direct effect on its income. It is more
relevant to income generating premises. These features include operating expenses, quality of
management, tenant mix, rent concessions, lease terms, lease expiration dates, renewal options,
and lease provisions such as expense recovery clauses. Therefore, an appraiser has to scrutinize
these characteristics carefully to have proper analysis of the comparables and to come up with
reliable estimate of a final value opinion. Attention must also be given in regard to units of
comparison such as net operating income (NOI) per unit since it reflects a combination various
economic features.

Use

The current use or the highest and best use of a potential comparable sales and the subject
property must be addressed. Two properties located in the same area can be physically similar
but they are used for different purposes need either an adjustment or needs elimination of the
property from the list of comparable. Thus, the appraiser must recognize the difference and
determine if the sale is an appropriate comparable and, if so, whether an adjustment is required.
Suppose an appraiser is valuing the subject property, near the center of the city, used for
residential purpose. However, one of the comparable properties which are a very similar house
is used for office. The value of the subject property depends on its anticipated highest and best
use even if its zoning condition permits it to be used for office purpose. The appraiser cannot use
the office building as comparable property provided that he/she believes the highest and best use
of the subject property is residence. The decision depends on the anticipated use of the subject
property as its highest and best use, not on its historic or current use.

Non-Realty Components of Value

In some cases the sales price of the comparable properties may include the price of personal
properties such as furniture, fixture, equipment, TV and etc. Thus, the price of comparable must
be adjusted for these non-reality components of comparables. The appraiser has to use the
current market prices of these components in the process of adjustment, not either original cost
or today’s replacement cost. If the value of the non-realty component cannot be separated from

33
the value of the property as a whole, the appraiser should make clear that the value indication
using the sales comparison approach reflects both the value of the real estate and the value of the
business operation.

The most common required adjustments are adjustment to:

 real property rights conveyed

 financing terms

 condition of sale

 expenditure made after purchase

 market conditions

 location

 physical characteristics

 economic characteristics

 use

 non-reality component(personal property)

The last topic in this chapter is how to estimate the value of the property using seal comparison
approaches.

To do this we can compute the following example as follow

Example

Suppose that the subject property (fee simple interest) is small commercial building in a small
town is going to be appraised tomorrow. It contains 3,500 sq.ft gross building area and was
constructed 10 years ago. The seller has agreed to provide a special financing package worth
3,100. It is located in competitive market and rented with 27 birr per sq.ft. Vacancy rate of the

34
market in which the subject is located is 3%, and 2% of effective gross income is a reasonable
management expenses. Price of real property has been increasing at about 0.0012% per day. The
current assessed value of the subject property is found to be 775,680.

Information regarding comparable is presented below:

Comparable 1: has 3700 sq.ft of gross building area and sold 4 years ago for 450,450 at
financing term typical of market. It was fully leased for 25 birr per sq.ft of gross building area
when it sold with a lease in place that has 45 months remaining. The market discount rate is
10%. The assessed value of it was 82% of sold price by the time of sale and is assumed to be the
function of market price of property.

Comparable 2: has 3,500 sq.ft of gross building area and sold 5 years ago for 490,000 at 1.7%
favor of financing term. Comparable 2 which is fee simple interest rented with market rate per
sq.ft of gross building area. The vacancy and management expense is similar with the subject
property. The assessed value of it was 87% of sold price by the time of sale and is assumed to be
the function of market price of property. It has air compressor that is five years old and has 10
years life. The current market value of air compressor is 1500 birr. Remember it isn’t found in
Comparable 1 and in Comparable 3 and in subject property

Comparable 3: has 3,400 sq.ft of gross building area and sold 7 years ago for 380,000 for relative
by reducing 2.5% of sold price at financing term typical of market. The property required
deferred improvement which cost 150 birr and increase with market. It was leased for 29 birr per
sq.ft of gross building area when it sold with a lease in place that has 27 months remaining. The
market discount rate is 10%. The assessed value of it was 85% of sold price by the time of sale
and is assumed to be the function of market price of property.

Your task is to show the indicative value of the subject property based on:

1. AREA

2. ASSESSMENT VALUE AND

DIRECT CAPITALIZATION OF SALE COMPARISON APPROACH

35
UNIT 4: COST APPROACH

4.1. Basic concepts of cost approach

Cost approach is the other methods of property valuation. Like the sales comparison and
income capitalization approaches, the cost approach to value is based on comparison.

In the cost approach, the appraiser compares the cost to develop a new property or a
substitute property with the same utility as the subject property.

The estimate of development cost is adjusted for differences in the age, condition, and
utility of the subject property to generate a value indication by the cost approach.

The cost approach reflects market thinking because market participants relate value to
cost.

Buyers tend to judge the value of an existing structure not only by considering the prices
and rents of similar buildings but also by comparing the cost to create new building with
optimal physical condition and functional utility.

Moreover, buyers adjust the prices they are willing to pay by estimating the costs to
bring an existing structure up to the physical condition and functional utility they desire.

This unit provides an outline of the cost approach and explains the fundamental appraisal
concepts that support this approach to value.

The cost approach is based on the principle of substitution. No one would pay more for a
property than the cost of buying land and building a new one. Also, no one would buy or
rent an old building when they could build a new one with more efficient and cost-
effective systems at the same price.

In many situations, the time required to construct a new building will inhibit a buyer from
building a new one when existing improvements are available at slightly higher prices. In
other words, a buyer may pay a premium to buy an existing building if they are in a hurry
or not have the time to dedicate to the construction process

36
Supply and Demand

As you remember in microeconomics shift in supply and demand causes prices to

increase or decrease.

When the demand for real estate increases, the supply will increase in the long run as
new units are added. However, in the short run the: supply will not change and prices will
increase with the higher demand. If too many new units are built to meet the increase in
demand, he supply will outstrip demand and prices will fall.

Contribution

The principle of contribution states that the cost of an improvement must be in

proportion to the value of the site. As an example, consider the following market
activity:

 A residential builder buys a lot in a subdivision for Birr 40,000 and invests the
construction process Birr 200,000 in the improvements. This represents a ratio of
Birr 5 invested in the building to each Birr 1 of investment in the land (land =
17% of the property value).

 A second residential builder pays Birr 40,000 for a vacant lot and invests Birr
180,000. This represents an investment of Birr 4.50 in the building to each Birr 1
paid for the land (land = 18.18% of the property value).

 A third residential builder puts a Birr 200,000 house on a Birr 50,000 site. This
represents a ratio of Birr 4 in the building to each Birr 1 for the land (land = 20%
of the property value).

 A fourth residential builder puts a Birr 175,000 house on a Birr 40,000 lot for a
ratio of Birr 4.38 of building investment for each Birr 1 invested in the land (land
= 18.6% of the property value).

The subject property is a proposed residence and garage (described from blueprints) that
will cost Birr 350,000 on a Birr 40,000 lot. The subject improvements will represent

37
 Birr 8.75 of investment for each Birr 1 of land value (land = 10.26% of the property
value). Most appraisers would consider the subject an over improvement for the land
value, and there will be a substantial loss when the property is resold.

Many appraisers misread this phenomenon and attribute it to a lack of support for the
property from surrounding homes, i.e., an over improvement is a property that is not
supported by the neighborhood or district. The Dictionary of Real Estate Appraisal, 4th
edition, defines over improvement as

An improvement that does not represent the most profitable use for the site on which it is placed
because it is too large or costly and cannot develop the highest possible land value; may be
temporary or permanent. Can be considered a super adequacy and measured accordingly in
estimating depreciation.

In this example, the proposed house is an over improvement because the investment in the
building is out of proportion with the investment in the land.

The optimum ration of land value of building value can and will vary from market to market, so it
is important for appraisers to research the most common ratio in any given market. In one market
land may most often represent 25% of total property value, but in other markets land may
commonly account for 50% of property value. Research into land value-to-property value ratios
will be good information for residential and non-residential appraisers alike. For some property
types such as fast food restaurants, branch banks, and drugstore chains, the percentage ration of
land value-to-total property value will give you an interesting perspective and may lead to more
supportable value conclusions.

Highest and Best Uses

Highest and best use considerations are very important in all three approaches to value, but
problems related to highest and best use can be more significant in the cost approach. In the sales
comparison and income capitalization approaches, losses due to improper improvements on the
site, over improvement, or other highest and best use problems are often reflected in the market
data for comparable properties, but these lessen have to be identified and adjusted for in the cost
approach.

38
For example, if the subject property is a residence with only two bedrooms in a market where a
floor plan with three or four bedrooms is the norm, you may still find two-bedroom comparables
and therefore not have to estimate the amount of the loss when applying the sales comparison
approach. However, in the cost approach, no such market recognitions possible, and the amount
of the loss must be estimated from other sources to make a line item adjustment for functional
obsolescence. Note that depreciation will be discussed in detail in the upcoming unit.

Stabilization

The term Stabilization describes the point at which a property reaches a profitable and sustainable
level of occupancy. When income-produces are much less than 100%. A property that is capable
of 100% occupancy but is at 50% occupancy will be much less valuable to an investor than a
building that is already fully occupied. In other words, a buyer for an empty building will factor
in the cost (Construction, broker fees, debt service, taxes, etc.) to bring the building up to
stabilized occupancy. That cost should be accounted for in the calculation of reproduction cost in
the cost approach.

4.2. Procedures in cost approach

After gathering all relevant information and analyzing data on the market area, site, and
improvement, an appraiser follows a series of steps to derive a value indication by the
cost approach.

1) Estimate the value of the land as though vacant and available to be developed to
its highest and best use

2) Determine which cost basis is most applicable to the assignment: reproductive

cost or replacement cost.

3) Estimating the direct (hard) and the indirect (soft) costs of improvements as of
the effective dates

4) Estimate an appropriate entrepreneurial profit or incentives from analysis of the

market

39
 5) Add estimated direct costs, indirect costs, and entrepreneurial profit or incentive
to arrive at the total cost of improvement

6) Estimate the amount of depreciation in the structure and, if necessary, allocate it

among the three major categories

a. Physical deterioration

b. Functional obsolescence

c. External obsolescence

7) Deduct estimated depreciation from the total cost of the improvements to derive
an estimate of their depreciated cost

8) Estimate the contributory value of any site improvements that have not already
been considered

9) Add land value to the total depreciation cost of all the improvements to arrive as
the indicated value of the property

10) Adjust the indicated value of the property for any personal property (e.g.
furniture, fixture, and equipment) or any intangible asset value that may be
included in the cost estimate.

4.3. Land Value

As indicated in the previous unit, land value is always estimated as if the site were vacant
and available to be put to its highest and best use. This analysis helps appraisers judge
when buildings should be torn down and the site redeveloped. Land valuation is the first
step in the process. It is usually done by sales comparison analysis, but other techniques
can be used.

40
4.4. Cost Estimates

Reproduction and Replacement Cost Estimates

The cost to construct an improvement on the effective date may be developed as the
estimated reproductive cost or replacement cost of the improvements. While estimating a
reproductive cost sounds like an easy thing to do, it can sometimes be impossible. Building
features or components that were available 30 years ago may not be available today, and in
that situation estimating reproduction cost may not be possible. Reproduction cost also
includes any cost for super adequate items such as the plaster walls found in older
buildings where dry wall (gypsum board) is contently used. Plaster walls would be super
adequate because they cost a lot but add no more to value than less expensive drywall.
Reproduction cost would also include the cost of installing old knob-and-tu be wiring if the
subject has it Note that knob-and-tube wiring is prohibited by most current building codes
and therefore cannot actually be reproduced.

A replacement cost estimate does not cure all functional obsolescence nor negate the need
to compensate for it. If the subject has plaster walls, using replacement cost instead of
reproduction cost would remove that issue. However, if a building has a poor floor plan,
estimating replacement cost does not remove the need to calculate the loss due to
functional obsolescence

To develop cost estimates to the total building, appraisers must consider direct and
indirect costs. Both types of costs are essential in a reliable cost estimate.

Direct Costs

Direct costs, which are typically in the builder's contract, include expenses for all typical
materials, labor, fees, and charges. Direct costs are also referred to as hard costs. Most
appraisers have no problem including all these expenses in their cost new estimates.

Indirect Costs

Indirect costs are also incurred in building an improvement, but they are not typically
included in the builder's contract. The owner or developer usually pays these expenses,

41
 which include architectural fees, appraisal fees, insurance during construction, the cost of
changing title, and the cost of marketing the property or leasing the space up initially.
Indirect costs are commonly referred to as soft costs. Appraisers often forget to include
some of these expenses in their cost estimates.

4.5. Depreciation

Depreciation is the difference between what an improvement costs and the value of the
improvement on the effective date of appraisal. Depreciation can be estimated by
comparing the cost new of an improvement and the value of the improvement on a sale
property. When preparing the cost approach, you will need to estimate the total
depreciation that has accrued to the improvement as of the date of appraisal.

Depreciation can be broken down into three types:

 Physical deterioration

 Functional obsolescence

 External obsolescence

It is not really necessary to segregate and label the various types of depreciation if the
data used to estimate depreciation is accurate and similar and it reflects the attitudes of
the typical buyer. However, segregating and labeling the different types of depreciation
can be of considerable benefit in some situations, particularly when one type of depre-
ciation is significant and another is not. It is important for appraisers to speak a common
language so they can identify various types of depreciation and readers of their reports
will understand the jargon.

1. Physical Deterioration

Physical deterioration is the loss in the value of an improvement because of wear and
tear or the passage of time. This type of depreciation is found in all properties with
improvements that are not new. This is not considered obsolescence because that word
implies a problem with the use of an improvement rather than with its condition.

42
 2. Functional Obsolescence

Functional obsolescence is the result of incompatibility with current market

requirements. In other words, this type of depreciation is the loss in value due to a
problem with the utility of certain property improvements. Nearly all improved
properties have some functional obsolescence after a few years.

Changing decorating styles, construction techniques, and standard features are all
sources of functional obsolescence.

3. External Obsolescence

External obsolescence is the loss in the value of the improvements due to outside
sources such as a house that is located next to a busy interstate highway or an office
building next to a contaminated site. The loss in clue due to external forces will usually
also cause the property to have a lower land value, which requires special treatment when
the building and land are segregated in the cost approach. The loss in value to the land
due to an external problem results in just a lower land value. The loss in value to the
improvement from the same cause is called external obsolescence. Only the building
portion of a property can have obsolescence.

5.6 Building Cost Estimate

Dear distance learner, in the previous section we have discussed the cost approach to
valuation. To apply the cost approach to value, an appraiser must prepare an estimate of the
cost of the improvements as of the effective date of appraisal. Such an estimate can be
prepared by an appraiser who understands construction plans, specifications, materials, and
techniques and can access a variety of data sources or computer programs available for this
purpose. Alternatively, the work can be done with the assistance of the expert cost
estimators. In either case, the appraiser is responsible for the result. Existing improvements
should be carefully reviewed and described by all individuals who are delegated to estimate
costs.

Proposed improvements may be valued based on plans and specifications provided the

43
appraiser discloses that the improvements have not yet been built and that their completion
as specified is a hypothetical condition of the appraisal. Residential appraisers are commonly
asked to provide an opinion of prospective value under the hypothetical condition that a
property will be completed as planned. Nonresidential appraisers are also asked to value
property that has not yet been completed, and sometimes two prospective values are called
for: the value at the time of completion and the value at the time stabilized occupancy and
income are achieved.

Cost Data Sources

Construction contracts for buildings similar to the building being appraised provide a
primary source of comparable cost data. Some appraisers maintain comprehensive files of
current cost data, including current costs for completed houses, apartments, hotels, office
buildings, retail buildings, and industrial buildings. These costs can provide a basis for
calculating the cost to construct an existing or proposed building. The cost of new
improvement can be estimated using unit in place method or quantity survey method.

1. Unit-in-Place Method

The unit-in-place method segregates the building into units of construction. This technique
may involve estimating the cost of a wall including all components. Most appraisers do not
use this method to estimate cost because it is too complicated and time-consuming. If a
client asks for this level of detail in a cost analysis, the appraiser will commonly hire a
professional cost estimator.

2. Quantity Survey Method

The quantity survey method is the most detailed way to estimate the cost of
construction. With this technique, appraisers estimate the cost of every component of a
building. This method is used even less than the unit-in-place method because of the
time and cost involved. With the advent of computerized cost estimation, the quantity
survey method may be more feasible than it once was, but appraisers still will not use
it unless it is specifically requested by the client. The quantity survey method is more
commonly used by contractors who bid jobs by distributing blueprints to subcontrac-

44
tors who factor in the small details. General contractors tend to just add up the cost
estimates provided by the subcontractors.

4.6. Depreciation Estimates

Dear colleague, as we have discussed in the previous unit, depreciation estimate is a crucial
element in valuation process. Several methods may be used to estimate depreciation. Each is
acceptable and should result in roughly the same value as long as the appraiser applies the
method consistently and logically. The method used should reflect the reaction of an informed
and prudent buyer to the condition and quality of the property and the market in which the
property is found. The primary goals of depreciation analysis are to identify all forms of
depreciation recognized by the market, to treat all these forms of depreciation, and to charge only
once for each form of depreciation (i.e., to avoid double counting items of depreciation). The
various methods of estimating depreciation may be used in combination to solve specific
problems or each may be applied separately to test the reasonableness of the estimates derived
from other methods.

