Commercial Property Values – The Basics
Commercial property, unlike residential property, is not valued according to a comparative market analysis or CMA method. The CMA method uses recently sold prices of similar, recently sold properties in a specific area to determine the realistic value of a specific house. Instead, commercial properties are valued using the income capitalisation method. By using this method, the property is valued based on the income it generates.
So, what information do we need to use this method?
We need to know what the income or rental is, and we need to know what the expenses are. If the property is currently vacant then we need to use a market related rental, in other words an achievable rental for a similar property in that area. Expenses, otherwise known as operating costs, include municipal rates, building insurance, maintenance, and other monthly costs like levies. Once we have these figures, we can work out the net income that the property produces.
Let’s consider a commercial property that receives R100,000 per month in rental from a tenant as an example. This rental would be called the gross rental, and from this we would then deduct the operating costs. Let’s say that the costs are as follows:
- Building insurance – R5,000 per month
- Rates and taxes – R15,000 per month
- Average maintenance – R3,000 per month
The net income after operating expenses would therefore be R77,000 per month. We do not include other council charges like electricity, water, or refuse in the expenses as they are recovered from the tenant. We also do not factor VAT into the equation. Once we have the net income, we annualise the income. In this case, the annual income would be R77,000 x 12, which comes to R924,000.
We then divide the net income by the relevant capitalisation rate, or cap rate. The cap rate is basically the yield or expected return on the value of the property. This cap rate is heavily influenced by risk. A property can be deemed high risk by an investor for various reasons – the property may be old, be in an unpopular area, or may be difficult to let. In this case, an investor would require a higher return on their investment in order to compensate for the risk. This higher cap rate would, in turn, affect the value of the property. Although the cap rate and yield may seem the same we refer to yield when dealing with an individual property, and cap rate when referring to properties in the same area.
For instance, using the above figures, let us say that two properties are identical in size and have the same operating expenses, and even receive the same rental rate, but have different layouts and are in different areas.
Property A is in a new, sought after area and is practical and easily lettable. A typical investor in this area buying this type of property would expect an 8% return on their investment. So the value would be R924,000 divided by the expected return, or cap rate, giving us R11,550,000.
Property B is in older industrial area and is specialised to a certain type of business or industry, and therefore not as easily lettable. An investor in this area for this type of property would expect an 11% return. R924,000 divided by this cap rate gives us R8,400,000.
Property B generates more income for the capital outlay, for every R100 invested in the property there is a net return of R11 to the investor. As long as the building is occupied and receiving rental, it is technically a better investment. However, the risks associated with the property being vacant are high, and there may be periods of time where there is no income but there are still expenses. For this reason, the risk/cap rate/expected return is higher.
Applying the Knowledge
Which type of property is for you? Well, that depends on your investment strategy and how risk averse you are.
When valuing a vacant commercial property, it is very important to be able to estimate the potential rental income and how easy or difficult it may be to let the property, as the income is based on achievable market rentals in a specific area. This is where a broker’s assistance is invaluable. Brokers are generally area specialists, and they understand what kind of rental rates are actually achievable in a specific area and what type of properties are in demand in which areas. Without sufficient market knowledge, you could overpay for a property. In fact, this is why banks and professional valuers continuously consult with brokers as they are the ones in closest contact with the areas and clients.
If you are looking to purchase a commercial property as an investment or to house your own business, then contact us and let us assist you in making an informed decision to invest in the right type of property for your needs.