Understanding how commercial property assets are valued
Commercial property valuation is a complex process that requires an understanding of market factors, industry terminologies and familiarity with the area where a property is located. However, there are a few methodologies real estate professionals use which may assist with understanding how a commercial property is valued.
Let’s look at the key valuation approaches used to determine the worth of a commercial property to assist with your research and purchase decisions.
1. Capitalisation rates (cap rates)/property yields
Capitalisation rates, or cap rates, are used to help determine the expected annual cash flow, or yield, you can earn from a commercial property.
To determine the cap rate for a commercial property, first calculate the Net Operating Income (NOI) by deducting operating expenses from the revenue produced by the property. Once you have the NOI and the current market value, you can apply the following formula to calculate the cap rate:
Cap rate = (NOI/current market value) x 100. The cap rate will then be expressed as a percentage. Higher cap rates indicate a higher potential return, while lower cap rates suggest lower returns on an investment property.
Note: NOI excludes principal and interest on a commercial property loan, tax, depreciation and amortisation and therefore is the figure property valuers refer to as the true net figure, rather than the gross net figure, of a property. You can learn how interest rates affect cap rates for a commercial property here.
2. Base land values
The base land value is a crucial component of valuing a commercial property, especially if you’re considering buying a new development. It represents the estimated worth of the land the property is situated on, excluding any structures or improvements.
In New South Wales, investors can visit the Valuer General to determine the base land value of a property or seek advice from their selling agent who can assist and provide additional advice.
A report from the valuer general will provide details on land values for the past five years (where available), the valuing year used to calculate council rates, the valuation basis, notice of any concessions or allowances that apply to the land value, the property number, address and zoning information and the area and boundaries of non-strata properties.
It’s important to consider factors such as location, zoning, accessibility and market demand as they all can influence the base land value of a property.
3. Improved rate
While base land values focus on the land’s worth, improved rates consider the value of the property with all its improvements and structures. The improved rate assesses features such as building quality, size, age and functional utility.
It’s recommended to speak with your selling agent at Commercial Collective to obtain the improved rate of a property. They have access to data on comparable properties available on the market in the location you’re looking to buy, to perform direct market comparisons and provide reliable information on market trends that are influencing property prices in the area.
4. Blended rate
Often commercial properties have more than one income stream. For example, the space is used for both retail, office and residential units. Here, a blended rate valuation should be used as it accounts for the diversified mix of tenants and revenue streams. Each income stream should be assessed based on factors such as lease terms, rental rates, tenant credit worthiness and market conditions specific to that income source.
Once the individual income streams have been evaluated, a weighted average is calculated to determine the blended rate. The weight assigned to each income stream depends on its contribution to the overall income of the property. For example, if one income stream accounts for a larger portion of the property's total income, it will have a higher weight in the calculation of the blended rate.
The blended rate is then applied to the income generated by the property as a whole to estimate its overall value. This helps commercial investors to determine the overall income potential and risk associated with owning the property.
5. Discounted cash flow (DCF)
This valuation technique focuses on estimating the value of future cash flow the property will generate for an investor, rather than the value of the property itself. It considers the projected rental income, operating expenses, capital expenditures over the holding period and can also consider tax deductions claimable via negative gearing, capital works deductions and plant and equipment depreciation.
A DCF analysis provides a comprehensive assessment of the property’s income potential and risk and allows investors to determine the property’s net present valuation (NVP).
Which valuation method is best?
A savvy purchaser or investor will likely use multiple methods to best determine the value of a commercial property. This is because cap rates/yield analysis provides insights into a property’s income potential, while base land value and improved rate methods determine the worth of the land and the building and any improvements.