The three principal methods for estimating depreciation are

 The market extraction method

 The age-life method

 The breakdown method

4.6.1. Methods of Estimating Depreciation

Estimating an appropriate amount for depreciation in the cost approach can be difficult.
There are typically three recognized methods of estimating depreciation:

 Market extraction method

 Age-life method

 Breakdown method

45
Market Extraction Method

The market extraction method is the most direct and probably most accurate method of
estimating depreciation. It does not segregate the depreciation estimate into categories.
Instead it deals only with the total amount of depreciation.

This technique requires appraisers to find improved comparable sales with similar losses
as the subject to ensure that the extracted depreciation rates are applicable to the subject. If
the subject property has a poorly designed floor plan but the comparable properties
analyzed do not have that problem, the depreciation rate extracted from the comparable
sales will not include the loss due to the poor floor plan, and the amount of depreciation
present in the subject will be underestimated.

The market extraction procedure follows five simple steps:

1) Find sales of improved properties that reflect the same losses as the subject. Since
depreciation can have physical, functional, or external causes, the comparable
should reflect improvements of similar quality and age, an equally desirable
location, and similar supply and demand factors. The comparable can be from
outside the subject's market area but should reflect similar losses. If the compa-
rable sales do not suffer from the same losses, adjustments may have to be made to
compensate. For example, if the subject has floor plan problems but the
comparable do not, the extracted depreciation will not be correct without an
adjustment.

2) Make adjustments to the sale prices for property rights conveyed, seller financing
assistance, and conditions of sale. Market condition adjustments are not needed
because the goal is to measure the loss as of a specific date, not from one date to
the next. Making market conditions adjustments will skew the depreciation rates.
If a comparable sale occurred at a poor time in the market cycle but the current
market is much healthier, the extracted depreciation may reflect external losses
that may not be present at a later date. If there are obvious losses in the
comparable that are not present in the subject, adjustments can be made to

46
 calculate an estimate of physical depreciation only.

3) Subtract the value of the land. Because land value is always estimated at its
highest and best use, additional depreciation may be caused by an improper
improvement. If the improvement does not represent the highest and best use of
the land, the extracted amount of depreciation reflects functional obsolescence. If
the improvements suffer from a great deal of functional obsolescence, large
adjustments to the extracted rate would be necessary.

4) Estimate the reproduction or replacement cost of the improvements as of the

effective date of appraisal. If reproduction cost is used as the cost basis in the cost
approach, it must also be used as the basis of the market extraction method and
vice versa.

5) Subtract the calculated value of the building from the estimated reproduction or
replacement cost of the improvements to determine the amount of depreciation.
This amount of depreciation can be converted to a percentage by dividing the
dollar amount of depreciation by the cost new of the structure.

The market extraction method does not segregate the types of depreciation, which means
a property could appear to be in inferior condition when in fact it is suffering depreciation
from other functional or external problems. Many appraisers consider this technique a
way to establish the maximum amount of depreciation-i.e., if overall depreciation is
known, the total of all other forms of depreciation must fit under this ceiling. Other
losses can be estimated and then incorporated into the subject's cost estimate using
paired data analysis and other techniques for estimating depreciation.

Table lists three comparable sales of newly improved properties used to estimate
Depreciation rate.

In most markets, newer improvements will have a lower amount of total depreciation but
a higher annual depreciation rate.

The total economic life can be extracted from this data by dividing the annual

47
Depreciation rate into 1.00 (100%); the percentage of depreciation per year is the
important information gained from this analysis. Calculating total economic life to
estimate depreciation using the age life method is unnecessary if the amount of
depreciation is already known through market extraction. Note that the rate of
depreciation per year is higher for the newer improvement. This would imply that annual
depreciation rates are higher in the early years of an improvement's life and lower as the
improvements get older. This limited amount of data could not give a conclusive answer
but implies this conclusion with this data alone.

To illustrate the process of estimating the depreciation of older improvements, consider

the properties described in the table below. In this market, maintenance levels are high
and owners tend to invest in their properties regularly. The properties in the table are
single-family homes, but the same process works for non-residential properties. The
extracted depreciation rate is often higher for non-residential properties than single-
family homes. Remember that the extraction method includes all forms of depreciation,
and some property types are prone to more or less physical deterioration or functional
obsolescence. The improvements in this case are depreciating at an annual rate of less
than 1 %.

48
Table 4.1 Depreciation of Newer improvements Estimated using sales comparison

Sale 1 Sale 2 Sale 3

Address Kebele 02 CHIRO Kebele 03CHIRO Kebele04CHIRO
Sale price Birr255,000 Birr265,000 Birr275,000
Rights conveyed Birr0 Birr0 Birr0
Seller concessions Birr0 Birr0 Birr0
Conditions of sale Birr0 Birr0 Birr0
Net sale price Birr255,000 Birr265,000 Birr275,000
Estimated land value -Birr50,000 - Birr52,000 - Birr55,000
Site improvement value - Birr5,500 - Birr6,500 - Birr7,500
Depreciated valueof buildings Birr199,500 Birr206,500 Birr212,500
Reproduction cost Birr212,000 Birr225,000 Birr235,000
Less building value -199,500 - Birr206,500 - Birr212,500
Total depreciation Birr12,500 Birr18,500 Birr22,500
Percentage depreciation 5.90% 8.22% 9.57%
Actual age 3 5 6
Percentage depreciation per1.97% 1.64% 1.60%
year

49
Table 4.2 Depreciation of older improvements
Sale 1 Sale 2
Address Kebele 03 CHIRO Kebele02 CHIRO
Sale price Birr355,000 Birr390,000
Rights conveyed Birr0 Birr0
Seller concessions Birr0 Birr0
Conditions of sale Birr0 Birr0
Net sale price Birr355,000 Birr390,000
Estimated land value - Birr65,000 - Birr59,000
Site improvement value - Birr5,500 - Birr6,500
Depreciated value of buildings Birr284,500 Birr324,500
Reproduction cost Birr386,000 Birr430,000
Less building value - Birr284,500 - Birr324,500
Total depreciation Birr101,500 Birr105,500
Percentage depreciation 26.30% 24.53%
Actual age 70 69
Percentage depreciation per year 0.38% 0.36%

Because the depreciation of short-lived items is accelerated in the early years and the
normal replacements occur after the first 10 years, annual depreciation in later years tends
to decrease. For example, in this market single-family homes may depreciate at an
average rate of nearly 2% per year in the first years after completion, but they will de-
preciate at an average rate of less than 1% per year after 40 or 50 years of age. Note that
the percentages of depreciation indicated in older homes are larger than the percentages
for the newer homes shown in the table above, but the annual rates are much lower
because the higher total amount of depreciation is spread over many more years.

The overall depreciation rate can be divided by the age of the improvements to produce a
straight-line estimate of overall depreciation. This does not imply that the depreciation
rate remains fixed over the life of the improvement. In most markets, the annual
depreciation rate diminishes as the improvements get older. At a lower annual
depreciation rate, the total economic life would be much longer, which implies that
mathematically the total economic life increases as the improvements age. This seems
counterintuitive, but the important information in this analysis is the amount of
depreciation, not the economic life. Appraisers do not need to calculate economic life
when they already have the answer to the larger appraisal question, namely, how much
the property has depreciated.

50
The depreciation of an office building can also be estimated using market extraction, as
shown in the table below. The depreciation rate is likely to be location-specific. In one
market, the depreciation may be very high, but a similar building in a better area might
suffer much less depreciation. Owners of property with high rents should have excess
money to invest in replacing worn items, update the condition, and remodel when
needed. If a property does not rent for much, the owners typically cannot afford to or are
unwilling to invest in the same items of repair or remodeling, and the properties will fall
into disrepair and eventually be razed when they no longer contribute any value.

The market extraction method does not segregate the losses by classification, making
adjustments for dissimilar improvements more difficult to gauge accurately. Because the
calculations of overall depreciation are based on estimates of land value and reproduction
or replacement cost, any errors in those analytical steps may often be repeated in the later
analysis. That is, if the appraiser underestimates the Ian d value in the extraction
technique, the same underestimation will commonly appear in the subject's cost approach.

Age-Life Method

The age-life method of estimating depreciation is based on the assumptions that any
improvement has a life span that can be estimated and that depreciation can be estimated
by dividing the age of the improvement by the total length of its life. Actual age is usually
an easily obtained fact, but effective age is an estimate by the appraiser. Effective age is
higher than actual age when the improvements have had poorer-than-average main-
tenance, and it is adjusted below actual age when the improvements have had better-than-
average maintenance. The effective age rating relates more to the condition rating of the
improvement than the actual age.

Age-life techniques for estimating depreciation are best illustrated and applied to building
components rather than to the entire improvement. For example, a to-year-old roof covering
that typically has a useful life of 20 years can be said to have depreciated by 50%. That
depreciation rate could not be applied to the entire property wl1en some components in the

51
building have short lives and others have long lives. The total economic life of roof shingles
can be obtained from a survey of roofing companies who can tell the appraiser how long the
roof shingles last. Some appraisers use the date of demolition of comparable buildings as an
indication of the total economic life of the building, but that logic can be flawed because
buildings are often razed as a result of external factors or economic considerations-e.g., an
improvement is razed to mal e room for a nave' building with another use.

Estimating the economic life of short-lived components is easy, but estimating the
economic life of the entire structure is more difficult and harder to support. The market
extraction method discussed earlier can be used for this purpose. Remember that the total
economic life of an improvement is location-specific, and the rate of depreciation varies
throughout the term. Therefore, extraction of the economic life for one property type in one
market cannot be automatically extended to another property in another market.

 The economic age/life method (also called the straight line method) is the most common
 Depreciation technique employed by residential appraisers. It is easy to use and easy to
 Explain to a client.
 Depreciation is calculated by multiplying the ratio of the effective life to the total
 Economic life by the replacement cost new of the subject. The underlying assumption in
 the economic age/life method is that deterioration occurs at constant average annual rate.
 Percentage Depreciation = Effective Age ÷ Total Economic Life
 Dollar Amount of Depreciation = Effective Age ÷ Total Economic Life x Replacement
 Cost New

 Total Economic Life = Effective age + Remaining Economic Life

Breakdown Method

In the breakdown method, appraisers identify and estimate the different kinds of losses
due to depreciation of the improvements. This technique is limited by the difficulty of
estimating losses to long-lived improvements and external obsolescence, but it is
appropriate and accurate when coupled with the market extraction method.

52
The breakdown method can be used to segregate and label particular types of depreciation
if overall depreciation is known. 0I\ce isolated by extraction, the segregated depreciation
can be applied to 'a property that has similar losses. Working the other way, the
breakdown method can be used to develop an overall estimate of depreciation by estimat-
ing and adding up all the separate forms of depreciation found in a market. This requires
appraisers to identify and measure each form of depreciation for all components of a
building.

Calculating Depreciation in the Breakdown Method

The five methods of calculating depreciation are:

Estimation of the cost to cure the problem: used primarily for functional
obsolescence and physical deterioration.

Application of the estimated age-life ratio: used primarily for physical

deterioration.

Application of the functional obsolescence procedure: used for functional problems

only.

Analysis of market data, usually using paired sales and income capitalization: used
for physical, functional, or external losses.

Capitalization of the income loss: used for physical, functional, or external losses.
Capitalization of income loss applies to property types for which the typical buyer
is primarily concerned with the potential income.

The breakdown method is not widely used because it is laborious and difficult to support
when many calculations are necessary. In most market value appraisals depreciation can
be estimated using the sales comparison (market comparison) or age-life techniques, so
the more time-consuming breakdown method is not popular. Also, it requires appraisers to
know what types of depreciation exist and to measure each one. It is not usually more
accurate despite the extra time and effort involved.

53
 UNIT 5 THE INCOME APPROACHE

5.1.Concepts of income capitalization (income approach)

This unit is composed of four sections. The first section will introduces about principles in
income capitalization approach, applicability and its limitation. The second section will describe
definition of basic terms such as lease, rent, future benefits, operating expenses, rate of return,
and the procedure used in this approach. The third and the forth section will describe direct and
yield capitalization respectively.

The income capitalization approach or the income approach is one of the methods of property
valuation. It is clear that property owners who have income generating property anticipate that
they will receive cash flows from the property in the form of income from rental operations and
price appreciation. The value of the property in this approach is, therefore, a function of the
income stream that is expected to produce. In the income capitalization approach, an appraiser
first estimate the periodic income obtained from the property in the future and the convert the
income forecast in to present value. The process of converting periodic income (by using either
direct capitalization or yield capitalization method) into an indication of a present value is
referred to as income capitalization. This indicates that the principle of anticipation is
fundamental to this approach.

5.2. Appraisal Principles

The principles on which the income capitalization approach is based are described as follows.

Anticipation and Change

This principle states that all income capitalization method, techniques and procedures try to take
anticipation of future benefits to account and estimate their present value. This may involve
either forecasting the anticipated future income or estimating the capitalization rate which
implicitly shows the anticipated pattern of change in income over time. This approach also
considers the effect of change in the factors that affect the value of income generating properties.
In order to get good value estimate of a property, an appraiser has to cautiously consider and
predict the expectation of investors on change in income level, the expenses required to ensure
income and probable increases or decreases in property value. This means, income capitalization

54
approach has to be forwarding thinking. The capitalization process has to reveal the probability
of difference in actual future income, expenses, and property value from those originally
forecasted by an investor on the date of value opinion. If it is difficult to estimate such variables
with less uncertainty, the investment shall be risky. But risky investment can generate higher
return and less risky investment can generate less return. This situation ought to be elaborated in
using discount rate and capitalization rate taken from market research. To summarize, this
principle is fundamental to income capitalization approach.

Supply and Demand

The principles of demand and supply are beneficial in anticipating future benefits and estimating
rates of return in income capitalization approach. Both income and rate of return are determined
in the market. If there are competing properties in the market, the rent charged by one owner
may not be as such different from rents charged by other owners of the competing properties.

According to this principle if demand is greater than supply of a property, property owners will
increases rent of the property. This situation increases occupancy rate and reduces vacancy rate.
This means, most of the properties will be rented out. The value of the property may be increased
until supply fulfils demand. On the other hand, if supply is greater than demand, there will be a
decrease in rent for a property. As a result, occupancy rate shall be decreased and vacancy rate
will be increased. Thus, appraisers should observe demand (both existing and forecasted) and
supply of a property so as to anticipate future income and estimate rate of return.

5.3. Terminologies used in Income Approach

LEASE

Lease is a contract between a property owner (lessor) and a tenant (lessee) that transfers
exclusive use and possession of space to the tenant. During the term of lease the owner possess a
leased fee property with a reversion in the space that allows him or her to repossess a property at
the expiration of the lease period. In other words, lease refers to a written document in which the
rights to use and occupy land or structures are transferred by the owner to another for a specified
period of time in return for a specified rent.

55
A valid and enforceable lease has to contain the following elements:

 The names of the landlord and tenant

 An adequate description of leased property

 An agreement to transfer possession of the property from the landlord to the tenant

 The start and end date of the agreement

 Description of rental payment

 The agreement has to be in written form

 The agreement must be signed by both parties

Lease income is the basis of most real estate valuation using the income capitalization
approach. Thus, an appraiser commences the income capitalization approach through
understanding all existing and proposed leases that shall be applied to the subject property and
thereby he/she can gather information concerning base rent, other income, and the division of
expenses between the landlord and the tenant. An agreement between the lessor and the lessee on
operating expenses has an effect on income of the property. The following agreement can be
made in between the landlord and the tenant regarding payment of expenses. If the agreement is
based on gross lease, the landlord shall pay most or all operating expenses of the property. But if
they agree on a net rental basis, the tenant will pay all expenses. When leases are negotiated on a
modified gross rental basis, the landlord and the tenant shall share the expenses.

Lease is divided into the following categories or types.

 Flat rental lease

 Variable rental lease

 Step-up or step-down rental lease

56
  Revaluation lease

 Percentage lease

Flat Rental Lease

The simplest treatment of rent is to keep it flat for the entire lease term. Flat rental lease
means a lease with a specified level of rent that continues throughout the lease term. It
specifies a level of rent that continues throughout the duration of the lease. For instance, a five
year office lease might specify a fixed rental rate of 100 birr per square meter per year. Flat
rental lease is usual and suitable form of lease in a stable economy. This type of arrangement is
likely to be observed in short term lease. It is also prevalent in net rent situations where changes
in expenses are the responsibility of the tenant. If the economy is not stable it is advisable to
have an agreement that can be adjusted according to the in the market condition.

