Learning how to use some simple metrics to quickly apply a "guesstimate valuation" can be important in successful commercial property investing. A few approaches are used to have a go at determining the value of a commercial property.
- The income approach
- Direct comparison approach
- Cost approach.
The main one I use for initial study is the income approach, which many lenders use.
The income commercial property valuation approach uses the property's potential income. It's used for income producing commercial properties like factories and industrial.
- The Cap Rate method: involves calculating the property's net operating income (NOI) and dividing it by the capitalisation rate. This gives you the return an investor expects to earn from a property. And the good thing is: it's super quick to figure out.
- For example, if an industrial factory generates an NOI of $100,000 per year and the cap rate for that kind of property is 6%, the value of the property would be $1,666,667 (or $100,000 / 0.06).
- So how do we get the right cap rate when valuing a commercial property? By considering recent comparable sales using the same metric. It's not an exact science, and ultimately the lender will have final say on what they are comfortable with.
- For properties over say $15,000,000 then lenders may use the discounted cash flow model, so let's have quick look at what that is here:
Discounted Cash Flow method of commercial property valuation:
- Estimates the property's future cash flows with rental income minus expenses, inflation & even potential growth.
- The cash flows are "discounted" to their present value using a discount rate that is similar to other assets or properties in its category. In this case an industrial commercial factory.
- Let's say an industrial unit used by a mechanic is expected to earn $50,000 per annum for the next ten years in rent, & the discount rate is 8% (based on other industrial units), the present value of the cash flows would be approximately $378,024. The DCF approach estimates the Net Present Value (NPV) of the rental income to guesstimate the "today's" dollar value. It also includes other metrics such as the Internal Rate of Return.
- Once again, this model is much more in depth and usually only employed over $15 million or if say the property had a few changes coming in it's future. Here, the analyst can play "what if" scenarios to their hearts content, so unless you need to, try sticking with the income method outlined above.
- Or perhaps you can do both to check how close they are. If there is a dramatic difference, you may not have appropriate capitalisation rate etc.
The Direct Comparison Approach to valuing a commercial property:
Compares the industrial commercial unit to other industrial commercial units in the same location, much like a residential valuer would do. This is far easier and sometimes a great and accurate way of coming up with a valuation.
You can compare sales or gross rent. Let's have a look at both - but just briefly:
- Sales Comparison Method involves recent sales of properties and adjusting for differences.
- An example would be a similar office building sold for $2 million, but this property has a worse location and less amenities. You would adjust your estimate of valuation to be lower.
- Now the value of the industrial commercial property can be estimated based on the sales prices of "comparable" properties.
Gross Rent Multiplier method of valuing commercial property:
- used mainly for properties with more than one rental stream such as a block of apartments. To determine this, you divide the sales price of a comparable property by its gross rental income. This gives you the gross rent multiplier.
- Let's look at an example of this method. Let's say a comparable unit block of 4 units sold for $2,500,000 with a rent of $300,000 per annum, then the Gross Rent Multiplier would be 8.33 or $2,500,000 / $300,000.
- Now you can use this multiplier to estimate the properties expected value.
There is also the replacement cost method o valuing a commercial property: calculates the cost of replicating the property using "current" construction costs. You then subtract depreciation to determine the property's value.
Valuing commercial property: involves the use a few different approaches depending on the property value and condition of the market. I would use the income method if looking at commercial industrial property less than $5m.
As a commercial property investor, when you know the income method of valuation, you can look at loads of properties and work out quickly and roughly where each one should sit. Play around with the numbers and you'll see.
You should use a mortgage broker for your loan application. We know which lenders have appetites for different properties and loan amounts etc. I would be happy to look at your deal.
Loan Market Matthew Stack - 0423 237 242
