Whether it is an office, shop, warehouse, or even a factory, some investors are attracted to commercial property for portfolio diversification or for positive cash flow.
But the thing is, successful commercial property investment is a different niche.
It requires an understanding of complex market factors, unique financing requirements, property management options, leasing arrangements, and a good grasp of the potential risks.
And this starts with the most important… how to calculate a commercial property’s value because it’s very different from how you value residential real estate.
While the values of commercial properties are largely driven by rental returns or the potential for capital growth when it comes to the valuation of a commercial property, there are five ways professionals approach it:
- Income capitalisation
- Comparable sales
- Summation
- Replacement cost
- Hypothetical development
So to help you better understand which method is most appropriate for a particular property, here’s a breakdown of each one with everything you need to know.
1. Income capitalisation
Valuation of a commercial property using income capitalisation is possibly one of the most simple methods.
Commercial property is generally used to generate income so a quick and easy way to value commercial property is to estimate how much return a buyer is likely to get on their investment – otherwise known as the capitalisation rate, or cap rate for short.
Using this method you’d calculate an estimated annual income using annual rental income, minus any expenses, and compare it to other similar properties in the area.
The calculation looks something like this.
First, you’ll need to get the net operating income (NOI) of the commercial property and the capitalisation rate based on other comparable sales.
Here’s the formula for these:
Rental income – operating expenses = NOI
And then…
NOI ÷ purchase price = capitalisation rate
Now you use these two figures to calculate the property value.
Here’s the formula:
NOI ÷ capitalisation rate = property value
Here’s an example of the calculations in action:
You own a commercial property which generates a gross rental income of $40,000 and your operating expenses are calculated to be $5,000.
$40,000 – $5,000 = an NOI of $35,000
You’ve done your research on comparable sales and using the calculation we listed further up, have calculated a cap rate of 5%.
$35,000 ÷ 5% = a property value of around $700,000
2. Comparable sales
Another simple method for valuing a commercial property is the comparable sales method.
You’ll need to look for recently sold commercial properties similar to yours, taking into account the size, location, zoning, distance to amenities, age, and condition.
You would need to find at least three comparable properties to help calculate the approximate market value of your property.
You can also calculate the price per square metre of comparable properties and then apply this to your own.
The equation would look like this:
Average price per square metre x property size = property value
This method gives a good idea of what the commercial property is worth, but it isn’t the most reliable because it relies on direct comparable sales.
3. Summation
Also known as the cost approach method, summation involves calculating the value of various parts of commercial property and then adding them all together to determine the overall value.
This means you would calculate the cost of the land, any construction or improvements, any fixtures or amenities, or even landscaping.
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.
Things like the property size, location, age, condition, energy efficiency, and whether it is on a strata scheme will also be taken into account to make the calculations
The costs are then totalled to give the valuation of the property via summation.
4. Replacement cost
The replacement cost method of valuing a commercial property is generally used for insurance purposes, rather than for sale.
It is pretty straightforward.
The replacement cost is calculated by concluding how much it would cost to replace the existing property with a similar property.
This means that the replacement cost method only takes into account the building structure itself, and not the value of the land which hasn’t been built upon.
The value of the land is deducted from the overall value to arrive at the value of the structure.
The tricky part with this method is that the cost of building, construction, and materials vary greatly year-to-year (or in the current market month-to-month).
Also, the value of the property itself would generally depreciate over time thanks to wear and tear, while the value of land appreciates.
5. Hypothetical development
The hypothetical development method of valuation is generally used to value land suitable for development, particularly if dividing up a large section of land into blocks.
This is done by calculating the value of the land if it was developed to fit the maximum number of dwellings.
Then, the cost of getting the land to a stage at which it can be developed needs to be subtracted from the value of the dwellings.
The calculations look like this:
Gross total sales of finished property – selling expenses = net realisation
Net realisation – developer’s profit and risk = total capital outlay
Total capital outlay – development costs = total value
This calculation will help to indicate whether the development would be financially feasible or not.
The problem with the hypothetical valuation calculation is that it would need to be calculated very accurately (taking into account rising costs, time to build, and property price projections) in order to give a true representation.
Which is the right fit?
As you can see, there are various options for a valuation of commercial property but which one works best for you first depends on what the valuation is for.
Income capitalisation, comparable sales, and summation can be used to calculate a commercial property’s value for sale/purchase, while replacement cost is typically used for insurance purposes and the hypothetical development method used by developers looking for a plot to build.
The most important thing when looking to value commercial property is to get expert advice.
The key is to make sure your validation is as accurate as possible, with no detail left out so that you’re paying for, or selling, exactly what the commercial property is worth.