Variable Rental Lease

A variable rental lease is a type of lease which is relevant to the situation if the owner of the
property predicts that there is change in market rent of the property. In some cases, it may
stipulate a periodic percentage change in rent. In other cases, change in rent might be tied to
change in a regularly reported index, the most common of which is consumer price index. For
example, assume that the rental rate indicated in the above example of five year office lease is
fully indexed to the consumer price index with changes in contract rate annually. If the change in
the general price level was 5 percent during the first year of the lease, the rental payment for year
two would increase to 1051 birr per square meter per year. This rate would remain be fixed for 12
months and in the 3rd year it will be adjusted according to change in the market condition. Future
lease payment is based on change in the consumer price index and is not known in advance.

Graduated Rental Lease

This type of lease put a pre-specified increases or decreases in the amount of rent. For example, a
first five year office lease might be specified as a rental rate of 100 birr per square meter per

57
year, increasing by a 5 birr per square meter each year for the remaining four years of lease. It
can be advantageous to a tenant establishing a business in a new location. These pre-specified
rent increases are referred to as “step-ups”. However, the pre-specified rent decreases are
referred to as “step-downs”. Step-down leases are less common than step-up leases. They are
generally used to reflect unusual circumstances associated with a particular property such as the
likelihood of reduced tenant appeal in the future or capital recapture of interior improvements
during the early years of a long-term lease.

Revaluation Lease

This type of lease may have periodic rent adjustments based on revaluation of market rent under
the prevailing market conditions. Although revaluation leases tend to be long-term, some are
short-term with renewal option rents based on revaluation of market rent when the option is
exercised. When the parties to a lease cannot agree on the value or rent, revaluation through
appraisal or arbitration may be stipulated in the lease.

Percentage Lease

It is common that the lease of shopping centers contain the clause which ties rent payment to the
tenant’s sales revenue. In this case, some or all of the rent charged is based on a specified
percentage of the volume of business, productivity, or use achieved by the tenant. In percentage
there is usually a flat or fixed component referred to as base rent. The tenant shall get a pre-
specified percentage of tenant sales.

5.4. RENT

The income generated by investment properties includes primarily of rent. There are various
types of rent that have an effect on the amount of income that the property will generate. These
are market rent, contract rent, effective rent, excess rent, deficit rent, percentage rent and overage
rent. Let us discuss each of them separately.

Market Rent

Market rent refers to the amount of money that the property would fetch under current market
conditions. It is indicated by the current rents that are either paid or asked for comparable space

58
with the same division of expenses as of the date of the appraisal. Market rent is sometimes
referred to as economic rent. This type of rent ignores the leases.

Contract rent

In our earlier discussion we have discussed about lease. So contract rent is a form of rent that is
stipulated in a lease. In other words, it refers to the actual rental income specified in a lease. It is
the rent agreed on by the landlord and the tenant and may be higher than, less than, or equal to
market rent. For leased properties it represents the potential gross income.

Effective Rent

Effective rent refers to the rental rate net of finical concessions such as free of rent, during the
lease term, may be calculated on discount base, reflecting the time value of money, excessive
tenant improvements, moving allowances, lease buyout, cash allowances, and other leasing
incentives. Effective rent can be calculated based on rental income from existing leases at
contract rates or rental income from leases at market rates. An appraiser has to allow for rent
concessions in effect at the time of the appraisal, discounts, or other benefits that may have
prompted a prospective tenant to enter into a lease.

Example

Suppose the owner of a 1,000 square meter of office building has rented it for 2,000 birr per
month for three years term with level income throughout the lease term. When the lease was
negotiated, the tenant received free rent for the first month of each year as a concession. So how
much are the contract rent and the effective rent per square meter?

As we have discussed, the contract rent is the amount of rent stipulated in the lease. Therefore,
the contract rent of the property in our example is

Contract rent  24,000 birr / 1,000 sq .m

 24 Birr per square meter

However, according to the concession the tenant has got a concession of free rent for the first
month of each year. Thus, the effective rent of each year is 22,000 birr. As a result, the effective

59
rent per square meter is:

Effective rent  22,000 birr / 1,000 sq .m

 22 Birr per square meter

Excess rent

As its name indicates excess is the amount of rent of a property by which contract rent exceeds
the market rent at the time of the appraisal. Excess rent is created by a lease that is favorable to
the lessor and may reflect superior management or a lease that was negotiated in a stronger rental
market. It may be expected to continue for the remainder of the lease. Excess rent is a result of
the lease contract rather than the income potential of the underlying real property on the
valuation date. The existence of excess rent does not automatically indicate the situation that an
additional non-realty value is present.

Deficit Rent

Deficit rent is the opposite of excess rent. It refers to the amount by which market rent exceeds
contract rent at the time of the appraisal. It is created by a lease favorable to the tenant and may
reflect uninformed parties, inferior management, or a lease executed in a weaker rental market. It
is the result of the income producing potential of the property on the date of valuation. In some
cases, the landlord may try to get out of the contract if the deficit is large enough.

Percentage Rent

As you remember we have raised the concept of percentage lease in our previous discussion.
Thus, percentage rent is a type of rent generated based on the terms of a percentage clause in a
lease. It is usually derived from retail tenants and is based on a certain percentage of their sales
revenue. It is often paid at the end of each year and is more difficult to collect than other forms
of rent paid on a more regular basis. As a result, percentage rent involves more risk than other
forms of rent and may be capitalized or discounted separately or at a different rate.

Overage Rent

Overage rent refers to the percentage rent paid over and above the base rent. As we have

60
discussed before, the level of sales at which a percentage clause is activated is specified in a
lease and it is referred to as breakpoint. The level of sales at which the percentage rent exactly
equals the base rent is said to be the natural break point. However, the breakpoint does not
necessarily have to be the natural breakpoint. It encourages the owner of the retail center to
spend money to promote the business of the tenant as it is in the landlord’s best interest for the
sales above the base amount.

Example

Suppose that the yearly base rent of a retail property indicated in the lease is 10,000 birr with
percentage of retail sales specified in the lease as 5 percent.

 Determine the sales volume at the natural breakpoint and find the overage rent based on
the breakpoint specified in the lease.

 Find the sales volume of the tenant if the percentage rate jumps to 11,000 birr per year.

The natural breakpoint is

base rent
Natural breakpo int 
percentage of retail sales
10,000

0.05
 200,000 birr

The sales volume of the tenant at a rent of 11,000 birr per year with the percentage is:

11,000
Sales volume at breakpo int 
0.05
 220,000 birr

INCOME RATES

In this subsection we will discuss about income rates. Income rates are rates that express the
relationship between one year income and the corresponding capital value of a property. There
are various types of income rates. But the most important rates used in income capitalization

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approach are: overall capitalization rate, discount rate, and yield rate, internal rate of return,
overall yield rate and equity yield rate.

Overall capitalization rate

An overall capitalization rate ( R0 ) is a type of income rate that refers to the relationship of one
year net operating income of the property to the value or sales price of that property. It is used to
change the net operating income of a property in to an indication of property value. It is not a
rate of return on capital or a full measure of investment performance. But it may be equal to,
more than or less than the yield on capital invested.

Discount rate

Discount rate refers to the rate of return on investment assuming that the investors get all their
money back to at the end of the holding period. A discount rate is used to converts several future
cash flows in to a single present value.

5.5.Procedure in Income Capitalization Approach

There are two methods in income capitalization approach. These are direct capitalization and
yield capitalization. Both methods require a comprehensive study of historical income and
expenses for the subject property. This study is combined with an analysis of typical income and
expense levels for comparable properties you will get in our next discussion. The yield
capitalization method needs consideration of probable income and expenses over a specified
holding period. Thus, the appraiser has to project the appraiser income and expenses over time
together with the eventual reversion or resale value of the property. On the other hand, the direct
capitalization method needs a one year net operation income and an overall capitalization rate to
estimate value. Prior to applying either direct capitalization of yield capitalization method, an
appraiser has to work down from potential gross income (PGI) to net operating income (NOI)
before using any of these methods. The procedure is explained as follows:

1. Initially the appraiser should research the income and expense data of the subject
property and comparable properties.

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 2. Next to this estimate the potential gross income of the subject property by summing the
rental income and other potential incomes. It is usually analyzed on annual basis.
Potential gross income (PGI) is the total potential income attributable to the property at
full occupancy before operating expenses are deducted.

3. In the third step the appraiser ought to estimate vacancy and collection loss which is an
allowance for reduction in potential gross income attributable to vacancies, tenant
turnover, and nonpayment of rent. It is also referred to as vacancy and credit loss or
vacancy and contingency loss.

4. In the fourth step deduct vacancy and collection loss from potential gross income and
there by determine effective gross income (EGI).

5. Estimate the total operating expenses of the subject property by adding fixed expenses,
variable expenses and replacement allowance. Fixed expenses are operating expenses that
generally don’t vary with occupancy and which prudent management will pay whether
the property is occupied or vacant whereas variable expenses vary with occupancy or the
extent of services provided. Replacement allowance represents an allowance that
provides for the periodic replacement of building components that wear out more rapidly
than the building itself and must be replaced during the buildings economic life.

6. In the sixth step subtract the estimated total operating expenses from the estimated
effective gross income and arrive at net operating income (NOI) of the subject property.

7. In the last step apply one of the methods of income capitalization to generate an
estimated value of the subject property.

1. Income and Expense Analysis

There are two methods used in income capitalization approach. Both methods require a
comprehensive income and expenses analysis of the subject property. When converting
periodic income into a single value estimate of the subject property, appraisers can
estimate value from:

 Potential gross income using a potential gross income multiplier

63
  Effective gross income using an effective gross income multiplier

 Net operating income using a capitalization rate

 An equity dividend rate using an equity

capitalization rate and adding back the value of
the mortgage

There are four types of first year income that can be converted into value estimates for
different property interests in direct capitalization. These are :

 Potential gross income (PGl)

 Effective gross income (EGl)

 Net operating income (NOI)

 Equity dividend (IE)

2. Estimating and Adjusting Market Rent

An investigation of market rent levels starts with the subject property. By examining financial
statements and leases and interviewing selected tenants during property inspection, an appraiser
can verify the subject property's current rent schedule. Further verification may be necessary if
the owner's or manager's information is in doubt. The sum of current rents may be compared
with previous totals using operating statements for the past several years. Statements of rents,
including the rent paid under percentage leases or escalation clauses, should be examined for all
building tenants. After analyzing the existing rent schedule for the subject property, the appraiser
reduces all rents to a unit basis for comparison. All differences in rents within the property are
described and explained, and then rental data for comparable space in the market is assembled so
that equivalent market rents can be estimated, if necessary, and reduced to a unit of comparison.

When a, market rent estimate of the subject property is required, the appraiser gathers, compares,
and adjusts comparable rental data. The parties to each lease should be identified to ensure that
the party held responsible for rent payments is actually a party to the lease or, by endorsement,

64
the guarantor. It is also important to ascertain that the lease represents a freely negotiated, arm's-
length transaction.

The rents of comparable properties can provide a basis for estimating market rent for a subject
property once they have been reduced to the same unit basis applied to the subject property.
Comparable rents may be adjusted just as the transaction prices of comparable properties are
adjusted in the sales comparison approach. Recent leases relating to the subject property may be
a good indication of market rent, but lease renewals or extensions negotiated with existing
tenants should be used with caution. Existing tenants may be willing to pay above market rents
to avoid relocating. Alternatively, a landlord may offer existing tenants lower rent to avoid
vacancies and the expense of obtaining new tenants.

The amount of data needed to support a market rent estimate for a subject property depends on
the complexity of the appraisal problem, the availability of directly comparable rentals, and the
extent to which the pattern of adjusted rent indications derived from the comparables differs
from the income pattern of the subject property. When sufficient, closely comparable rental data
is not available, the appraiser should include other data, preferably data that can be adjusted. If an
appraiser uses proper judgment in making adjustments, a reasonably clear pattern of market rents
should emerge.

3. Income and Expense Data

To derive pertinent income and expense data, an appraiser investigates comparable sales and
rentals of competitive income-producing properties of the same type in the same market. For
investment properties, current and recent incomes are reviewed, and vacancy and collection
losses and typical operating expenses are studied. Published and electronic information on
property values for several consecutive years can suggest the pattern of appreciation or
depreciation applicable to various property types. Interviews with owners and tenants in the
area can provide lease and expense data. Lenders may be contacted for information on available
financing terms.

Appraisers try to obtain all income and expense data from the income producing properties used
as comparables. This data is tabulated in a reconstructed operating statement and filed by

65
property type. (A suggested format for reconstructed operating statements is illustrated later in
this chapter.)

Like expense data, rental information is difficult to obtain. Therefore, appraisers should take
every opportunity to add rents to their rental databases. Long-term leases may be filed in public
records. A separate county index may cite the parties to recorded leases and the volume and page
where leases are recorded. Sometimes this information is listed with deeds and mortgages, but it
is usually coded for easy identification. In certain cities, abstracts of recorded leases are printed
by private publishing services. Classified ads may also provide rental information. Many
appraisers periodically check advertised rentals and recorded rental information by property type
or area. It is convenient to file rental data under the same property use classifications used for
sales data.

Income and expense comparables should be filed chronologically and by property type so they
can be retrieved easily and used to estimate the expenses for a similar type of property. Income
and expense figures should be converted to appropriate units of comparison for analysis. For
example, income may be reported in terms of rent per apartment unit, per room, per hospital
bed, or per square foot. Expenses for insurance, taxes, painting, decorating, and other required
maintenance can be expressed in the same units of comparison used for income, or they can be
expressed as a percentage of the effective gross income. The unit of comparison selected must
be used consistently throughout the analysis for the subject property and the rental database
information.

Rental property data may show vacancy rates as a percentage of potential gross income and
operating expenses as a percentage of effective gross income. This data is essential in valuing
income-producing property.

4. Lease Data

If written leases exist and the income estimate is based on the continuation of lease income, the
appraiser examines lease provisions that could affect the quantity, quality, and durability of
property income. The appraiser may either read the leases or rely on the client or another
authorized party to disclose all pertinent lease provisions through lease summaries or briefs. In

66
any case, the source of information and level of verification should be described in the scope of
work section of the appraisal report. The appraiser also analyzes the leases of competitive
properties to estimate market rent and other forms of income applicable to the market for
competitive space.

Typical lease data includes

 Date of the lease

 Reference information, if the lease is recorded

 Legal description or other identification of the leased premises Name of lessor

i.e., owner or landlord

 Name of lessee-i.e., tenant

 Lease term

 Occupancy date

 Commencement date for rent payment

 Rent amount, including any percentage clause, graduation, and payment terms

 Rent concessions, including any discounts or benefits

 Landlord's covenants-i.e., items such as taxes, insurance, and maintenance for which
the owner or landlord is responsible

 Tenant's covenants-i.e., items such as taxes, insurance, maintenance, utilities, and

cleaning expenses for which the tenant is responsible

 Right of assignment or right to sublet-i.e., whether the leasehold, or tenant's interest,

may be assigned or sublet, under what conditions, and whether assignment relieves
the initial tenant of future liability Option(s) to renew, including the date of required
notice, term of renewal, rent, and other renewal provisions

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  Expense caps and expense stops, escalation rent, and expense recoveries Options to
purchase and any accompanying conditions

 Escape clauses, cancellation clauses, and kick-out clauses

 Continued occupancy contingency

 Security deposits, including advance rent, bond, or expenditures by the tenant for
items such as leasehold improvements

 Casualty loss-i.e., whether the lease continues after a fire or other disaster and on
what basis

 Lessee's improvements, including whether they can be removed when the lease expires
and to whom they belong

 Non compete and exclusive use clauses

 Condemnation, including the respective rights of the lessor and the lessee if all or any
part of the property is appropriated by a public agency Revaluation clauses

 Special provisions

Special attention should be paid to lease data on rent, rent concessions, the division of
expenses, renewal options, escalation clauses, purchase options, escape clauses, and tenant
improvements.

Rent

The amount of rent to be paid by the tenant is a basic lease data. An appraiser considers rent
from all sources, which may include base, or minimum, rent, contract rent, percentage rent, and
escalation rent. The sources of rental income should be clearly identified.

Developing Reconstructed Operating Statements

The appraiser estimates income and expenses after researching and analyzing

68
the following:

 The income and expense history of the subject property Income and
expense histories of competitive properties

 Recently signed leases, proposed leases, and asking rents for the subject and
competitive properties

 Actual vacancy levels for the subject and competitive properties

 Management expenses for the subject and competitive properties

 Published operating expense data and operating expenses at the subject and
competitive properties

 Forecast changes in taxes, energy costs, and other operating expenses

Appraisers often present this information in tabular form to assist the reader of the report.
Income and expenses are generally reported in annual or monthly dollar amounts and analyzed in
terms of nominal dollar amounts, dollars and cents per unit of rentable area, or dollars and cents
based on another unit of comparison. To show how historical and forecast data on operating
expenses is commonly arrayed, Table 2.1 summarizes the operating expense history of a
downtown office building with 60,000 rentable square feet of space. Table 2.2 summarizes the
operating expenses of five comparable properties in the same market area and allows for easy
comparison of the subject property and the comparables. It is obvious that the total operating
expenses of the subject, at $14.79 per square foot, for the year being studied are significantly
higher than those of the comparables, which range from $12.65 to $13.92 per square foot. For
most of the operating expenses listed, the per-unit expenses for the subject fall within the ranges
set by the comparable properties, but the expenses for electricity, at $4.14 per square foot, and
cleaning, at $2.28 per square foot, are higher than for any of the comparables. In the income and
expense analysis, the appraiser will have to investigate the reasons for the higher cost of
electricity and cleaning for the subject property.

