There are several methods that can be used to value a commercial property. These methods include:
- Direct Market Comparison;
- Capitalisation Method; and
Direct Market Comparison
Direct market comparisons are often used as the primary approach by valuers to develop an opinion on property value. The approach involves an objective assessment of the subject property and assessing it against ‘like-for-like’ recently sold properties that are in proximity. ‘Like-for-like’ means comparing apples with apples, which in the context of valuing commercial properties means comparing the subject property to properties with similar or identical:
- Property use;
- Physical characteristics;
- Amenities and services;
- Location; and
- Block or floor size.
For the direct market comparison approach, the date of sale is a key attribute when determining suitable comparable properties. Generally, properties sold within 6 months of the valuation date are preferred, as they are more reflective of the market at the time of valuation. It should be noted however that the valuer may use comparables sold within 12-24 months especially if there are a lack of recent sales. Typically, other valuation methods are used in conjunction with the direct market comparison approach, especially when a valuer can only find older sales (comparable properties sold beyond a 6–12-month period) for comparison.
Capitalisation Method (Valuation Based on Income)
The capitalization method is an approach that estimates the value of a property based off the income it generates, and applying a capitalisation rate to this income.
The capitalization rate is a measure of the ratio between the net operating income produced by the property and its current market value. A valuer will assess market evidence to determine an appropriate capitalization rate, oftentimes using secondary information from CBRE or Knight Frank reports, which report capitalization rates. The valuer would also look at primary sources to determine the capitalization rate, by examining the current market value of a commercial property and its overall yield. The capitalization rate is calculated as follows:
If a commercial property is purchased for $500,000 and it produces $50,000 net from rent (minus outgoings and other fixed and variable costs), then $50,000 / $500,000 = 0.1 = 10%. In this example, the capitalization rate is 10%.
Ideally, a valuer will try to find several comparables where there is an appropriate current market value and known expected income, to validate the appropriateness of a capitalization rate. The benefit of using a capitalization rate is that buyers can determine the expected revenue from a property, and from this determine what a commercial property is worth.
If a valuer has a capitalization rate plus expected income from a commercial property, the value of that property can be calculated as follows:
If a commercial property has a net income of $50,000 and the capitalization rate has been calculated at 6%, the capital value is ($50,000 x 100) / 6%, which equals $833,333.
The capitalization method can still be used even if the commercial property is vacant and not generating an income. In this instance, the rent can be determined via working out the fair market rent, typically using the direct market comparison approach.
Summation Method (or Cost Approach)
The summation method involves determining the underlying land value of a property, and then adding the depreciated value of the improvements to give a total property value. Depreciation is a loss in value of an asset whether through time, wear and tear or other factors, and should be considered when determining the value of improvements.
The summation method is typically used where there is a paucity of comparable sales data and as an additional check method. There may be a lack of comparable sales data especially if the commercial property to be valued is a special use property, located in isolated markets or is a public property or utility where there is no formal trading market.
It should be noted that this method can only be used for freestanding commercial and residential properties and cannot be used for single lots in a strata.
For further reading please visit the ATO’s Guide to Market Valuation for Taxation.