Values of commercial properties are largely driven by rental returns or the potential for capital growth. There are a number of methods that can be used when appraising property.
These methods include:
- Comparable sales method
- Replacement cost
- Hypothetical development
Below we look at these various methods of appraisal and explain each approach in further detail.
Comparable Sales Method
Sometimes referred to as Comparative Market Analysis (CMA). This method is also referred to as ‘direct comparison’ and is a popular way to appraise commercial property. It involves comparing the property with others of similar types and standards that have been recently sold.
This direct comparison is generally the basis for sales analysis and this method relies on actual market evidence. Direct comparison is fairly simplistic in operation and also forms an integral part of other appraisal methods. Comparable market analysis (CMA) or direct comparison method is best used for appraising industrial strata units, as they are often highly comparable. Other forms of commercial property can vary greatly, making this form of appraisal less reliable. Factors commonly reviewed in this method include:
- Date of Sale
- Location of property
- Size of the property
- Physical characteristics (clearance, access etc)
- Amenities and services (proximity to public transport, infrastructure etc)
- Zoning of the property
Summation Method (Cost Approach)
The term ‘summation’ means adding the values of the various parts of a property to calculate its full value. The summation method is based on attributing a value to each component of the property, rather than a value for the property in its entirety. The Summation Method is mostly used as a ‘check’ appraisal. Under the Summation Method, one calculates the cost of the land, the cost of the improvements, such as the factory, and office and the cost of establishing the parking, fencing and landscaping. The costs are then totalled.
Summation is based on current cost less depreciation and is also referred to as the ‘cost approach’ method. In most instances when the cost approach is involved, the overall methodology is a hybrid of the cost and sales comparison approaches.
For example, while the replacement cost to construct a building can be determined by adding the labour, material, and other costs, land values and depreciation must be derived from an analysis of comparable data. The summation method is particularly useful in developing suburbs. However, because a person has spent a particular sum on property does not mean that others will be willing to pay for the improvements (this is what is referred to as over-capitalisation).
An over-capitalised property (one which has been developed well above the average price of the area) may be very hard to sell for a price that will recover all the money spent on it by the current owner. The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties. The cost approach is often the only reliable approach when dealing with special use properties (e.g. abattoirs, public assembly, marinas).
Depreciation is an important factor to consider when using the summation method. Sometimes it is necessary to understand how to determine the length of time a building will remain useful as a source of value. This requires an understanding of how to calculate depreciation and involves determining where a building or improvement has reduced in value over time which is accrued depreciation. Buildings and improvements age and deteriorate over time and even if maintained, may not compare with buildings or improvements which are more up to date and modern.
Depreciation is a loss in value of a property through any cause whatever and is the difference between replacement cost new and the current market value. When adopting the summation valuation method, always remember that cost does not always equal value! For example, an owner spends $250,000 extending and refurbishing their existing factory. There is no guarantee that the property is immediately worth $250,000 more than before this was done.
You may also use the summation method as a check for the comparable sales method. It is used mainly for valuing or appraising property such as:
- Property in markets where comparable sales data is extremely limited
- Special use properties, also where sales data is limited
- Property located in isolated markets
- Public property or utilities where there is no formal trading market
The value of improvements is added to the land value, as in the following example:
- 400sqm factory – estimated value @ $200 per sqm
- 100sqm wash bay @ $400 per sqm
- Fittings and fixtures
- Land $350,000
Therefore the value of the property by summation is
Land value is determined by direct comparison to similar vacant land sales or by analysing improved sales to obtain a vacant land value. The value placed on land for rating purposes can be used as a general guide by agents, but analysing sales helps to lessen inaccuracies.
This method is based on the income of the property and is mainly used to value or appraise income producing property. The calculations are based on the property’s net income, rather than gross rental income, as outgoing expenses for property can be vastly different from one to another.
The Capitalisation Rate (or Cap Rate) is a ratio used to estimate the value of income producing properties. Put simply, the cap rate is the net operating income divided by the sales price or value of a property expressed as a percentage.
Investors, lenders and valuers use the cap rate to estimate the purchase price for different types of income producing properties. A market cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. The Cap Rate calculation incorporates a property’s selling price, gross rents, non- rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value than if only a property’s selling price and gross rents were taken in to account.