Table 5.1 Subject property Operating expense History

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 Actual Actual Actual Budget
Per Per Per per
Year 1 sq.ft Year 2 sq.ft Year 3 sq.ft Year 4 sq.ft
dollar dollar dollar dollar
Fixed expenses
Real estate tax $232,812 $3.88 $272,378 $4.54 $314,433 $5.24 $323,400 $5.39
Insurance 2,378 0.04 2,350 0.04 6,625 0.11 6,700 0.11
variable expense
Electricity $200,390 $3.34 $216,632 $3.61 $211,789 $3.53 $248,350 $4.14
Steam heat 79.211 1.32 71,390 1.19 72,675 1.21 85,250 1.42
Cleaning 117,102 1.95 109,775 1.83 128,987 2.15 136,750 2.28
Payroll 8,432 0.14 10,208 0.71 11,386 0.19 12,600 0.21
Repair and Maintenance 17,388 0.29 30,688 0.51 38,875 0.65 52,825 0.88
water and swear 3,0101 0.05 3,030 0.05 2,412 0.04 4,800 0.08
administrative, legal 0.18
and accounting 1,180 0.02 1,778 0.03 10,856 0.18 10,850
management fee 4,757 0.08 4,930 0.08 5,010 0.08 5,350 0.09
Miscellaneous 3,031 0.05 88 0.001 610 0.01 600 0.01
Total Operating
expense $696,782.00 $11.16 $723,247.00 $12.05 $803,658.00 $13.39 $887,475.00 $14.79
Dear colleague figures have been rounded

After thoroughly analyzing property and lease data for the subject and comparable properties, the appraiser develops a
net operating income estimate for the subject property. If the appraiser is focusing on the benefits accruing to the equity
investment, the equity dividend is also estimated

Table 5.2 Analysis of Operating Expense Comparables

A B C D E
Subject 130 110 717 133 One
property pro Main Second Fourth Third Commerce
forma Street Avenue Avenue Avenue Plaza
Operating year 2003 2002 2002 2002 2002 2002
Year Built 1996 1996 1985 1978 1981 1995
Rentable area in square foot 60,000 75,000 49,411 56,411 52,000 66,000
Operating Expense*
Fixed expenses
Real estate tax 5.39 5,51 5.48 5.01 5.47 5.35
Insurance 0.11 0.06 0.09 0.10 0.17 0.09
variable expense
Electricity 4.14 4.03 3.47 3.31 3.25 3.45

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 Steam heat 1.42 1.25 1.60 1.35 1.75 1.55
Cleaning 2.28 1.61 1.38 1.27 1.28 1.30
Payroll 0.21 0.25 0.32 0.78 0.73 0.21
Repair and Maintenance 0.88 0.45 0.63 0.98 0.99 0.38
water and swear 0.08 0.08 0.08 0.08 0.09 0.10
administrative, legal and
accounting 0.18 0.19 0.19 0.26 0.08 0.11
management fee 0.09 0.08 0.08 0.08 0.09 0.10
Miscellaneous 0.01 0.02 0.01 0.02 0.02 0.01
Total Operating expense 14.79 13.53 13.33 13.24 13.92 12.65
*per square foot

Potential Gross Income

Appraisers usually analyze potential gross income on an annual basis. Potential gross income
comprises

 Rent for all space in the property e.g., contract rent for
current leases, market rent for vacant or owner occupied
space, percentage and overage rent for retail properties

 Rent from escalation clauses

 Reimbursement income

 All other forms of income to the real estate-e.g., income from services supplied to the
tenants, such as switchboard service, antenna connections, storage, garage space, and
income from coin-operated equipment and parking fees

Because service-derived income mayor may not be attributable to the real property, an appraiser
might find it inappropriate to include this income in the property's potential gross income. The
appraiser may treat such income as business income or as personal property income, depending
on its source. If a form of income is subject to vacancy and collection loss, it should be
incorporated into PGI, and the appropriate vacancy and collection charge should be made to
reflect effective gross income.

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Vacancy and Collection Loss

Vacancy and collection loss is an allowance for reductions in potential gross income attributable
to vacancies, tenant turnover, and nonpayment of rent or other income. This line item considers
two components:

 Physical vacancy as a loss in income

 Collection loss caused by concessions or default by tenants

The rents collected each year are typically less than annual potential gross income, so an
allowance for vacancy and collection loss is usually included in the appraisal of income-
producing property. The allowance is usually estimated as a percentage of potential gross
income, which varies depending on the type and characteristics of the physical property; the
quality of its tenants; the type and level of income streams; current and projected market supply
and demand conditions; and national, regional, and local economic conditions.

Published surveys of similar properties under similar conditions may indicate an appropriate
percentage allowance for vacancy and collection loss. An appraiser should survey the local
market to support the vacancy estimate. The conclusion in the income capitalization approach
may differ from the current vacancy level indicated by primary or secondary data because the
estimate reflects typical investor expectations for the subject property only over the projected
holding period. Other methods of measuring vacancy and collection loss include comparing
potential gross income at market rates against the subject property's actual collected Income.

Effective Gross Income

Effective gross income is calculated as the potential gross income minus the vacancy and
collection loss allowance.

Operating Expenses

Operating expenses may be recorded in categories selected by the property owner. The records
also may follow a standard system of accounting established by an association of owners or by
accounting firms that serve a particular segment of the real estate market. Generally, operating

72
expenses are divided into three categories:

 Fixed expenses

 Variable expenses

 Replacement allowance

However operating expenses are organized, an appraiser analyzes and reconstructs expense
statements to develop an estimate of the typical operating expense forecast for the property on an
annual cash basis.

Fixed Expenses

Most reconstructed operating statements contain line items for real estate taxes and building
insurance costs. Tax data can be found in public records, and the assessor's office may provide
information about projected changes in assessments or rates and their probable effect on future
taxes. If a property is assessed unfairly, the real estate tax expense may need to be adjusted in the
reconstructed operating statement. If the subject property is subject to an unusually low
assessment compared to other, similar properties or appears to deviate from the general pattern
of taxation in the jurisdiction, the most probable amount and trend of future taxes must be
considered. Any past changes in the assessment of the subject property should be studied. If the
assessment is low, the assessor is required by law to raise it. If the figure is high, however, a
reduction may not be easily obtained. In projecting real estate taxes, an appraiser tries to
anticipate tax assessments based on past tax trends, present taxes, the municipality's future
expenditures, and the perceptions of market participants.

For proposed properties or properties that are not currently assessed, appraisers can develop
operating statement projections without including real estate taxes. The resulting estimate is net
operating income before real estate taxes, and a provision for real estate taxes is included in the
capitalization rate used to convert this net income into property value. For example, assume that
real estate taxes are typically 2% of market value and net operating income after real estate taxes
would normally be capitalized at 11% to derive an opinion of market value for the subject
property.

73
In this case the estimated net operating income before real estate taxes could be capitalized at
13% (11% + 2%) to derive a property value indication alternatively, the appraiser may choose to
estimate real estate taxes for a proposed project based on building costs or the taxes paid by
recently constructed, competitive properties. Any unusual, unpaid special assessments or other
mandatory, one-time expenses should be addressed as a lump-sum adjustment at the end of the
analysis, if that is what the market would do.

An owner's operating expense statement may show the insurance premiums paid on a cash basis.
If the premiums are not paid annually, they must be adjusted to a hypothetical annual cash
expense before they are included in the reconstructed operating statement. Fire, extended
coverage, and owner's liability insurance am typical insurance items; depending on the (type of
property, elevators, boilers, plate glass, or other items may also be insured. The appraiser must
determine the amount of insurance and, if it is inadequate or super adequate, adjust the annual
cost to indicate appropriate coverage for the property.

Insurance on business inventory, business liability, and other business property is the occupant's
responsibility and therefore should not be charge, to the operation of the real estate. When
questions concerning co-insurance (or terms of coverage arise, an appraiser might need to obtain
professional insurance counsel.

Variable Expenses

Operating statements for large properties frequently list many types of variable expenses such as
the following:

 Management charges Leasing fees

 Utilities-e.g., electricity, gas, water, and sewer Heat

 Air-conditioning

 General payroll

 Cleaning

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  Maintenance and repair of structure Decorating

 Grounds and parking area maintenance

 Miscellaneous-e.g., security, supplies, rubbish removal, and exterminating

Replacement Allowance

The annual replacement allowance for each component of a property is usually estimated as the
anticipated cost of its replacement prorated over its total useful life, provided this does not
exceed the total useful life of the structure. Some appraisers use simple averaging (with or
without calculating a sinking fund payment), while others prefer to show the actual cost and
timing of these replacements. New elevators or other components that are expected to have
useful lives that equal or exceed the remaining useful life of the structure do not require an
allowance for replacement, unless making replacements or installing new equipment increases
the remaining useful life of the structure beyond that of the long-lived items. Examples of
building components that may require a replacement allowance are listed in Table 2.3 below

Table 5.3 Building Components Requiring Replacement Allowance

Roof covering
Carpeting
Kitchen, bath, and laundry equipments
Compressor, elevator, and boilers
Specific structural items and equipments that have limited economic life expectancies
Sidewalks
Driveway
Parking areas
Exterior painting

Total Operating Expenses

Total operating expenses are the sum of fixed and variable expenses and the replacement
allowance cited in the operating expense estimate.

Net Operating Income

After total operating expenses are deducted from effective gross income, the remainder is the

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net operating income.

Additional Calculations

After the appraiser reaches a value for net operating income, further calculations may be
needed to determine

 Mortgage debt service Equity dividend

 Expense and income ratios

Mortgage Debt Service

Mortgage debt service is the annual sum of all mortgage payments. Mortgage debt service is
deducted from net operating income to derive equity dividend, which is used in certain
capitalization procedures. The definition of market value assumes financing terms compatible
with those found in the market.

Thus, in estimating market value, the mortgage debt service to be deducted from the net
operating income must be based on market terms. In some cases the appraiser may be asked to
develop an opinion of the value of the equity investor's position based on existing financing.
Here the debt service would reflect the terms specified in the existing mortgage(s).

Equity Dividend

Equity dividend is the income that remains after all mortgage debt service is deducted from net
operating income.

Expense and Income Ratios

The ratio of total operating expense to effective gross income is the operating expense ratio
(OER). The complement of this ratio is the net income ratio (NIR), which is the ratio of net
operating income to effective gross income. These ratios tend to fall within ranges for specific
categories of property. Experienced appraisers recognize appropriate ratios, so they can identify
statements that deviate from typical patterns and require further analysis.

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The following format indicate the classical Reconstructed Operating Statement of Income

Section 3: Direct Capitalization

Most of income-producing properties are purchased with the expectation of receiving future
income. Because of this, the income capitalization method is usually most applicable and
appropriate in their valuation. There are two basic income capitalization models: direct
capitalization and yield capitalization. Direct capitalization is a method of income capitalization
used to convert a single year’s income expectancy of the subject property in to a value
indication. It is the simplest method of income capitalization. It only has three working parts: net
operating income, overall capitalization rate, and property value. Thus, in this section we will
discuss about the different methods of deriving overall capitalization rate, estimation of property

77
value using the direct capitalization rate. In addition to these, we will see the different residual
techniques in direct capitalization for determining the value opinion of a property.

Have you tried to do this question? If your answer is no, please try to discuss with your friends
and answer the question. If your answer is yes, good, write your answer on a rough paper and try
to relate it with the following analysis.

Basics of Direct capitalization

Direct capitalization is a method of estimating a property’s market value by dividing a single

year’s net operating income (NOI) by a capitalization rate. This conversion is accomplished in
one step, either by dividing the income estimate by an appropriate income rate or by multiplying
it by an appropriate income factor. Appraisers usually apply direct capitalization method when
properties are already operating on a stabilized basis and enough comparable sales available in
the market. However, it may not be feasible to use it there is a possibility of irregularity in
change income and/or expenses pattern over time. The advantages of direct capitalization are that
it is simple to use, easy to explain, often expresses market thinking, and provides strong market
evidence of value when adequate sales are available.

Direct capitalization usually involves comparable sales to develop rates

 Does not require explicit projections of income for the subject property

 Assumes that expectations for future income are similar for the subject and the
comparables from which the rates were extracted

 Reliable income rates from sales must be obtained

The basic formula for direct capitalization (which indicates the relationship between market
value and net operating income) is

NOI
MV 
R0

78
Where MV is market value, NOI is stabilized net operating income of the next calendar year and
R0 is the capitalization rate.

the different methods of deriving overall capitalization rate

Derivation of Overall Capitalization Rates

Any interest in real estate that is capable of generating income can be valued by direct
capitalization. For owner-occupied properties or properties not subject to a lease, it is most
common to appraise the fee simple interest. However, if a property is subject to a lease, then the
appropriate interest to appraise is the leased fee interest. The direct capitalization formula that
applies to these types of valuation assignments is

Net Operating Income

Market Value 
Overall capitaliza tion rate

Overall capitalization rates can be estimated with various techniques; the techniques used depend
on the quantity and quality of data available. In this method, the property’s first year NOI
(Property’s over all cash flow) has been converted in to values estimates. As a result, R0 is
referred to as overall capitalization rate or the going-in cap rate. It is not a discount rate which
can be applied to the future cash flows. It is simply the ratio of the first year annual income of
the property to the overall value of the property. The following techniques are accepted as
different methods of estimating the overall capitalization rate provided that appropriate market
data are available.

 Derivation from comparable sales

 Derivation from effective gross income multipliers and net income ratios

 Band of investment-mortgage and equity components

 Band of investment-land and building components

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  The debt coverage formula

 Yield capitalization techniques

.Derivation of R0 based on Comparable Sales

Appraisers usually rely on recently completed transaction of comparable properties to obtain the
overall capitalization rate to be used to value the subject property. Rearranging the above basic
NOI
capitalization formula gives us R 0 
MV

It enables us to estimate the overall capitalization rate from the comparable sales data provided
that we have the sales price of comparables and their respective net operating income. This
method of estimating the overall capitalization rates is referred to as direct market extraction.
The estimated capitalization rate can be applied to capitalize the estimated first year NOI of the
subject property in to an estimate of market value.

Example

Suppose a valuation expert has collected comparable sales data of five properties (recently sold)
that are similar with the subject property. These properties are comparable to the subject property
in terms of location, size, age, condition and intensity of land use. The appraiser has estimated
the expected NOI from the current market rent and all appropriate expenses. Then the NOI of
each property is divided by its sales price to get the overall capitalization rate as indicated in the
following table.

Table 5.4 Direct Market Extraction of overall Capitalization Rate

Comparables NOI Sales Price R0

A 80,000.00 825,000.00 0.097

B 114,000.00 1,200,000.00 0.095

C 100,000.00 971,000.00 0.103

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D 72,000.00 713,000.00 0.101

E 90,000.00 910,000.00 0.099

Average 0.099

As it shown in the above table the average of the five comparable capitalization rates ( R0 ) is 9.9
percent. An overall capitalization rate provides compelling evidence of value when the following
conditions are satisfied:

 Data must be drawn from properties that are physically similar to the property being
appraised and from similar (preferably competing) markets. Where significant differences
exist for a given comparable, its indications are afforded less weight or may be discarded
entirely.

 Sale properties used as sources for calculating overall capitalization rates should have
current (date of sale) and future market expectations, including income and expense
patterns and likely value trends, that are comparable to those affecting the subject
property.

 Income and expenses must be estimated on the same basis for the subject property and all
comparables properties.

 The comparable property's price must reflect market terms, or an adjustment for cash
equivalency must be possible.

 If adjustments are considered necessary for differences between a comparable and the
subject property, they should be made separately from the process of calculating the
overall capitalization rate and should be based on market evidence.

Derivation of Ro from Effective Gross Income Multipliers

Sometimes an overall capitalization rate cannot be derived directly from comparable sales since
the availability of necessary information may be difficult. In such cases an effective gross

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income multiplier can be derived and used in conjunction with a net income ratio (NIR) to
produce an overall capitalization rate. The NIR is the complement of the operating expense ratio
(OER). Thus, NIR = 1 - OER. (The derivation of income multipliers is discussed later in this
chapter.)

The net income ratio is the ratio of net operating income to effective gross income. Although
effective gross income multipliers can be based on annual or monthly income, annual income is
used unless otherwise specified. Monthly income is primarily used for single-family or small
multifamily properties. Frequently, an appraiser can obtain market wide averages of operating
expense ratios as well as the effective gross income multipliers indicated by comparable sales. If
a comparable is truly comparable to the subject, it may be appropriate to use the subject's net
income ratio and the comparable's effective gross income multiplier to develop the rate.

