So you are looking to purchase commercial property or you already have one and you want to get it valued. The reasons for getting a valuation can include to get the initial loan, to refinance the property to a different loan or lender, or to see how much equity you have in the property for further investment or improvements. Unlike residential property where Valuers can generally find plenty of similar, recently sold properties to compare another property with, commercial property can be more challenging because often there are no similar properties nearby. Valuers have 3 main commercial property valuation methods that help them work out a valuation figure for even the most unusual of properties.
Residential properties have a certain amount of sentimental value attached to them and this is what Real Estate Agents capitalise on when they sell a home for higher than the valuation. If buyers fall in love with a property they can be willing to pay significantly more for it. Commercial property, on the other hand, tends to be a purely business transaction so the valuations tend to be a very good indication of what the property will sell for. Of course high demand can increase the selling price, but for most investors, the decision will be based on the numbers.
The valuation methods used are:
Method 1 – Income Capitalisation
Method 2 – Sales Comparison
Method 3 – Cost Approach (Depreciated Replacement Cost)
The valuation will provide 3 different values based on these different methods and the Valuer then picks the most appropriate one to use. Let’s look at what each method involves:
Method 1: Income Capitalisation
We talked about this method in my post on Commercial Property Investment Guide – The Quick Sums You Need because this is one that you can work out roughly by yourself as part of your initial property research. The Valuer will go into much more detail in each part of the sums, to make sure that all the figures are as accurate as possible. It’s worth you knowing how they do the calculations because then you will have a better understanding of how they compare different properties, and what factors are important.
The Valuer uses the rental income being received on the property. They assess the rate being paid on a ‘per square metre basis’ for the property and they can then compare this figure to other properties. For example, for a 100m2 property receiving $100,000 per annum in rent we need to work out the rent per square metre:
Rent = $100,000 / 100m2
Rent = $1,000 per m2
The Valuer will then check this against a leasing database for the same area to work out if this rent is equivalent to other similar properties in the area. In some cases they may find that the rent being charged is lower than the market average – perhaps the tenant has been in the property for a long time and the owner has left the rent the same. Similarly, if there has been increased vacancy in similar properties in the area (perhaps because of recent construction of new properties creating an oversupply) the rent being charged may be higher than newer leases are achieving. This is where the Valuer can work out what the market rent for the property should be. In particular they are looking at:
- Size of the property
- Age and presentation of the property.
- Location – is the property close to transport, does it have easy access and are similar properties surrounding it.
- Vacancy rates – if there are vacant properties due to low demand it could take 12 months to find a tenant.
- Visibility – this is important if the property is a shop.
- Factories – they consider the roof clearance, height of roller doors and available office space.
By comparing the value per m2 with other properties in the same area they can come up with a range of values for the particular property. Then they multiply that value per m2 by the size of the property to give the rent payable. They now have a rental estimate that reflects the local market.
Now that the Valuer has determined the appropriate rent, they will look at recent sales of leased properties to get a figure called Cap Rate, (also known as Capitalisation Rate or Yield).
For properties that have been recently sold, this is calculated by dividing the Net Operating Income (rent minus costs) by the sale price of the property. For example, for a property with a Net Operating Income of $100,000 which was sold for $1,250,000, the Yield or Cap Rate would be:
Cap Rate = Net Income / property value
Cap Rate = 100,000 / 1,250,000 = 0.08 or 8%
So we can say that the buyer of the property is achieving an 8% yield or return on his investment.
The rate of return is affected by the risk of the property. So the Valuer will get a range of Cap Rates from recent sales for the area and then consider the risk of the property to narrow down the Cap Rate. The risks that the Valuer considers when working out a Cap Rate for the property include the length of the lease (the longer the better), the quality of the tenant, and how easy the property is to re-lease.
Re-leasing is easier if there is not an oversupply of similar properties in the area. Shops in the CBD are easier to let than shops in tiny suburban shopping strips, and factories generally take longer to re-let than shops.
Now, using the Net Income and Cap Rate, they calculate the Estimated Value of the property:
Estimated value = Net Income (rent minus costs) / Cap Rate
For example, for an office in Sydney CBD, with a Cap Rate of 5% and $100,000 annual Net Income,
Estimated value = $100,000 divided by 0.05 = $2m (by converting the 5% into a decimal 0.05)
If you prefer, you can calculate it as:
Estimated value = 100,000 x 100 divided by 5 = $2m (the result is the same, it just depends what you are most comfortable with).
So, how much difference does the Cap Rate make?
If you’re wondering if the Cap Rate makes much difference to the value of a property, it definitely does!
The table, below, shows the estimated value of commercial properties around Sydney, each with rent of $100,000 per annum, with different Cap Rates.
|Location in Sydney||Cap. Rate (Yield)||Estimated value based on $100,000 p.a. rent|
|Shop in Sydney CBD||4.50%||$2.2m|
|Shop in suburban Sydney||6.00% – 7.00%||$1.7m – $1.4m|
|Office in Sydney CBD||5.00%||$2.0m|
|Office in suburban Sydney||6.00% – 7.50%||$1.7m – $1.3m|
|Small factory in Sydney’s inner west (within 5km of CBD)||6.50% – 7.00%||$1.5m – $1.4m|
|Medium factory in Sydney’s outer west||7.5% – 8.75%||$1.3m – $1.1m|
As you can see, while all these properties have the same amount of income, the difference in Cap Rate for different areas and property types can mean a variation in property value from $1.1m to $2.2m!!
Method 2: Sales Comparison
Just as they do with residential properties, Valuers will compare similar properties that have recently been sold with the property they are valuing.
They will still work out the cost per m2 for the building area, and will adjust it for any extra land including car parking spaces.
This method will obviously work best in areas where there are many similar properties and there are recent sales to compare with.
Method 3: Cost Approach (Depreciated Replacement Cost)
This method looks at what it would cost to build the property, and then takes off depreciation to give the estimated value.
So the Valuer takes the land value and adds the cost of the buildings on to it. They then take away any depreciation based on the current condition of the property.
Land value + cost of structures – depreciation = estimated value
This tends to be the least accurate method because it ignores what the market is paying in rent for a property and just focuses on the build costs.
Commercial property valuation can be quite complex and certainly very varied when you think that it can range from valuing a small retail shop in the suburbs to a whole apartment building or a massive factory site. For this reason it has developed to be based around a ‘per m2’ value to allow easier comparison of different properties. With the range of factors considered and the comparisons that the Valuer needs to do, a commercial valuation report contains a lot more detail than a residential valuation report. This is what makes commercial valuations more expensive, and why the price of a commercial valuation is not fixed – it depends on the characteristics of the property. After all, if you’re buying the small shop you certainly don’t want to pay the same valuation fee as the massive factory site!!
Please leave us a comment. Have you had a valuation done before? Are you looking at buying commercial property? Was this explanation useful?
If you would like us to investigate a commercial loan for you please contact me through the Enquiry Page.