Understanding Commercial Property Valuation Methods
Knowing how to value commercial property is a crucial step in becoming a successful commercial property investor. In Australia, several approaches are commonly employed to determine the value of commercial properties. These methods include the income approach, the direct comparison approach, and the cost approach. Each approach utilises different techniques to assess the property's worth. Understanding these valuation methods can help property owners, investors, and professionals make informed decisions. Let's explore each approach in detail, along with relevant examples.
The income approach focuses on the property's potential income generation capacity. It is widely used for income-producing commercial properties such as office buildings, retail centres, and industrial facilities. Two commonly employed techniques within this approach are:
a. Capitalisation Rate (Cap Rate) Method:
The Cap Rate method involves calculating the property's net operating income (NOI) and dividing it by the capitalisation rate. The capitalisation rate represents the return an investor expects to receive from the property. For instance, if a commercial property generates an NOI of $100,000 per year and the prevailing cap rate in the market is 6%, the value of the property would be $1,666,667 (Value = $100,000 / 0.06). The appropriate cap rate is determined by considering recent comparable sales using the same metric.
b. Discounted Cash Flow (DCF) Method:
The DCF method estimates the property's future cash flows, considering rental income, expenses, inflation and potential growth. These cash flows are then discounted to their present value using a discount rate that reflects the investment's risk. For example, if a commercial property is expected to generate annual cash flows of $50,000 for the next ten years, and the discount rate is 8%, the present value of the cash flows would be approximately $378,024. Summing up the present value and adding any residual value gives the estimated property value. (The DCF approach calculates the Net Present Value of all cash flows over the investment horizon to give an estimate of today's dollar value, along with other important investment metrics such as the IRR, or Total Return.)
DCF is typically employed for assets worth $20 million or more, usually with multiple tenancies and various potential future scenarios. It allows for 'what if' scenario analysis and is therefore useful for investors seeking to quantify and compare different 'value add' strategies. However, the technique is inherently more complex and subjective owing to the need to estimate future events, such as inflation, and is therefore used in conjunction with other methods, typically 'direct comparison'. The additional complexity and subjectivity mean that the technique is not favoured by the courts
Direct Comparison Approach:
The direct comparison approach determines the property's value by comparing it to similar properties recently sold in the market. This method is suitable for a wide range of commercial properties and relies on analysing sales prices and adjusting for relevant factors. Two commonly used techniques within this approach are:
a. Sales Comparison Method:
The Sales Comparison method involves finding recent sales of comparable properties and making adjustments to account for differences. For instance, if a similar office building sold for $2 million, but the subject property has a better location and additional amenities, adjustments are made to reflect these factors. After appropriate adjustments, the value of the subject property can be estimated based on the sales prices of comparable properties.
b. Gross Rent Multiplier (GRM) Method:
The GRM method is often applied to properties with multiple rental units, such as apartment buildings. It involves dividing the sales price of a comparable property by its gross rental income to determine the Gross Rent Multiplier. For example, if a similar apartment building sold for $2.5 million with an annual rental income of $300,000, the GRM would be 8.33 ($2,500,000 / $300,000). This GRM can be applied to the subject property's rental income to estimate its value.
The cost approach estimates the property's value by considering the cost of constructing a similar property from scratch, deducting any depreciation. It is commonly used for specialised properties or those with unique characteristics. Two primary techniques within this approach are:
a. Replacement Cost Method:
The Replacement Cost method calculates the cost of replicating the property using current construction costs. Depreciation is then subtracted to determine the property's value. For instance, if the cost of constructing a similar office building is $5 million and depreciation is estimated at 20%, the value of the subject property would be $4 million ($5,000,000 - ($5,000,000 x 0.20)).
b. Depreciated Cost Method
The Depreciated Cost method starts with the original cost of the property and deducts depreciation based on factors such as physical deterioration, functional obsolescence, and economic obsolescence. The remaining depreciated cost represents the property's value. For example, if a commercial property was purchased for $1 million ten years ago and has depreciated by 30%, the value would be $700,000 ($1,000,000 - ($1,000,000 x 0.30)).
Valuing commercial properties in Australia involves the application of various approaches and techniques. The income approach, market approach, and cost approach offer distinct perspectives on the property's value, considering income potential, market comparables, and construction costs. Each method has its strengths and weaknesses, and a professional valuer often considers multiple approaches to arrive at an accurate valuation. The Cap Approach and the Direct Comparison method are the most commonly used approaches, along with DCF for more complex assets.
Understanding these valuation methods empowers investors and buyers agents to make informed decisions based on solid financial analysis when conducting due diligence on a commercial investment property.