The formula for deriving an overall capitalization rate from a net income ratio and an effective
gross income multiplier is

NIR
R0 
EGIM

Considering a property which was recently sold for 500,000 birr has a potential gross income of
80,000 birr and a vacancy and collection loss of 6.25% of the PGI. Determine the overall
capitalization rate based on the EGIM assuming that the operating expense is estimated to be
30,000 birr. Given this information the overall capitalization rate is

Table 5.5 Derivation of Ro from Effective Gross Income Multipliers

Sales Price of a Property in Birr 500,000

Vacancy and collection loss (6.25% of PGI) 5,000

Effective Gross Income (EGI) 75,000

Operating Expenses 30,000

Net Operating Income (NOI) 45,000

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Net Income Ratio (NIR) = NOI/EGI 0.6

Effective gross income multiplier (EGIM)=Sales price/EGI 6.67

The overall capitalization rate = NIR/EGIM 0.09

The above table shows that the overall capitalization rate extracted from the effective gross
income multiplier of this property is

NIR 0.6
R0    0.09 or 9%
EGIM 6.67

Derivation of Ro by Band of Investment-Mortgage and Equity

It is clear that a real estate market is composed of equity investors and lenders. Both parties are
considered as investors. They combine their resources to create band of investment. The band of
investment method produces a capitalization rate which is a weighted average of these
components. This method combines a rate for mortgage loan money and a rate for the investor’s
equity money. Lenders must anticipate receiving a competitive interest rate commensurate with
the perceived risk of the investment or they will not make funds available. Lenders generally
require that the loan principal be repaid through periodic amortization payments. Similarly,
equity investors must anticipate receiving a competitive equity cash return commensurate with
the perceived risk, or they will invest their funds elsewhere. When the mortgage and equity
capitalization rates are known, an overall capitalization rate may be derived with the band of
investment or weighted-average, technique using the following formulas:

R0  (MxRM )  ( ExR E )

Where M represents the loan to value ratio, RM represents the mortgage capitalization rate, E is

the equity portion of the property investment and R E represents the equity capitalization rate.

The mortgage capitalization rate RM is the ratio of the annual debt service to the principal
amount of the mortgage loan. The mortgage capitalization rate is a function of the interest rate,
the frequency of amortization, and the amortization term of the loan. The equity investor also

83
seeks a systematic cash return. The rate used to capitalize equity income is called the equity
capitalization rate (RE). It is the ratio of annual equity dividend to the amount of equity
investment.

Example

Les us assume that 70% of the property investment is financed from loan which has 9% interest
rate and with duration of 30 years. Determine the overall capitalization rate provided that the
mortgage capitalization rate is 11% and the equity capitalization rate is 7% as it has been derived
from the comparable sales.

Dear colleague! The overall capitalization rate is calculated as follows

R0  (0.7 x0.11)  (0.3x0.07)

R0  0.098 or 9.8%

Derivation of Ro by Band of Investment – Land and Building

The overall capitalization rate can also be determined based on land and building values.
Although the elements addressed in this method are the physical components of a property, we
are going to use similar technique that we have used for mortgage and equity, i.e., a band of
investment technique. Similar to that of mortgage and equity, weighted rates can be developed
for the land and buildings when accurate rates for these components can be estimated
independently and the proportion of total property value represented by each component can be
identified. The formula that can be used to calculate the overall capitalization rate using this
method is

R0  ( LxRL )  ( BxR B )

Where L represents the land value as a percentage of property value, RL represents land

capitalization rate, B is the building value as a percentage of total property value, and R B
represents building capitalization rate.

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Land capitalization rate is a rate used to convert the land income into an indication of land value
when band of investment technique is applied. It is the ration of land income to land value.
Similarly, building capitalization rate is the rate used to convert the building income into an
indication of building value.

Example

Dear colleague! Calculate the overall capitalization rate give that land takes 22% of the property
value and the improvement (building) represents the remaining 78% of the property value.
Assume that the land capitalization rate extracted from the comparable sales is 7% and the
building capitalization rate is 11%.

The overall capitalization rate is

R0  (0.78 x0.11)  (0.22 x0.07)

R0  0.1012 or 10.12%

Yield Capitalization and Discounted Cash Flow Analysis

The previous section has been devoted to direct capitalization which relies heavily on data from
comparable sales. Its effective use requires a high degree of comparability between the subject
property and the comparable transactions. However, such comparability is often difficult for
appraisers to obtain. Most of the commercial properties are subject to long term lease which may
carry rental rates above or below the current market rate. In addition to this, the comparable sales
data may need adjustments. For such reasons, yield capitalization method is often a necessity.
Yield capitalization is a method of converting future economic benefits, especially periodic
income stream and reversion, of ownership into present value by discounting each anticipated
benefit at an appropriate yield rate. The yield rate is a rate of return on capital. This method
simulates typical investor assumptions by using formulas that calculate the present value of
future economic benefits based on specified rate of return requirements. The future economic
benefits that are typically considered in this analysis are periodic cash flows and reversion. The
procedure used to convert these future economic benefits into present value is called discounting,
and the required rate of return (or yield rate) is referred to as the discount rate. This valuation
method can be used to value the fee simple interest in a property, or any property interest for

85
which all future economic benefits can be estimated. This section includes two subsections
namely: basics of yield capitalization and discounted cash flow analysis. It covers forecasting of
future cash flow, estimation of yield rate, income patterns, reversions of from a property and
discounting cash flow analysis.

Basics of Yield Capitalization

Yield capitalization is the other essential method, in income capitalization approach, which
property appraisers use so as to estimate the value of the property. There are several techniques
within this methodology for converting a series of future cash flows over time into value of a
property. Yield capitalization is used to convert future benefits into an indication of present value
by applying an appropriate yield rate. Cash flow refers to the periodic income attributable to
the interests in real property.

To use this method, an appraiser

 Selects an appropriate holding or study period

 Forecasts all future cash flows or cash flow patterns (including the reversion)

 Chooses an appropriate yield rate

 Converts future benefits into present value by discounting each annual future benefit or
by developing an overall rate that reflects the income pattern, value change, and yield rate
using one of the various yield formulas

The application of capitalization rates that reflect an appropriate yield rate, the use of present
value factors, and discounted cash flow analysis are all yield capitalization procedures. Similar to
direct capitalization, yield capitalization should reflect market condition.

Discounting is a procedure used to convert periodic income, cash flows, and reversions into
present value based on the concept that benefits received in the future are worth less than the
same benefits received now. The discount rate is the interest rate used for discounting process
and may be the property yield rate, equity yield rate or other defined rate. In real estate appraisal

86
practice the most commonly used rate is the property yield rate ( Y0 ). The standard formula of
discounting future value in to present values is:

Future value
Pr esent value 
(1  r ) n

Where r is the rate of return on capital per period (discount rate) that will satisfy the investor
1
and n is the number of periods that the payment will be deferred? is the discount
1  r n
factor.

So far we have considered only single period cash flow. However, we can use the same principle
to find the present value of cash flow at any point in time. We can write the present value of a
series of cash flows CF1 , CF2 , CF3 ….As

CF1 CF2 CF3 CFn

PV     .... 
1  r  1  r 2
1  r 3
1  r n

Using a summation sign

n
CFi
PV  
i 1 1  r i

To apply the discounting procedure, the appraiser must be familiar with the following concepts
and techniques:

 Income patterns

 Capital return concepts

 The mathematics of the discounting process

 Investor requirements or expectations ,i.e., holding period, anticipated market growth,

and inflation

 The appropriateness of the selected yield rate

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Discounted Cash Flow Analysis

The term discounted cash flow analysis refers to the process and procedures for estimating future
cash flows from property operation, the net cash flow from disposition of the property the end of
the investments holding period and the appropriate required internal rate of return, i.e. the
discount rate, and using these inputs to generate the indicated value for the subject property.

Discounted cash flow (DCF) analysis is appropriate for any pattern of regular or irregular
income. In many markets, DCF analysis is the technique investors prefer. Discounted cash flow
analysis can be used both to estimate present value and to extract a yield rate from a comparable
sale. Generally, DCF analysis is used to solve for present value given the rate of return or for the
rate of return given the purchase price.

In discounted cash flow (DCF) analysis, an appraiser can discount each payment of income and
reversion separately and add all the present values together to get the present value of the
property being appraised. The DCF formula treats the reversion as a cash flow that can be valued
separately from the income stream. Using this formula the estimated value of the property that
generates income might be:

NOI1 NOI 2 NOI 3 NOI n  NOI n1  1

PV     ....  
 
( )
1  r  1  r  1  r 
2 3
1  r   r  g  1  r n
n

 NOI n1  1
Where 
  represents the discounted reversion value (salvage value), g is
 r  g  1  r 
n

inflation rate and r is discount rate, NOI is the net operating income of the property.

Discounted cash flow analysis requires appraisers to follow certain procedures to determine the
net operating income from the potential gross income of the property.

 Estimate the potential gross income of the property

 Project vacancy and collection loss

 Deduct the vacancy and collection loss from the potential income and determine the
effective gross income of the property

88
  Estimate the operating and maintenance expenses of the property

 Deduct the operating and maintenance expenses from the effective gross income of the
property and find the net operating income of the property

 Determine the time of reversion and

In DCF analysis, the variables should be projected over the holding period, from 5 to 15 years.
Typical forecast categories in DCF analysis include:

 Current market rental rates and expected rate changes

 Existing base rants and contractual base rents

 Renewal options

 Existing and anticipated expenses recovery provisions

 Tenant turnover

 Operating expenses

 Net operating income

 Reversion

 Discount rate

Example 2 Suppose that the initial rent for a commercial property is 20 birr/square meter per year. If
the net leaseable area is 10,000 square meter, the vacancy and collection loss is 5% of PGI and if
operating and maintenance (O&M) expenses are estimated to be 5 birr/Square meter per year. Forecast
the NOI for a 10-year holding period. Knowing that the opportunity cost of capital is 10% and the rate of
inflation is 3% what would be the market value of the property?

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 Solution
Year 1 2 3 4 5 6 7 8 9 10 11

Net leasable area 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0 10,000.0

Rent per sq.m 20.6 21.2 21.9 22.5 23.2 23.9 24.6 25.3 26.1 26.9 27.7

PGI 206,000.0 212,180.0 218,545.4 225,101.8 231,854.8 238,810.5 245,974.8 253,354.0 260,954.6 268,783.3 276,846.8

Vacancy rate 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05
Vacancy &
Collection loss 10,300.0 10,609.0 10,927.3 11,255.1 11,592.7 11,940.5 12,298.7 12,667.7 13,047.7 13,439.2 13,842.3

EGI 195,700.0 201,571.0 207,618.1 213,846.7 220,262.1 226,869.9 233,676.0 240,686.3 247,906.9 255,344.1 263,004.4
O &M expense per
sq.m 5.2 5.3 5.5 5.6 5.8 6.0 6.1 6.3 6.5 6.7 6.9
Operating and
maintenance
expense 51,500.0 53,045.0 54,636.4 56,275.4 57,963.7 59,702.6 61,493.7 63,338.5 65,238.7 67,195.8 69,211.7

NOI 144,200.0 148,526.0 152,981.8 157,571.2 162,298.4 167,167.3 172,182.3 177,347.8 182,668.2 188,148.3 193,792.7

Discounted NOI 131,090.9 122,748.8 114,937.5 107,623.3 100,774.5 94,361.6 88,356.8 82,734.1 77,469.2 72,539.3
Total discounted
NOI 992,635.84
Discounted
Reversion value 1,067,364.16

2,060,000.00
2
Market value

2
The market value of the property is the summation of the discounted NOI and the discounted reversion value.

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 UNIT 6 RECONCILING AND REPORTING APPRAISALS

6.1. Reconciliation

Reconciliation can be defined as the last phase of any valuation assignment in which two or
more value indications derived from market data are resolved into final value opinion which may
be either a final range of values or a single point estimate3. An appraiser may find different value
estimates for a single property using different approaches or may get different value opinions
using single approach, like in sales comparison approach through using different elements of
comparison and in income approach by using either a direct capitalization or yield capitalization
technique. The reconciliation of value of a property is important for determining a final value
indication of a property. The final value opinion does not simply represent the average of the
different value indications obtained. There is no precise mathematical formula which enables us
to choose the one value indication over others rather a final conciliation relies on the proper
application of appraisal techniques and the appraiser’s judgment and expert opinion.

Before reconciling the multiple value indications of a property, an appraiser has to review the
purpose and use of the appraisal, relevance and adequacy of data gathered and all tasks
previously carried out to be sure that an adequate appraisal was performed and can lead to
consistent judgment. These tasks can be categorized into two steps:

 Review of the overall appraisal process

 Review of the technical accuracy

1. Review of the Appraisal Process

In the reconciliation, the first step that should be performed is to review the overall valuation
process. How the valuation has been carried out? In this step, the appraiser is expected to ask
various questions such as:

 Is the property precisely located and identified?

 Are the property rights to be appraised clearly identified?

91
  Have the agreed scope of work and the purpose of the appraisal been considered?

 Is the effective age of the property used in the cost approach consistent with the physical
condition reported?

 Is the same physical condition assumed in making adjustments to rent comparables,

expense comparables, and sales comparables in the income and sales comparison
approaches?

 Are the results of all the approaches consistent with the appraiser's conclusion of highest
and best use?

 Do the indications derived from the approaches applied reflect the same defined value?
For example, a value indication derived from income capitalization that is higher than an
indication based on the cost approach may or may not include a non-realty or business
enterprise value component.

2. Review of the technical accuracy

The next step is reviewing the mathematical calculations preferably by someone other than the
person who carried out them originally to check for possible errors. Significant errors can lead to
incorrect value indications, but even minor errors can diminish the client's confidence in the
appraisal.

Initially, the calculations should be checked for accuracy. It should address the measurements
used in the appraisal as well. Secondly, the completeness and adequacy of the data for the
purpose for which they were used ought to be verified. Thirdly, an appraiser has to check for
consistency. Getting a positive answer for the following questions indicate that the data in the
valuation process have been used in a consistent way.

 Was the highest and best use of the property used as a basis of valuation?

 Is the property used in the sales comparison approach the same in the cost approach?

92
  Were the desirable features rated in the sales comparison approach also considered in
estimating the rents for the income approach?

 Was any economic or functional obsolescence in the cost approach also adjusted for the
sales comparison and income approach?

Finally, the appraiser has to review any assumption considered during the appraisal process.

3. Final Opinion of Value and Rounding

At the end of the valuation process, i.e. in the appraisal report, the appraiser normally reaches to
a single estimate of value opinion. Because of legal or other requirements, most clients require a
single estimate of value. An opinion of value which is reported as a single monetary amount is
referred to as a point estimate. A point estimate is required for many purposes:

 Real estate taxation

 Calculating depreciation deductions for tax

 Estimating compensation in casualty, liability, and condemnation cases

 Determining value-based rent

 Making property transfer decisions

It may also be stated as a range of values if it is specifically stated in the appraisal assignment
and the agreement with the client. There is no magic method to reach to a final value opinion of
the property. It is not a mathematical average of the three value indications. Arriving at a final
value opinion is the most difficult task in the appraisal process. However, it is sometimes
justifiably a weighted average of the three value indications. After giving full consideration to
each approach, the appraiser uses judgment and reasoning to arrive at one conclusion. The
greatest confidence is placed in the approach which seems to produce the most reliable solution
to the specific appraisal problem, realizing that it must be reasonable and capable of being
supported convincingly.

93
The final value conclusion should not be reported in odd birr and cents rather it should be
rounded to reflect the degree of precision the appraiser can associate with the particular opinion
of value. There are no standards of practice for rounding. Often the manner in which the figure is
rounded is a matter of convention-e.g., to two or three significant digits4. For example, if the
final value estimate is a six-digit number, the figure will likely be rounded to the nearest
thousand or ten thousand birr. In other words, the value 233,495 birr can be rounded to 230,000
birr or 233,000 birr. If it is a seven-digit number, it will likely be rounded to the nearest ten
thousand or hundred thousand birr. In some instances, when market data is more diverse, the
range may be wider.

The final value conclusion might be presented with different numbers of significant digits
depending on the appraisal process and the data used. For instance, one appraiser’s reconciliation
process may lead to a value conclusion of 230,000 birr which has two significant digits. Another
appraiser might conclude the value of the same property as 233,495 birr which has six significant
digits.

6.2. Report of Appraisal Opinions

6.2.1. Standards of Written Reports

Professional appraisers are expected to conduct their appraisal activities in line with the
requirements of the Uniform Standards of Professional Appraisal Practice (USPAP). The
Preamble to the Uniform Standards of Professional Appraisal Practice states,

It is essential that professional appraisers develop and communicate their

analyses, opinions, and conclusions to intended users of their services in a
manner that is meaningful and not misleading.

Standard 2 of USPAP sets forth the requirements for reporting an appraisal of real property. (As
it is stated in the Appraisal of Real Estate Book, 12th ed.)

