Pinning Down Value
Ascertaining the true value of a commercial property is far more difficult than people realise. Miriam Bell talks to the experts to find out what’s involved. PINNING DOWN
1 May 2018
A building is a building whether it’s a house or a warehouse. So calculating the value of a commercial building can’t be much different to calculating that of a residential building. Right? Wrong. Valuing commercial properties is not like comparing apples to apples and it’s a common mistake made by investors new to the sector.
While it’s generally true to say that no two residential properties are identical, there are, ultimately, overarching similiarities in residential property. These allow for a more standardised approach when it comes to valuing residential properties.
Opteon Solutions (formerly Sheldon & Partners) valuer Mark Davidson says that residential properties tend to be valued using a comparative sales approach. This is where you look at sales of comparative properties in the same suburb. A secondary approach might be to use a sum approach where the value is divided into land and house components.
"You do need to think about some of the subjective things like location, schools, views and the like too. But it’s more straightforward than commercial where there are more factors that you have to take into account. Valuing commercial properties is more complex and the numbers are critical.”
That’s because no two commercial properties are exactly alike. Not only are there the different commercial sectors but, within those sectors, the building types, property compositions and attached features vary widely. And then there’s leases that need to be taken into account.
JLL associate research and consulting director Tom Barclay says that if you had two identical residential properties side by side you could expect they would sell for a similar price. But that’s not the case with commercial properties. For example, if you had two identical commercial properties (same age, quality, NBS%) side by side, each could sell for a very different value depending on the lease terms and tenant, he says.
“If property one had a remaining lease term of six years to a national tenant with annual built in rental growth and hard ratchet clauses and property two had a remaining lease term of six months to a small local operator you could expect property one to sell at a higher level than property two.” The reason for this is that property one offers security of income and built in growth over the next six years before a purchaser will have to worry about vacancy or re-leasing of the property, he says.
‘The value of a commercial investment property is dictated by the quality of its income stream in terms of security, length of lease, quality of tenant and review provisions’ TOM BARCLAY
“That means the investment is less risky so a purchaser will pay more for that income stream. In contrast, the purchaser of property two would pay less given the risk of having to re-lease the property in six months’ time as they are facing a period of vacancy where rent won’t be paid.”
When the value of a commercial property is being calculated, there is a lengthy list of fundamental attributes which are assessed.
First up, there are the physical attributes. These include location; zoning; size, age and visibility of the building as well as its architectural appeal and the quality of construction; security, access and car parking; common areas; maintenance programmes; and earthquake ratings.
The potential versatility of a property is also a factor – ie: whether the property can be used for a range of uses or whether it is limited to a specialist activity like a gas station. Development potential is another attribute to consider.
Then, if the property is tenanted, there are the lease and tenant attributes. These include type of tenure; lease terms (eg: length of lease, rights of renewal) and rent review conditions; quality of tenants and their activities; the tenancy mix if it’s a multi-tenant property; and the appeal of the property to other tenants should an existing one move on. The quality of neighbouring tenants should also be assessed.
For Barclay, the value of a commercial investment property is dictated by the quality of its income stream in terms of security, length of lease, quality of tenant and review provisions. Essentially, a commercial investor is buying an income stream, the “bricks and mortar” are merely the means to secure the said income stream, he says.
“The important factor for the commercial investor is how the income stream relates to the value of the property. The income stream divided by the value, or price paid, gives a yield (ie: return) in percentage terms. Investors will have a desired return (ie: 7%) which reflects the return on risk they are seeking relative to other investment options by risk (ie: low risk term deposit at 3%).”
But capital expenditure requirements, which include earthquake strengthening, can also be a major factor affecting the value of a property, he adds. “If the property is not maintained to a decent standard it will be hard to retain tenants and even harder to re-let in the market. This is an issue for properties with deferred maintenance – it’s harder to sell a property if the purchaser knows they are going to have to spend a lot of money on fixing existing issues.”
Davidson says that while a tenanted property with a solid cash flow is the aim for many investors, others want to purchase vacant properties. “That’s with the intention of adding value by renovation and then leasing the premises. They would look to buy the building at a discount due to the risks associated with vacancy, such as the time to find a tenant, operating expenses and incentives.”
On top of the fundamental attributes considered when valuing commercial properties, each of the three main commercial sectors (industrial, office and retail) have their own distinct factors to be assessed. Those factors are as follows:
Industrial: The specific attributes considered when valuing an industrial property include floor space; stud height and storage capacity; vehicular access; roller door access; external yard space; the presence of sprinklers as this has a bearing on how high racking can go; and the presence or not of columns which can limit usability and manoeuvrability.
Davidson says the office/warehouse/ showroom configuration is important, but varies depending on the size of the building. “For example, for a smaller industrial building a maximum of 30% office/showroom space is ideal. Any more and the tenant doesn’t need the higher value office/showroom space and they feel like they are paying too much for it. But the balance is crucial and it can vary from tenant to tenant, location, size of building overall and other factors.”
Location is another key factor for industrial properties, Barclay says. “A premium is applied to locations with good access to arterial routes. Access to sea ports or inland container ports is important for logistics occupiers. Manufacturing occupiers or industrial business with higher employee numbers will want to be close to blue collar worker populations.”
Office: Attributes considered when valuing office properties include floor plate size and ceiling height; plant such as lifts and air conditioning systems; the existing fitout which can either add or detract value depending on the quality of it; common areas like foyers, kitchen, toilets, lunch space and outdoor space; views/outlook; Green Star and NABERS ratings; proximity to amenities like transport, retail, and dining/bar options.
Barclay says it’s worth noting that in the office sector, higher rents are achieved for newer spaces that meet modern day requirements. “A premium is paid for new build space with the latest specs or high quality refurbished or character space.”
Again, location is important when valuing office property. It is city dependent, with Auckland attracting the highest rents, and property in desirable locations, like Auckland’s waterfront, attracting a premium.
Retail: The retail sector is currently going through a period of digital-provoked change, but location remains one of the critical factors affecting a retail property’s value. Tenants will pay more to be located in affluent catchment areas while locations with higher foot traffic command a rental premium, especially where there is limited parking nearby, Barclay says. “Microlocation is also important: corner tenancies attract a premium given their exposure, as do high-traffic areas of shopping centres.”
The other attributes that need to be assessed in retail property include frontage and window space – with the more being the better; the depth of the retail space with less value being placed on the rear of a retail space; stud height; stock storage space; and, in bigger retail properties, tenant mix.
Davidson says all of these factors are considered when valuing a commercial property but that, typically, a number of approaches are employed to arrive at the value of the property.
The approaches used include the capitalisation approach, which uses market income and market capitalisation rates to derive a value; the discounted cashflow (DCF) analysis which forecasts future cashflow and discounts to a value today; the sales comparison method; and/or the replacement cost method.
But the most important factor for commercial property is the income stream, Barclay says. “So that means the most heavily relied upon methodologies for valuing commercial property are the income approach and the DCF approach.”