Commercial Property Investment Guide -Commercial Property Valuation Methods

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.

Commercial property valuation
Commercial property valuation can be challenging because often there are no similar properties to compare with.

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.

Rental Income

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.

Commercial Property Valuation Methods
Rental calculations are adjusted for factors such as location, access and condition of the property.

Cap Rate

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.

Estimated Value

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.

Commercial Property Valuation
CBD car parking spaces can add a set amount to the property value per space because they are so valuable.

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.

Happy borrowing!

Rachel

6 Replies to “Commercial Property Investment Guide -Commercial Property Valuation Methods

  1. This is a very informative post. It really breaks down the general concept and knowledge necessary for property evaluation. I’m actually very interested in Real Estate but I will have to start with residential first but the goal is to eventually work my way up to commercial. But this is great insight and information for me to start with before I embark on my real estate journey. I do have a question though, why is it that the estimated value goes down when the yield goes up? Shouldn’t it be the other way around?

    1. Hi Ian,

      Great question! It’s probably best to explain this by looking at the yield. Since yield is calculated by dividing the Net Income by the value of the property, as the value goes up so the yield is reduced (if the rent remains the same).

      When there is high demand for properties, such as in the CBD, the cost of buying a property goes up. As the price goes up so the yield decreases. So you can have a high value property with low yield.

      When there is low demand for properties, such as some regional centres or small retail areas, then prices fall but if rent stays the same the yield will be higher. So this would give you a lower value property with higher yield.

      So paying a lower price for a property will give you higher yield – so it’s worth doing those basic sums so you know what sort of yield you’re getting from the property and can decide if that fits with your investment strategy. Many people are looking for cash flow from their investments and yield is where you can determine that.

      So you might be wondering how you get capital growth on the property. If the rent goes up (and often the lease agreement is linked to CPI so it goes up automatically each year) then the value of the property will go up, since the value is calculated largely on the rental income.

      Part of working out your investment strategy is deciding if you are focusing on capital growth or income. Many people now are focused on positive cash flow from commercial property so they are looking for properties with high yields and are less focused on capital growth.

      That was a bit of a round-a-bout response but I hope it answered your question.

      Happy borrowing!

      Rachel

  2. Thanks for this very interesting and well explained post.
    Me, being a real estate practitioner myself, could really relate to what you are sharing here. It is a very handy reference source and I have bookmarked the link for future use. I basically know what it is all about, but because one don’t work with all the valuation methods every day. It is handy to have a source like this at hand. …Thanks 🙂

    1. Hi Cobus,

      Thanks for the positive feedback!

      I’m glad you found it useful and I’ll be continuing with the Commercial Property Investment Guide posts so stay tuned for lots more information.

      Happy borrowing!

      Rachel

  3. Wow, This a great post on real estate. I really enjoy reading it because I currently learning to invest in real estate and just bought my first residential income.

    I am also looking at bigger like the commercial for investment but due to the huge capital and amount, I decided to go for residential first. Need to increase my knowledge on this.

    You know what. I like the valuations method you described above and I can say I have more insight now.

    Thank you

    1. Hi Maxx,

      Thanks for your feedback! And congratulations on buying your first property. I do believe that the first is the hardest because it is all so unfamiliar, you have to save the deposit and all the costs and it tends to be the first time that people take on a lot of debt which can be quite scary.

      I’m glad this has helped you understand a bit more about commercial lending. Don’t be put off it by thinking that it’s more expensive than residential lending. Often commercial properties can be cheaper than residential because you can buy a small office space (much smaller than a house) and let it out. I’ll be continuing my series of posts about commercial property so keep reading and let me know if you have any questions at all. I’m always here to help.

      Happy borrowing!

      Rachel

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