Standards Rule 2-1 states that each written or oral real property appraisal report must:

94
  Clearly and accurately set forth the appraisal in a manner that will not be misleading;

 Contain sufficient information to enable the intended users of the appraisal to understand
the report properly; and

 Clearly and accurately disclose any extraordinary assumption, hypothetical condition, or

limiting condition that directly affects the appraisal and indicate its impact on value

Standards Rule 2-2 requires that each written appraisal report be prepared under one of the
following three options, which must be prominently stated in the report:

 Self-contained appraisal report

 Summary appraisal report

 Restricted use appraisal report

The essential difference between the three reporting options is the level of detail required in
certain areas of presentation and the accompanying work file. The following table shows the
elements included in the above mentioned reporting options.
Table -- Comparison of Reporting Options according to Standards Rule 2-2 of USPAP5

Self contained Appraisal

Sr.No Report Summary Appraisal Report Restricted Appraisal Report
State the identity of the client State the identity of the client
and any intended users by and any intended users by State the identity of the client by
1 name or type name or type name or type
State the intended use of the State the intended use of the State the intended use of the
2 appraisal appraisal appraisal
Describe the information Summarize the information
sufficient to identify the real sufficient to identify the real
estate involved in the estate involved in the appraisal
appraisal including the including the physical and
physical and economic economic property State the information sufficient to
property characteristics characteristics relevant to the identify the real estate involved in
3 relevant to the assignment assignment the appraisal
4 State the real property State the real property interest State the real property interest

5
Appraisal of Real Estate, 12th ed. Pp.608&609

95
 interest appraised appraised appraised
State the purpose of the State the purpose of the State the purpose of the appraisal
appraisal including the type appraisal including the type including the type and refer to the
and definition of value and and definition of value and its definition of value pertinent to the
5 its source source purpose of the assignment.
State the effective date of the State the effective date of the
appraisal and the date of the appraisal and the date of the State the effective date of the
6 report report appraisal and the date of the report
State extent of the process of
Describe sufficient Summarize sufficient collecting, confirming, and
information to disclose to the information to disclose to the reporting data, or refer to the
client and any intended user client and any intended user of assignment agreement retained in
of the appraisal the scope of the appraisal the scope of the appraisers work file that
work used to develop the work used to develop the describes the scope of work to be
7 appraisal appraisal performed
State all assumptions, State all assumptions,
hypothetical conditions and hypothetical conditions and State all assumptions, hypothetical
limiting conditions that limiting conditions that conditions and limiting conditions
affected the analysis, affected the analysis, opinions that affected the analysis, opinions
8 opinions and conclusions and conclusions and conclusions
Describe the information Summarize the information
analyzed, the appraisal analyzed, the appraisal
procedure followed and the procedure followed and the State the appraisal procedures
reasoning that supports the reasoning that supports the followed, state the value opinions,
analysis , opinions, and analysis , opinions, and and conclusions reached and
9 conclusions conclusions reference the work file
State the use of real state
existing as of the date of the State the use of real state
value and the use of real existing as of the date of the
estate reflected in the value and the use of real estate State the use of real state existing as
appraisal and when the reflected in the appraisal and of the date of the value and the use
purpose of the assignment is when the purpose of the of real estate reflected in the
market t value, describe the assignment is market t value, appraisal and when the purpose of
support and the rational for summarize the support and the the assignment is market t value,
the appraisers opinion of the rational for the appraisers state the support and the rational for
highest and best use of the opinion of the highest and best the appraisers opinion of the highest
10 real estate use of the real estate and best use of the real estate
State and explain any permitted
departures from applicable specific
requirements of standard 1; state the
State and explain any State and explain any exclusion of any of the usual
permitted departures from permitted departures from valuation approach ; state a
specific requirements of specific requirements of prominent use restriction that limits
standard 1 and the reason for standard 1 and the reason for use of the report to the client and
excluding any of the usual excluding any of the usual warns that the appraiser’s opinion
11 valuation approach valuation approach and conclusions set forth in the

96
 cannot be understood properly
without additional information in
the appraisers work file
Include a signed certification Include a signed certification
in accordance with standards in accordance with standards Include a signed certification in
12 Rule 2.3 Rule 2.3 accordance with standards Rule 2.3

6.2.2. Types of Reports

A final value opinion of a property may be communicated to the client orally or in a written
form. Written report prepared under one of the three reporting options mentioned above may be
form or narrative reports. An appraisal report is often prepared in a way requested by the
intended user. However, even if a client asks for a report that does not include detailed
documentation, the appraiser must undertake the analysis required by the assignment as set by
the scope of work. In such a case all material, data, and working papers used to prepare the
appraisal are kept in the appraiser's permanent file. Although the appraiser may never need to
provide written substantiation for an opinion that is submitted in abbreviated form, he or she may
be asked to explain or defend the opinion at a later time.

Oral Reports

An oral report may be carried out when the circumstances or the needs of the intended user do
not permit or demand a written report. The most common form of oral reporting is performed to
clients in person or by telephone when appraisers are asked for the opinion of value only. Expert
testimony presented in a deposition or in court is considered an oral report.

Standards Rule 2.4 of the USPAP states that an oral report must address, at a minimum, the
substantive matters set forth for a summary appraisal report. Each oral report must include the
underlying bases of the appraisal, especially any extraordinary assumptions or hypothetical
conditions used. After communicating an oral report, the appraiser must keep on file all notes
and data relevant to the assignment so that if asked at a later date, he/she could produce a report
that would meet the minimum requirements for a summary appraisal report.

97
 6.2.3. Form Reports

Institutions and agencies that regularly contract for appraisals require the use of standard form
appraisal report. Most form reports may be classified as summary appraisal reports, depending
on the level of detail and the quantity of supporting documentation. Form reports often meet the
needs of financial institutions, insurance companies, and government agencies. Form reports are
often preferred by appraisers and clients since they are usually designed in a standard check list
format on a printed page. They are required for the purchase and sale of most homes and existing
mortgages on residential properties created by government agencies and private organizations.
These intended users review many appraisals. As a result, they need to use a standard report form
since it is both efficient and convenient for them to review. Those responsible for reviewing the
appraisal know exactly where to find each category or item of data in the report. An appraiser
can make the form complete and thereby make sure that all items required by the reviewers are
included in the report.

Similar to all appraisal reports, form reports are expected to be prepared in line with Standard
rule 2 of USPAP. However, some forms currently in use may not address all of the information
required by professional standards. Such forms may be used only if they are augmented with
supplemental information so that they meet Standard rule 2 of USPAP.

Outline of the Narrative Report

The narrative appraisal report follows the order of the valuation process. The organization and
content of narrative appraisal report may be varied. However, there are certain common elements
that they should include. According to the Real Estate Appraisal Book, 12th ed., most narrative
appraisal reports have four major parts. These are:

 Introduction,

 Premises of the appraisal,

 presentation of data, and

 Analysis of data and conclusions

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In addition to these, several reports include the addendum or appendix which includes additional
information which supplements the description in the major report parts information. The general
outline of the narrative report which includes the four main subdivisions is stated as follows.
This outline can be adjusted according to the particular requirements of the valuation assignment.
General Outline of Narrative Appraisal Report

Part One: Introduction

 Title page
 Letter of transmittal Table of contents Certification
 Summary of important conclusions

Part Two: Premises of the Appraisal

 Identification of type of appraisal and type of report
 Extraordinary assumptions and hypothetical conditions
 General assumptions and limiting conditions
 Purpose and intended use of the appraisal
 Definition of value and date of opinion of value
 Property rights appraised
 Scope of work

Part Three: Presentation of Data

 Identification of the property
 Identification of any personal property or other items that are not real property
 History, including prior sales and current offers or listings
 Market area, city, neighborhood, and location data
 Land description
 Improvement description
 Taxes and assessment data
 Marketability study if appropriate

Part Four: Analysis of Data and Conclusions

 Highest and best use of the land as though vacant
 Highest and best use of the property as improved Land value
 Cost approach
 Sales comparison approach
 Income capitalization approach
 Reconciliation and final opinion of value
 Estimate of exposure time
 Qualifications of the appraiser

Addenda or Appendix

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 Detailed legal description, if not included in the presentation of data
 Detailed statistical data
 Leases or lease summaries
 Other appropriate information
 Secondary exhibits

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 UNIT 4: PROPERTY VALUATION PRACTICES IN ETHIOPIA

4.1. Purpose of Property Valuation in Ethiopia

Even if Ethiopia is characterized by undeveloped real property market, property valuation is

required for many purposes and can be categorized in to two main types: statutory (Legal
transaction) and non-statutory (Real property market transaction). In our complex society,
most of the market transactions requiring valuers are connected with the sale, purchase,
finance, management, and use of real property. By legal transaction, it mean government
actions involving real properties , and those private actions that take place in legal setting or
are otherwise regulated by law, like, eminent domain (expropriation), property tax assessment,
and loan foreclosure etc.

The major users of valuation of property are government authorities like (Municipality, Tax
Authority), real property developer, lenders, seller and buyer, etc to make important decisions
on the use and distribution of properties. For instance, the state needs to calculate the level of
compensation for land and improvement that is compulsorily acquired for public purposes, and
fixing the rent of state-owned real property. Real property developers often include the rent of
land as one of the cost of the finished product, as a result ,they, need to estimate rental value or
the equitable return on investment on capital. Banks often require valuation for
the mortgage lending process. The Civil Code contains provisions for mortgage that still are
partly applicable. There are provisions regarding creation of mortgage. Mortgage is valid only
in immovable property and when stated in a contract of certain form specifying the immovable
mortgaged. A mortgage, however created, have no effect before the day it is registered in the
register of immovable property. The effectiveness of expropriation, in terms of paying
compensation, mortgage finance system and base of property tax has profoundly effect on the
valuation approach and value of real property. Thus in the next sub section we will see
practices of valuation for compensation, mortgage, leased land and property tax purpose.

4.1.1. Property Valuation for Expropriation Purpose

In Ethiopia, no holding right shall be violated except where there is expropriation for the purpose
of public interest. This fact is manifested on the federal constitution which stipulated that ; the
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government has the power to expropriate private property on land for public purposes subject to
the payment of advance compensation commensurate to the value of the property. Thus, any
party which initiate expropriation procedure should provides for payment of “commensurate”,
amount of compensation during expropriation of property. Therefore, any type of land holding
may be expropriated for public purposes with advance payment of commensurate compensation.
For instance, it may include construction of road, public hospital school, town expansion,
building public institutions, irrigation development and land for investment. The implementing
agency shall have responsibilities to prepare detail data pertaining to the land needed for its
works and send same, at least one year before the commencement of the works, to the organs
empowered to expropriate land in accordance with Expropriation of landholdings for Public
Purposes and Payment of Compensation Proclamation No. 455/2005 and obtain permission from
them; and pay in advance of commensurate compensation to landholders whose holding have
been expropriated.

Where a woreda or an urban administration believes and decides to expropriate a landholding

provided that it should be used for a better development project, it shall notify the landholder" in
writing, indicating the time when the land has to be vacated and the amount of compensation to
be paid. The governing law for expropriation and compensation of property in Ethiopia is
Proclamation 455/2005 and Regulations 135/2007 issued at the Federal level. Based on the
Federal law, regional states are expected to issue directives for its implementation. The power to
expropriate is principally given to Woreda (district) and Urban Administrations upon payment of
advance compensation. However, the decision to expropriate may be made by the appropriate
higher regional or Federal government organs although there is no mention of who these “higher
organs” are. Theses provision clearly confirmed that compensation or payment to be made in
cash or in kind or in both to a person for his property situated on his expropriated landholding
must be equivalent to the damage sustained and the owner shall be placed in as good a
pecuniary position as if the property had not been taken. The experience indicated that
problems with compensation and valuation have contributed to unsuccessful development-
caused forced displacement experiences in Ethiopia. Those problems may be related to defects
in both the legal framework and its implementation.

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Perhaps the fundamental principles of compensation is taken to mean putting the displaced
person in a financial position as close as possible to what he or she would have enjoyed had
acquisition not occurred. This is the principle of equivalence which underpins almost all
compensation legislation around the world by making their constitutional requirements for
paying compensation that reflect “payment of just compensation”, “fair and just compensation”,
“reasonable compensation”, “commensurate compensation” etc- however, there are significant
differences in the details of how this principle is applied specifically the difference comes as
result of valuation methodology, how these value are determine? The discussion is therefore, do
expropriation procedures ensure appropriate compensation? If it does, what chain of variables
explains this fairness? If it does not, what are the interacting variables and how have they related
and have generated a process of unfairness overtime? To answer these issues we need to touch
up on the issues of compensable interests’, basis and methods of calculating amount of
compensation and valuers (professionals),
Most laws on compulsory acquisition broadly define equivalent compensation with reference to
market value or “Just compensation”. Pertaining to the issues international practice on
compensation for expropriation indicated that most countries around the world have
constitutional and/or statutory standards that call; “appropriate compensation”, “Just
compensation” ,“fair and “just compensation” etc. But constitutional and/or statutory standards
should require having mechanisms for how is this compensation determined. In estimating
compensation, it is a basis of value and methods of valuation that are fundamental measurement
principles of determining and describing whether constitutional requirements for paying
compensation are paid. A basis of value is not a statement of the method used, nor does it
describe the state or condition of the asset that is involved in the hypothetical transaction. A basis
of value typically describes the nature of the assumed transaction, the relationship and
motivation of the parties and the extent to which the asset is exposed to the market. For most
valuation purposes it will be appropriate to use one of the basis recognized in the International
Valuation Standards and identified in these standards coupled with any necessary assumptions or
special assumptions.
The value of property for compensation purposes may be determined based on various bases, but
the most common basis are market value, fair value and replacement cost. Besides, according to
IVSC (2007) fair value may be used where the valuers needs to estimate the price that would be

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fair in an exchange between two specific parties, without necessarily having to disregard criteria
that would not be replicated in the wider market, for example where special value or synergistic
value would impact on that price. Replacement cost basis often used for valuating loss of
structures on land. Its underlying principle is that an informed buyer will pay no more for an
improved property than the price of acquiring a vacant site and constructing a substitute building
of equal utility.
Pertaining to valuation methodology, the typical valuation methods used internationally to
determine the fair market value of the asset types typically impacted by government
expropriations: land, structures on land, crops, and common property resources are one or both
of two basic approaches: comparable sales approach, and/or capitalization or income approach.
Replacement cost approach is also recommend to be performed as controller or used to cross
check value obtained from the aforementioned approaches. Some observers describe a fourth
approach typically described as “expert opinion,” but expert opinions are typically based on one
or both of the other two approaches.
Similar to other countries, in Ethiopia Article 40 (8) of Federal constitution requires
“commensurate compensation” for all takings of private property. A brief review of
interpretations of the constitution suggests that the land holder is entitled to a vaguely phrased
“commensurate compensation”. Despite what “commensurate compensation” stands for is
defined neither in the constitution nor in its interpretations; the right to fair compensation and
due process is uncontested and is reflected in the constitution. The Ethiopian Civil Code has
adopted the indemnity theory in determinations of compensation. Article 1474 (1) of the code
says that the amount of compensation or the value of the land that may be given to replace the
expropriated land shall be equal to the amount of the actual damage caused by expropriation.
That is, if the amount of compensation is equal to the actual damage, there is no possibility for
the owner to be harmed or benefited as a result of the taking. Having this evidence and facts,
therefore, we can say that the constitution provides for the payment of “commensurate” amount
of compensation which signifies that compensation must be equal, proportionate, adequate, and
appropriate for loss of land assets upon expropriation.
Unfortunately in Ethiopia, the amount of compensation has been made based on some estimate
of what was deemed to be replacement cost: “the amount of compensation for property situated
on the expropriated land shall be determined on the basis of replacement cost of the property”.

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Such approach is practically not considered as an alternative to determine compensation, if the
constitution requires fair or just compensation. But, based on political economy of the country,
the quality of land acquired, the nature of the land right and status of land market, replacement
cost may be useful, specifically in a country where land markets is weak and doesn’t provide
reliable information about prices and comparable assets or acceptable substitutes are available
for purchase. Perhaps, there is such provision in Ethiopia but it may create a gap between
statutory compensation. So the question is does statutory frameworks set by the government
maintain a regulation of adequate compensation for expropriation?

Detail of the governing law with regards to determination of amount of compensation stated that
landholder whose holding has been expropriated shall be entitled to payment of compensation
for his property situated on the land and for permanent improvements he/she made to such land.
Applying cost replacement method payable to an urban dweller, it may not, in any way, be less
than the current cost of constructing a single room low cost house in accordance with the
standard set by the concerned region. Compensation for permanent improvement to land shall be
equal to the value of capital and labour expended on the land. The cost of removal, transportation
and erection shall be paid as compensation for a property that could be relocated and continue its
service as before. Furthermore, a rural landholder whose landholding has been permanently
expropriate shall, in addition to the compensation stated herein above be paid displacement
compensation which shall be equivalent to ten times the average annual income he/she secured
during the five years preceding the expropriation of the land. However if a rural landholder or
landholders of common land whose landholding has been provisionally expropriated (for limited
period), be paid displacement compensation until repossession of the land, compensation for lost
income based on the average annual income secured during the five years preceding the
expropriation (' the land; provided, however, that such payment shall not exceed the amount of
compensation payable for landholder whose landholding has been permanently expropriate.