There are two steps involved in determining net income for the property:
- Establish the property’s outgoings
- Deduct outgoings from gross rental income obtained
The net income is then capitalised at an appropriate rate derived from comparable sales analysis. For example, research may indicate that the net return on retail space in the area is averaging 6%. This rate of return is called the capitalisation rate and forms the basis for calculating market value.
Net capitalisation rate % = (Gross annual rental income-expenses x 100) ÷ Sales price
To use this formula, you need to multiply monthly rental income by 12. All property expenses including maintenance, agent’s fees and charges need to be calculated and then deducted leaving you with the following calculation:
Capitalisation rate = (Net rental annual income x 100) ÷ Sales price
If these calculations are done simply based on gross income the figures may be less comparable as they do not take into account the wide variance of outgoings across different buildings.
Property sold for
Maintenance, agent’s fees and all other outgoings total
Gross annual rental income
Net annual rental income $55,000 – $12,500
Capitalisation rate ($42,500 x 100) ÷ $850,000
The capitalisation rate is the net operating income of the property divided by its purchase price. The rate shows the expected annual percentage return for a specific investment. In the above example when the net income of $42,500 per annum is capitalised at 5% the result or capital value of this property would then be $850,000 with a yield or return on investment of 5% per annum. The benefit of using a capitalisation rate is that buyers can determine their expected revenue and define what a prospective investment is actually worth. Using the rate to work out the capital value of a property is as follows:
The net income for the property is $50,000 pa. Based on a capitalisation rate of 6% and using this capitalisation rate formula shown here the property has a capital value of $833,333.
CAPITAL VALUE = Net income ÷ Capitalisation rate
($50,000 x 100) ÷ 6
Property that is purchased on the basis of the return received from rental or net profit income is valued or appraised by an income method.
The underlying principle of capitalisation is that the income generated by the property is in perpetuity (forever). On this basis the property is valued on the assumption that the current net income will always be available. The relative risk of this income stream is measured by the capitalisation rate. The higher the risk of maintaining the current level of net rent or profit, then the higher the capitalisation rate will be.
With sufficient data this formula can be used to assist in appraising property value and agents can access current rental data from their own rent rolls provided they follow the comparative data principles of like with like and use up to date or recent information to ensure accuracy.
Valuers are often required to value property for insurance purposes based on current replacement costs. Whilst commercial property agents do not generally use this method to come up with a price estimate, it is worth understanding the replacement cost method as you may come across it when given information from clients. Agents managing properties for clients may also use this method when assisting a client with reviewing insurance cover to ensure covered values are up to date. When using the replacement cost method of property valuation, the building structure(s) alone are considered. The value of the land is deducted from overall value to arrive at the value of the structure.
This method involves having access to information about current costs of construction which can vary substantially between urban and rural areas. Building costs generally increase each year and it is essential to use accurate information that reflects current building industry guidelines when calculating replacement costs.
Note that an agent appraising an existing established property using replacement cost as a basis is likely to come up with an inaccurate figure or range as replacement cost has little bearing on market price of property due to the fact that property itself depreciates and in general the land is the component that appreciates. It is best left for purely insurance purposes.
Hypothetical Development (Feasibility)
This method is used in the valuation of land subdivisions and development sites. The value of the land to the developer is arrived at by taking into account a number of factors regarding the overall project:
- Gross total sales of finished project less selling expenses (plus GST) = net realisation
- Less margin for developer’s profit and risk = total capital outlay (development, land and interest costs)
- Less development costs, charges and interest (interest and contingency charges) = value of land and interest
- Less interest on land value = Total land value
It is this value that indicates whether the development will, hypothetically, be feasible or not. If the developers cannot buy the land and cover interest holding charges for around the price that their calculations show it is ‘worth’ to them, then generally the project won’t go ahead. Obviously, the other costs and sales estimates, together with timing, also need to be forecast very accurately.
The hypothetical development process can be summarised as:
- The developer selects a site based on what envisaged end product will exist
- The developer buys land and incurs interest on borrowed funds
- The site is developed with costs for development, building, interest on borrowings
- The developer goes through the selling process recouping losses and realising their profit
Most developers borrow funds to purchase land and as such incur interest. Those who do not still allow a cost for having the money invested in the land with no immediate return as opposed to returns obtained elsewhere. This is often call ‘opportunity cost’. The total capital outlay for the developer consists of land settlement, development and interest costs, plus profit and risk margins. To recoup all costs, the final selling costs plus the GST component of developed land would need to be added to the total capital outlay.
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