Cost approach, functional obsolescence and a highest and best use test that fails
A 1978 four-storey office building on a 1,200 sq m plot in Bengaluru's Richmond Road area has 2,700 sq m of built-up area, of which 2,400 sq m is usable. It has no lift, a single staircase and 2.1 m floor-to-ceiling height. The plot's present permissible FAR is 3.25, but the building was developed at FAR 1.5. The 900 sq m ground floor is let on a registered 20-year lease from 2016 at ₹210 per sq m per month with no escalation clause; the upper floors are vacant and the owner claims a market rent of ₹850 per sq m per month. Land sales of redevelopment plots in the locality are at ₹1,10,000 per sq m; renovated offices with lifts are transacting at ₹95,000 per sq m of built-up area; current construction cost is ₹32,000 per sq m; age-based depreciation of 56% is indicated; vacancy and collection loss is 10%, operating expenses 22% of gross rent and the capitalisation rate is 8.5%. Demolition would cost about ₹1,500 per sq m.
1. Test the highest and best use of the property and decide whether the depreciated building value should be added to land value at all.
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Apply the four tests expressly.
Legally permissible. Office use is permitted and the plot carries unused FAR of 3.25 against 1.5 developed, so redevelopment is permissible in principle, subject to setbacks and sanction.
Physically possible. Yes, though 1,200 sq m is small for a modern office with basement parking.
Financially feasible - the decisive test. Build 1,200 × 3.25 = 3,900 sq m; at 95% saleable, 3,705 sq m; at ₹95,000 per sq m, GDV ≈ ₹35.2 crore. Deduct construction 3,900 × ₹32,000 = ₹12.48 crore, demolition ₹0.41 crore, professional and approval costs at about 8% of construction = ₹1.00 crore, contingency ₹0.62 crore, marketing at 2% of GDV = ₹0.70 crore, developer profit at 20% of GDV = ₹7.04 crore and finance of roughly ₹2.0 crore. Total ≈ ₹24.3 crore, leaving a residual land value of about ₹10.9 crore, or ₹91,000 per sq m. The market evidence for land is ₹1,10,000 per sq m, i.e. ₹13.2 crore.
Maximally productive. Because the redevelopment residual is below the observed land value, demolition is not clearly justified at current sale rates and costs. The land market is already pricing higher expectations than this scheme delivers, or a lower developer hurdle. The defensible conclusion is that highest and best use is continued existing use with refurbishment, and that redevelopment is a sensitivity, not the valuation basis.
That conclusion matters: if redevelopment were the highest and best use, adding a depreciated building value would be double counting. Here the building is legitimately included, but its depreciation must reflect functional obsolescence (no lift, single staircase, 2.1 m ceiling) rather than age alone.
2. Compute the indications under the cost, income and sales comparison approaches.
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Cost approach. Land 1,200 × ₹1,10,000 = ₹13.20 crore. Building 2,700 × ₹32,000 = ₹8.64 crore, less 56% depreciation = ₹3.80 crore. Total ≈ ₹17.00 crore. This is a value in existing use; the age-based 56% probably understates total obsolescence.
Income approach - market rent. Gross 2,400 × ₹850 × 12 = ₹2.448 crore; less vacancy 10% and operating expenses 22% of gross, i.e. 32% in all, gives NOI = ₹2.448 × 0.68 = ₹1.665 crore; at 8.5% = ₹19.59 crore.
Income approach - ignoring the lease, i.e. applying contract rent to everything (the common error). Gross ₹1.757 crore × 0.68 = ₹1.195 crore, capitalised at 8.5% = ₹14.06 crore. Wrong twice: it applies vacancy to premises that are let, and it ignores reversion.
Income approach - correct treatment of the leased ground floor. Contract rent ₹0.2268 crore × 0.78 = NOI ₹0.177 crore, capitalised as an annuity for the 10.9 years to 2036 at 8.5% (factor 6.93) = ₹1.23 crore. Reversion at 2036 on market rent: ₹0.918 crore × 0.68 = ₹0.624 crore, capitalised at 8.5% = ₹7.34 crore, discounted 10.9 years at 8.5% (factor 0.411) = ₹3.02 crore. Ground floor ≈ ₹4.25 crore. Upper floors ₹1.53 crore × 0.68 = ₹1.040 crore, capitalised at 8.5% = ₹12.24 crore. Total income indication ≈ ₹16.49 crore.
Sales comparison. 2,700 × ₹95,000 = ₹25.65 crore, but comparables are renovated with lifts; a 15-25% adjustment for condition and obsolescence gives ₹19.2-21.8 crore.
3. Reconcile the indications, explain what the 2016 lease costs the owner, and state what you would put in the report.
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The three approaches give cost ₹17.0 crore, income ₹16.5 crore and adjusted sales comparison ₹19.2-21.8 crore. Cost approach measures value in existing use and should be a floor and a check. Income is anchored in verifiable rent and a market-derived capitalisation rate, and it already reflects the lease. Sales comparison reflects what buyers actually pay for similar stock, but the comparables are superior in condition and are smaller lots.
Weight income and sales comparison, using cost as support, and conclude a range of about ₹17.5-19.0 crore with a point estimate near ₹18.5 crore. Do not adopt ₹25.65 crore from unadjusted comparables: that figure assumes the subject is in renovated condition and ignores the lease.
The registered lease runs to 2036 at ₹210 against a market rent of ₹850 per sq m. The gross loss is 640 × 900 × 12 = ₹69.1 lakh a year. Capitalising the contract rent for the unexpired term and reverting to market at 2036 values the ground floor at about ₹4.25 crore, against roughly ₹8.42 crore if it were let at market today - a loss of about ₹4.2 crore, or nearly a quarter of the property's value. This should be quantified in the report rather than described qualitatively.
Report requirements: valuation date and inspection date; basis of value with its IVS 104 definition; the highest and best use analysis with the residual test shown; FAR and sanction status; the lease extract with unexpired term and registration details; all assumptions and limiting conditions; and the valuer's registration number and signature. Advise the owner that renegotiating or buying out the lease before a sale is worth more than the buy-out cost, and that refurbishment is the lower-risk route until sale rates justify demolition.