Formula: The formula for calculating the amount of compensation payable in accordance with
the Proclamation and Regulations shall be as follows:
1) Compensation for building = cost of construction (current value).
+ Cost of permanent improvement on land
+ The amount of refundable money for the remaining term of lease contract

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 2) Compensation for Crops = the total are of the land (in square meters)
X value of the crops per kilo gram
X the amount of crops to be obtained per square meter
+ Cost of permanent improvement on land
3) Compensation for unripe Perennial Crops = number of plants (legs)
X cost incurred to grow and individual plant
+ Cost of permanent improvement on land
4) Compensation for ripe Perennial crops = the annual yield of the perennial crops (in kilo
grams)
X the current price of the produce of the perennial corps
+ Cost of permanent improvement on land
5) Compensation for relocated Property = cost of removal
+ Cost of transferring
+ Cost of reinstallation
6) Compensation for Protected grass = area covered by the grass per square meter
X the current market price of the grass per square meter

Based on Article 19 of Regulations No. 135/2007, there are properties for which Compensation
is not payable. Accordingly, there shall be no payment of compensation with respect to any
construction or improvement of a building, any crops sown, perennial crops planted or any
permanent improvement on land, where such activity is done after the possessor of the land is
served with the expropriation order.
literatures in the area confirmed that the main rule for the assessment of compensation for the
property acquired is the market value. The basic valuation method is the sales comparison
method, although the income method and in certain situations with no market activities the cost
method may also be used. So the typical valuation methods used internationally to determine the
fair, equal, proportionate, adequate, and appropriate value of the asset types typically impacted
by government expropriations are comparable sales approach, and/or capitalization or income
approach. Therefore, the trend and experiences that Ethiopia has today contradict with the
dominant view in the literature. More importantly, if constitutional and/or statutory requires what
we call it fair compensation or just compensation, legislation or the law should clearly state what

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is understood by market value not replacement cost of the property. Perhaps, it may not be
possible to determine compensation based on market value and a replacement cost model may be
considered as an alternative approach. But caution must be taken to ensure that the proposed
solution is not an attempt to avoid paying equivalent compensation.
Therefore, in Ethiopia where the constitution requires commensurate compensation, it should be
questioned that what is understood by replacement cost of property for the following
shortcoming of the approach. A drawback of replacement cost approach is that it does not
consider the unique and basic characteristics of components of property; it usually does not
incorporate the expected economic benefits or the income generating potential of the land. It
does not take into account the factors of risk and uncertainty associated with realizing the
economic benefits associated with the asset. It may not provide an indication the "highest price
obtainable" in the open market, in the context of the "fair market value" standard. In addition to
this theoretically cost approach value is not related to either the demand/supply conditions of the
market or the locational situation of the property. Furthermore, cost approach required specialist
who know about construction plan, material specification in which the government should rely
on the inspecting engineer, who is more qualified and experienced in estimating construction
costs than the committee of experts.

In Ethiopia, there is neither an independent and developed valuation system, nor are there
available professionals in the field. In fact lack of adequate professional valuers, skilled man
power (few trained individuals in the field), is considered as the major problem in valuation
process. Since valuation has to be carried out by committees comprised of different experts of
different backgrounds who have the relevant qualifications. The other problem is related to
modality of compensation- displacement monetary compensation. In principle, hat rural land
holders have perpetuated right and it is inalienable -should be compensated at a much higher
rate. But in numerous cases, the competent authorities have decided that such households have
not entitled to equivalent compensation for their lifetime use rights. This is clearly stipulated in
Federal Democratic Republic of Proc. 455/2005), that is issued on expropriation of rural lands
and payment of compensation. Accordance with Article 8 ( 1 & 2) of this proclamation, a rural
land holder whose land holding has been permanently or provisionally expropriated shall, in
addition to the compensation payable under Article 7 of this Proclamation, be paid displacement

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compensation which shall be equivalent to ten times the average annual income he/she secured
during the five years preceding the expropriation of the land ('the land; provided, however, be
paid until repossession of the land, compensation for lost income based on the average annual
income secured during the five years preceding the expropriation and that such payment shall not
exceed the amount of compensation payable for permanently expropriated) .
As a matter of fact both the constitution and its implementation enacted by the federal state
provided farmers/pastoralists and other vulnerable group farmer perpetuate right to use on
agricultural land. Thus, compensation is the core issue in the process land expropriation from
individuals who has perpetuates us rights. The practice indicated that the government land
grantees do not receive adequate compensation. Hence, land compensation laws explicitly cap
the compensation for displacement compensation which shall be equivalent to ten times the
average annual income, leaving virtually no legal basis for farmers to demand a higher
compensation, or a compensation that affected farmers are willing to accept. Such a
compensation model which ignores farmers’ perpetual a right obviously isn’t expected to
guarantee the land-lost farmers’ interests (commensurate compensation). To the extent that
farmers have perpetual use right and it can be argued that farmers have rights over land
tantamount to private ownership, even if still it is not a complete private ownership. Thus,
compensation over rural land should reflect land price which is the capitalization of expected
income of land ownership. Hence in the meantime the government is authorized to sell use rights
to such expropriated land to commercial interests at a market price that is in most cases several
times higher even than the maximum compensation paid to affected farmers. So problems are
inevitable in the practice of the land expropriation because the average annual output value of
agricultural products, however, is not land net income in itself.

It has to be also noted that for the rural land-lost farmers, land is not only their base for living,
but also their only asset that can be transfer to the next generation and capital of development.
Thus, how could compensation that basis on average annual income secured on agricultural
products by ignores the land additional value and potential values restore framers to their original
position prior to expropriation; grant commensurate compensation. Considerably, rural land
mostly happens to be required for big projects like dams, hydropower stations, private
investments, and so on which real increase the value of land. But the government offers low

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compensation payment, and then gains the increment income by granting the land use right. The
justification for fixing this amount is unknown, and probably baseless. Neither does it follow any
of the valuation methods we discussed above. This provision has no economic or legal basis, and
as a result, remains a source of discontent, complaint and frustration for most of the farmers who
lose their holdings

It is also clear that the legislation fail to consider compensation should be made based on the
value of the land rights, improvements to land, and on any related costs. Hence farmers and
pastoralist and / or herders gathers have perpetuated right over the land that should be considered
during calculation of compensation. But the laws or government policies only provide guidance
on valuation of improvements to land, and on any related costs, no guidance on valuation of land
and rights on land. Determination of compensation is thus based on average agricultural yield of
the preceding 5 years regardless of farmers’ investment in land, location of the land, potential
best use of the land, local demand for such land, market price for agricultural product that the
land is producing, and other factors that typically consist of the value of farmland. Such
expropriation and compensation laws and policies appear to be irrational in a sense that current
compensation system ignores the value of perpetuate land use rights. This is a clear injustice.

Therefore, offering equal and reasonable compensation to land holders is always the aim in the
reform of the land expropriation compensation system in Ethiopia. Because these experiences
implied that despite the constitution supports the payment of commensurate, the amount of
compensation that basis on average income secured is really far from what is called
commensurate. Therefore, any compensation system must insist on the direction of market and
take the interests of the government, farmers and land users into account.

6.1.2 Property Valuation Mortgage Purpose

Although the possibility to mortgage land or rights in land together with its fixtures is due to
international experience a necessity for investments and economic development in a market
economy, the possibilities to use rights in land as collateral are very limited in Ethiopia. This is
due to the fact that land is owned by the state and the Ethiopian people, and as a result, it is not
subject to sale, mortgage, or exchange (Federal Proclamation No. 1/1995). Concerning the issue,

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the Civil Code contains provisions for mortgage that still are partly applicable (Title XVIII,
Chapter 4 of the FDRE, Civil Code Proclamation of 1960). There are provisions regarding
creation of mortgage. Mortgage is valid only in immovable property and when stated in a
contract of certain form specifying the immovable mortgaged. A mortgage, however created,
have no effect before the day it is registered in the register of immovable property. This
registration may nowadays take place in the registry of City Administration where urban land
tenure lease rights are registered. There are also provisions regarding rights of third parties,
priority and plurality of mortgages as well as extinction of mortgage.

Recently, notwithstanding, the government retains the “ownership right” the right to possess,
use, benefit from, and dispose of lands, the existing government made an amendment on both
rural and urban land to ensure the right of individuals to the use of land on the basis of payment
arrangements established by law. Thus a transaction can take place in a form of rent and lease
hold system. More specifically, land rental market has been legalized in recent years, lifting
extensive restrictions on rental and sharecropping, which paved the way for individuals to
acquire land through rent either in kind or cash from farmers for limited period of time in
contract. Here we should be clear with the word rent and lease since they have an implication on
mortgage and valuation as well. In a lot of studies made on the issue, scholars used the terms
“rent” and “lease interchangeably however, in the context of Ethiopia they have different
meaning and implications. In other words, rent means a system by which a farmer causes the use
of his land, which he gets it pursuant to this proclamation, for the service of another person
securing benefits in kind or cash for a limited period of time in contract. “Lease” means a system
by which any investor takes a rural land from government for a limited period of time, and, as it
is interpreted in relevant law, the right to use the land includes the holding of same for debt as
surety ship. Here I would like to ring a bell that it is only land that is obtained from state through
lease which can be mortgaged. To the contrary, Land that is acquired from any other user interms
of any kind of land transfer including rent cannot be mortgaged. This clearly shows that there are
policy confusion signals on the use of land as mortgage.
Agricultural investor means a person who wishes to possess and leases the land for profit
purpose. An effort has been also made to attract this kind of investor through providing special
rights on land. Any investor who received rural land in lease for definite period (maximum

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25years) of usufructuary right may secure as mortgage right to use his land or an asset produced
on it, or both for the effected period of the lease. If there is no a contrary agreement, where the
land use right is mortgage, the asset developed on the land shall be considered as it is withheld
together. But where only an asset produced on land is mortgage, the land use right shall not be
considered as mortgage together with same. It is important to remember that a farmer has no
right to mortgage his/her indefinite usufructuary right on land.

Similarly, any investor who received urban land in lease for definite period (maximum 99 years)
of usufructuary right may secure as mortgage right to use his land or an improvement, or both for
the effected period of the lease. If there is no a contrary agreement, where the land use right is
mortgage, improvement (building) shall be considered as it is withheld together. But where only
the building is mortgage, the land use right shall not be considered as mortgage together with
same. So an individual can mortgage only the improvement (Pro. No 272/ 2002). This simples
that in Ethiopia regardless of the type of land (Urban or rural land), any investor who received
land in lease for definite period (maximum 25 years –rural land and maximum 99 years- urban
land) of usufructuary right may secure as mortgage right to use his land or an improvement, or
both for the effected period of the lease. In addition to investors ,according to the amended
proclamation No 272/2002, any person who acquires the right to hold urban land on lease may
transfer or pledge such right or contribute it in the form of a share to the extent of the rent paid;
where the right to hold land on lease is mortgaged the building on the land and its auxiliary
facilitates shall, unless otherwise decided, also be mortgaged; likewise, where the building and
its auxiliary facilitates are mortgaged, the right to hold the land on lease shall also be mortgaged.

Theoretically, there is a general consensus that making land rights transferable would enhance
credit access and promote investment incentives. A stronger view is that there is no inherent
problem appears to debtor bankers from granting mortgage loans to borrowers who only hold
lease hold rights. Lease hold system is also assumed to be an ideal institutional vehicle for
creating land and credit market. Experiences of other countries of getting access to formal credit
by lease system confirmed practicability of the system. In other words it is not because of
leasehold that lessees cannot use their leased land rights as collateral. Instead, the possibility of
mortgage leasehold rights depends on the availability of well established institutions to delineate
and enforce lease hold interest. However, the prevalent practices in Ethiopia are against the
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above argument. Because the prevailing empirical observation indicated that despite the
proclamation of land lease provides that lessee should be given the value of the improvement or
building and a usufracturay right value by the time they used their real properties as collateral,
the practice doesn’t support the above facts. I.e. in the face of all lending institutions are aware of
the proclamation, neither of them have been experiencing lending of money which consider use
right as collateral. This indicates that the new land lease proclamation is unlikely to increase the
banks’ willingness to lend.

Banks in Ethiopia do not seem to accept lease title as a security (collateral) for loans to investors.
The general reason given is that in a country where land is public property and, characterized in
the absence of tenure security, undeveloped use right market in the country coupled with non-
existence of real property expert valuators, it is very complex and difficult to estimating the
market price of usufracturay right. More importantly the absence of well established institutions
that settled land and land related activities and problems. Above all, since land is public property,
if the borrower faces bankruptcy or if the borrower disappears, there is no any guarantee that the
lender recovers the loan. This implied that, there is a lot to be done in order for banks to make a
wise loan decision when considering a valued property/building and lease right as collateral.
Specifically, we should acknowledge importance of secure property rights to land is a
precondition for land-related investment in many settings. Well functioning land institutions and
markets also improve the investment climate because ability to use easily transferable land titles
as collateral reduces the cost of accessing credit for investors, thus contributing to the
development of financial systems in particular and the economic development in general.

Due to our poor property valuation system it is common to listen complain of either business
owners (real estate developers) or financial institution about deficiencies of the property
valuation approach that we have been using. Absence of standard valuation leads to extremely
subjective estimation as a result of which estimations are frequently exposed to under or over
valuation according to the interest of the parties involved. The basis of valuation for mortgage
purpose equivocally considered as a very important determinant of mortgage value. The
application stipulates in many countries that valuations for secured lending shall normally be on
the basis of market value, except when otherwise governed by law or statute. However, the

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practice of lending institution showed that banks have been experiencing of using replacement or
production cost as a basis of valuation which is contradictory with literatures. Hence, property
which is common used as collateral, specifically the income generating properties; it is not fair to
estimate the value of such property with cost approach. The practice indicated that, regardless of
the type and nature of building or improvements banks have been frequently employed cost or
contractor's approach.

These experiences also contradict with the dominant view in the literature which sees investment
or income capitalization and sale comparison method as the most appropriate for mortgage
valuation. Hence, developed country indicated that cost approach is often not very precise
because of the general methods used to calculate hard costs, depreciation cost in old properties,
adjusting the estimated replacement cost to reflect the age and inadequacy of the building.
Moreover it required specialist or experts who know about construction plan, material
specification in which the construction lender often rely on the inspecting engineer, who is more
qualified and experienced in estimating construction costs than the appraiser. Furthermore,
theoretically cost approach value is not related to either the demand/supply conditions of the
market or the locational situation of the property. However, surprisingly the practice of one bank
in Ethiopia is against the arguments of the above theory. Because experiences of Commercial
banks of Ethiopia exhibit consideration of locational value coupled with cost replacement
approach. Here is the evidence. Commercial Banks of Ethiopia (CBE ) after understanding the
fact that market lease value of land at the center of town where borrowers used to live is very
expensive compared to other undeveloped leased land found far from the center and resulted
consideration of locational value. The practice revealed that even if CBE has never consider
usufracturay right to be valued as a collateral, location value for leased land has been given a
place and considered in addition to value of the building.
The Ethiopian Bankers Association (EBA, 2010) has prepared and distributed its Real Property
Valuation manual, which is meant to provide uniform guidelines for the valuation of properties
in line with internationally accepted practices, to all member banks.

It is true that customers have been complaining about the difference in valuations among the
banks and the recently prepared manual is aims to avoid differences in the estimated values of
properties which are pledged as collateral by member banks. Unlike previous valuation systems

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followed by engineers, the EBA's manual uses income and cost approaches based on the
standards of the International Valuation Standard Committee (IVSC). An income approach is
based on the income which the property is generating at the time of valuation, while a cost
approach is based on the total cost of the construction of a property. Once the manual is put into
use, the valuation of property among banks is expected to be uniform with a variation of only
five per cent Employees of member banks, which have already received the manual, will be
trained in it, after which the manual will be put to use.
It has to be stressed, however, that adopting an alternative valuation system is not an end by itself.
Since for a mortgage system to function effectively legal rights must be both secure and
transferable, in which Ethiopia is lacking. Specific solutions based on them must therefore be
adapted to national conditions. The confidence in the system requires not only the legal rights to
transfer and mortgage property rights, but also the existence of a land or property rights market
with a reliable demand of rights in land. Promulgation of a mortgage law far in advance of the
development of the demand side of the property rights market is likely to have little immediate
impact. Lenders would like to be convinced of the property rights value as security before they
accept it as collateral. Pertaining to the issues of valuation methods for mortgage purpose,
despite Banks which supply loan for financing projected development are highly concerned with
market value (IVSC,2007), Banks have been using only cost approach to value property that
used as collateral. But this method is different from other methods used to estimate market value
of property which largely ignore the most important factor that influence value of property,
location.

More importantly, the high rate of inflation and exchange rate keeps on distorting construction
costs. Ethiopia import most of building materials whose price is affected by aforementioned
factors , using outdated lists of costs of building materials together with unpredictable variation
of inflation make projected cost over time very difficult to estimate. In fact in Ethiopia, the state
ownership of land is not only limited types of valuation but also keep down the emergence of
real estate developers. Because most of the time real estate developers come to the market by
assuming that they can finance their project via mortgaging their real property as collateral. In
this case, it is the land which is regarded as the best kind of collateral for real estate developer,
but it is not always the case that financing and valuation systems are comprehensible and

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transparent for real estate developers and other interested parties in a country like Ethiopia in
which value land is kept as dead. As a result, developers are forced to get loan by mortgaging
their improvement in which the value is determined by the market value of buildings that is
greatly based on the cost of construction materials.

6.1.3. Property Valuation for Determining Rental Price of Public Lease Land

Ethiopia’s persistent urban poverty has made urban land and housing policy the subjects of ongoing
debate. We know that in Ethiopian, the right to ownership of rural and urban land, as well as of all
natural resources, is exclusively vested in the state and in the peoples of Ethiopia. Land is a common
property of the nations, nationalities and peoples of Ethiopia and shall not be subject to sale. Yet
social justice, urban renewal and development, the provision of decent dwellings-and healthy
conditions for the people can only be achieved if land is used in the interests of society as a whole.
Since under absolute state ownerships of asset the government of Ethiopia didn’t brought significant
solution for the ever increasing poverty; the situation had put pressure on state to move from a
command to a market oriented economy. Hence, it was within this reform framework that urban land
leasing policy and legislation were promulgated and put in to effect. In other word, urban leasehold
land tenure system in Ethiopia was prompted by consideration of a free market philosophy.

It is also worth mentioning that the coming of lease hold system in Ethiopia was also inspired by
failures of the 1975 legislation, namely government ownership of urban land and extra houses
proclamation No. 47/1975. Because this law didn’t provide land value to express in monetary terms,
didn’t increase the accessibility of land for construction of residential houses by low income people,
the application system to get access to urban land was characterized by loopholes and making it
difficult to control discriminatory treatment of applicants and corruption etc. This led to the coming
of the first urban land lease proclamation, which came in to force on 23rd of December 1993 after the
repeal of its predecessor proclamation No. 47/1975.

It is believed that transferring urban land by lease for a fair price, consistent with the principles of
free market, will help the expansion of investment and urban land development in particular and
overall economic and social development in general. Therefore, despite the government retains the
“ownership right” the right to possess, use, benefit from, and dispose of lands, a transaction can take
place in a form of lease hold with the lessee having the “right to use” and “benefit from it. In spite of
the wide range legal and institutional reforms undertaken by the government, the fundamental

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elements and principles in the process of enacting policies aren’t the same as achieving what the
policy should serve. Due to limitation of the proclamation and change in demand of the society, the
1st urban land lease proclamation has been revised and amended two times in 2002.

One of the key open questions and dilemmas with Ethiopian urban lease policy are concerned with
the setting lease rent, land valuation and definition of the market value concept for the urban land
system. As basic rationality the government adopts this tenure system is to give market determined
exchange value to land or the lease arrangement would turn land from a timeless and cost less
resource into formally exchangeable commodity with both cost and time limit. Through such system
the government believed that it is possible to collect adequate revenue, by keeping the value of land
and appropriations of future land price increases by the public that shall be used to finance public
infrastructure. When a municipality grants the use of land under a leasehold system, it reserves the
right to claim substantial proportion of future increments in the capital value of land at the end or in
the middle of the contract.

The central issue is therefore what forms of legislative and institutional factors are most likely to
achieve these objectives of lease policy in different contexts? Of course different countries adopted
different methods/ despite differences in legislative and institutional factors affecting ground rental
leasehold tenures in different countries, some similarities do exist and the problem of how to
determine a fair ground rental rate under different lease terms and conditions are an international one.
Ground rentals are commonly valued by applying a ’ground rental rate’ as a percentage per annum to
an assessed vacant land value. In a number of other countries ground rental rates are determined by a
variety of processes, mainly administratively, legislative prescription, executive decision, precedent
or customary valuation practice and negotiation. In some countries the setting of ground rental rates
where land is leased from the state, government or municipal agencies, seems to be partly politically
or administratively determined”. This is particularly so where negotiations are not really open to
market forces or effective challenge and independent determination. For example determining the
price of a ground lease by auction is not the practice in the Netherlands, nor are there any signs that it
will ever become so. The asking price is set by the lessor (in practice, a municipality) and although
there is room for negotiations this room is small, for a municipality does not want to lay itself open to
the suspicion that it is acting arbitrarily, or favoring some lessees and not others.

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Review of literatures indicated that with an increasing pressure, world-wide, to deregulate
government institutions and to let market forces price the use of capital, pressure will be exerted to
remove ground rentals from administrative or prescribed formulae to market based determinations.
This concern also places greater pressure and requires Ethiopian governments to formulate a policy
which is consistent to market principles. It is obvious in Ethiopia lease price and market value of
isn’t possible to set by reference to the market condition of the land at the beginning of the ground
lease since land sale is impossible by law. Having such facts determining the price of a ground lease
by auction is the practice in Ethiopia. It is found that this approach of allocating urban land is a tool
to provide a clear signal of the land market value. In addition of creating opportunity to establish and
learn market values of land parcels, such tool also remove the shroud of secrecy surrounding many
land allocation decisions and place such decisions in an open and transparent form, eliminating to a
substantial degree the possibility of improper considerations. It is necessary to examine how it works

The urban land lease law of Ethiopia clearly stated that an urban land shall be permitted to be held by
leasehold through tender or auction. In this process initially regions and city administrations shall
prepare of urban land in advance plots. After that the body will set lease benchmark price or ground
rent base- the threshold price determined by taking into account the cost of infrastructural
development, demolition cost as well as compensation to be paid to displaced persons in case of built
up areas, and other relevant factors. The law confirmed that urban land shall be granted for highest
bidder on the basis of market (bid price) and competitive parameters (duration and amount of down
payment). A bid shall be cancelled if amount of bid is less than the lease benchmark price. In fact
determining rate of lease payment for urban land transfer through negotiation or allotment, not
auction has been one of the major common issue that has been frequently raised by society. Hence
those leaseholders who are entitled to pay land use fee are subject to payment of lease benchmark
price applicable to urban land holding granted by auction.

It is necessary to recognise that although determining rent and providing land market value raises
important technical and procedural questions, it is ultimately efforts of government related issues,
since such values over land cannot be isolated from packages of action in general made by the
government at the ground. Lack of land market and required skill in determining lease price within
most cities of the country creates a complex series of relationships in which policy related to any one
has major and often unintended repercussions on the others. The practice indicated that large volume

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of urban lands allocated through tender has been under developed. In this situation we can imagine
the difficulties associated with calculations of the ground rent base and proving land market value.
This trend does not mean, however, that there is no action taken by the government to achieve these
objectives of lease policy.

In Ethiopia a major complication of lease tenure arrangement has also observed in payment of lease
price. Payment of the lease which is auctioned, it can be assumed that the price will vary according to
the terms of the lease (e.g. restrictions on the use to which the land can be put), and according to
expectations about inflation and about real changes in the value of the lease. Such a method will
result in a price being paid equal to what the market considered to be the value of the ground lease.
The price could be either a capital sum (a premium, no further payments for the duration of the
lease), or an annual sum (to be paid every year for the duration of the lease, where the agreed price
could include arrangements for varying the annual payments during the life of the lease). Concerning
procedure of payment of lease amount in Ethiopia it is possible to pay in a single lump sum or over
time.

Despite there are unlimited number of possibilities on the way that the periodic payment and interest
are paid whenever a lessee extends a payment, the 1st lease law of Ethiopia didn’t say anything
which may create a room for regional and city administration to come up quite often, and more
complicated forms. However the revised proclamation placed some provision that will be made for
repayment of the principal (the total lease amount). According to Proclamation no. 272/2002 any
person permitted urban land lease holding in accordance with the law shall conclude a contract of
lease with the appropriate body by paying the amount of down payment, as determined by the region
or the city administration, shall not be less than 5% of the total lease amount. Indeed, this
proclamation indicated that the remaining balance shall be paid on the basis of equal annual
installments during the payment term and interest shall be paid on the remaining balance as per the
prevailing interest rate on loans offered by the Commercial Bank of Ethiopia. It is hoped that the
appropriate body shall follow up and update the applicable interest. The implication of such
arrangement suggested that the annual payment remain uniform for the lease period and implies that
the government arranges a loan for a lessee to make payment of the remaining balance in which a
government as lender gives use right on land to a lessee and the lessee agrees to return the use right
or repay the money, usually along with interest, at some future point(s) in time. It has to be stressed,

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however, that the applied principle of payment definitely contradicts with other objective of the lease
policy discussed below.

One of the reasons to establish urban land lease system in Ethiopia is to benefit from the expected
increase in land values and to capture these increases for the community. But, the increased demands
that lease hold system place upon the state have invariably proved less than the ability to do. Perhaps
the first point is the lease price it is not the result of demand and supply interaction rather it
incorporates other variables such as amount of down payment and duration of payment. Such
consideration like traditional approaches, seeks to replicate the “market” in a normative and
hypothetical approach since it assumes a willing but not over anxious leaseholder. Second urban
land administrators haven’t invested in their cities, in its public area, to make it an attractive place
for economic development and for living and working for their citizens. Hence such investment
increases in value of private property and thereby enables city administration or regional
municipalities to capture the increased value. Third lease price has not renewed during the lease
period. Such simplistic assumption may have serious negative consequences which have so far not
been fully acknowledged. For example lenders are not voluntary to accept such inflated land price as
market value of land. Since the lease price is over and above of the market value of land, and does
not show the market value, the borrower (lessee) is expected to develop the land in order to pledge
the land as collateral for loan provision.

Unfortunately most of the lessees take the land through paying higher prices not to undertake
development activities but to sale with higher prices for other land demanders. This makes the land
price over and above the market value. In such type of lease price, bankers are not confident to take
undeveloped land as collateral unless the lessee develops the land. At the same time giving priority
for those who pay the total amount of the lease price at the signing of the lease contract to be a
winner of lease auction also create additional problem. It is made clear that once the full payment is
done, no other payment is expected from the lessee until the contract expires. Although for initial
investment, a huge amount of money is required, the problem of encouraging full payment of the
lease price is that it contradicts with the objective of the retention of land in public ownership which
is meant to have the increase in land value accrue to the community.

It should be emphasized, however, that the main objective of public land lease system is not to
produce an immediate financial return for the municipality but to capture increasing land values

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through a periodic rise in ground rents. Hence one of the advantages of retaining land in public
ownership is to have the increase in land values accrue to the community at large calculation of the
ground rent, therefore, has a critical bearing on the success or failure of this endeavor (Mattson,
1995). However the practice in Ethiopia implies that the first-time lease payment is decided entirely
by the amount of down payment and grace period when parties sign the contract between them and
then annual payment is calculated as6:

Total Lease Amount−Amount of Down payement

Annual Payement =
Lease Period

In other word, the changes in the land value aren’t reflected in the lease rent or annual rental
payment, which can be orientated at the ups and downs of the land prices or at other indices, like the
living cost index. Although several years has been passed from the introduction of market-based
system in many sector , the system and practice of using and managing urban land in Ethiopia have
not been harmonized with the objectives because a great number of basic, conceptual problems have
not yet been solved. Currently, it seems inconceivable that lease land routinely let for very significant
periods of time on leases containing no provision for adjusting the level of rent. For example, in
Continental European leases the norm is for there to be indexation provisions or rent reviews to come
to know the open market rental level. However, the practice in Ethiopia indicated that ground rents
were fixed for the whole lease, which in periods of zero inflation maintained their value. This implies
that , it is necessary to recognized that the method for setting rental rates for urban lands leases and
payment arrangement should be evaluated in light of achieving its objectives; the legislature should
further think about the mechanism of achieving its goals.

It is clear from the literature contemplate that the rental stream should be a ‘mark-to-market rental
stream. That is the rents that the lessor would earn if the lease payment adjusted instantaneously to
evolving land values due to economic growth or changes in use. Therefore, in Ethiopia there should
be a mechanism that reserves municipality’s right to benefit from increase in land values and claim
substantial proportion of future increments in the capital value of land at the end of the contract. This
implies the current lease holding system require further improvement to address problems related to
change in land market value. There should be mechanism in which that the benchmark lease price

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shall be updated at least every three or five years to reflect market conditions and adopted to the
specific needs of lease annual rental payment

In this connection, there are a number of problems associated with payment of the remaining balance
which generate lots of discussions among the people. As demonstrated above, interest shall be paid
on the remaining balance as per the prevailing interest rate on loans offered by the Commercial Bank
of Ethiopia. Thus, the first concern is despite there are several typical ways of defining lease
payments around the globe, why Ethiopian adopts a system that is not common, provided its
economic development level. Hence the two most common of which are equal periodic instalments
during the entire lease period and equal periodic instalments, time to time adjusted up for inflation.
A few exceptions include the land lease in Hong Kong and Mainland China (where it was modelled
after the Hong Kong system), where the total sums is required to be paid up front. However, one-
time payments create a very uneven revenue stream for the government and is not sustainable in
long-run, because land for lease is limited and after the most of it is allocated for long term leases,
this source of revenue will dry up.

Regarding the payment structure for leases in Ethiopia, the unpaid part of the total lease value is de
facto interpreted as a loan from the government, subject to the interest. Thus in aggregate Ethiopian
system has two main differences from the common system mentioned above, which make it
extremely difficult to administer: i) It allows varying payment schedules (a buyer may choose any
size of a down payment above 5% of a purchase price and a duration of a payment period for the
outstanding part of the price) and (ii) It requires calculating and collecting the interest. Under the
given economic development level this raised debate about what are the benefits for Ethiopia of
overburdening itself by such a complex system of charging for auctioned land, given that the system
is expensive and too cumbersome to operate and is damaging the appeal of leasing in the eyes of the
population?

The regularizing of urban land tenure in Ethiopia through such complex and uncommon system may
have serious negative consequences which have so far not been fully acknowledged. Therefore, with
the concern one can argue that whether additional revenues from the interest on unpaid lease amounts
could justify the troubles associated with charging the interest seems to be very questionable. It
appears that even if the government is interested to address multiple needs from lease policy has little
experience of formulating and implementing urban land policies appropriate to all sections of
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demand. Thus, simplifying the structure of lease payments, on one hand, and improving collection of
lease and rent revenues, on the other hand, along with other measures to enhance municipal revenue,
could greatly benefit the country. This issues should places greater pressure on existing tenure
systems and requires governments to make the leasing system easier and cheaper to administer and
more attractive to the population.
The implication is despite one of the objectives stipulated in all urban land lease proclamation is to
give market determined exchange value to land, land users haven’t been made to realize the cost of
urban land and make an efficient use of the resource; and land prices doesn’t provide a clear signal
that leads to efficient land use and allow the recycling of primate lands for best uses. Importantly, the
reasons to establish a lease system are to benefit from the expected increase in land values and to
capture these increases for the community. But the practice indicated that there is no mechanism
designed in such a way that the increased value of the land can be captured by municipalities.

The high land price policy is regarded by many as the ultimate cause of Ethiopian’s deep-seated
social conflicts, including the wide wealth gap, ever-deepening economic concentration and a
disenfranchised majority of citizens who must struggle in a chronically high-cost, housing-deficient
economic environment which offers dwindling business and job opportunities. In Ethiopia the urban
land lease policy without providing land market value has been the chief contributor to the creation
of property market oligopolies, enabling a few real estate behemoths to extend their preponderant
power into other economic sectors over the past 18 years. It is not hard to understand why profit-
driven and land-rich developers and many property owners/investors/speculators insist the
government should retain its high land price policy Lease hold tenure is not a magic cure; however,
implementation of a lease system by a city administration or municipality requires trust between
government and citizens at the real estate market, and persistence.

6.1. 4 Property Valuation for Taxation Purpose

Government intervention in the supply of public goods is inevitable and can only is done if the
public pays taxes for the production and supply of such goods is high. In most country real
property tax is by far the largest source of revenue for both national and regional governments.
In property taxation, the valuation process is applied to develop a well-supported estimate of the
worth of a property, taking into account all pertinent data. Usually property taxes are based on

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the estimated market value of property. But this may not be the case in countries where there is
imperfect real estate market.

In value based systems, valuation entails the classification of each property in accordance with
an agreed set of characteristics relating to its use, size, type of construction and improvements;
the collection and analysis of relevant market data including data on sales prices, rents and
building maintenance costs, and details of the dates when these applied; and the determination of
the value of each real property in accordance with publicized procedures, where possible based
on market values and computer-assisted mass valuation systems. Practically this valuation
system indirectly implied the fact that in developing countries which have been experiencing the
impacts of population innovation, rapid urbanization doesn’t necessarily mean an increase in
burden of the government to finance public goods. Because if we come across consequences of
urbanization clearly and definitely, the growth of population and economic development resulted
in increases of land value by large unquestionably. This value which is created by socially and
economically factors allows the government to collect most of the created value of land and is
thereby, increasing revenue. But this would be true, if government adopt property tax which is
based on the value of property.

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