How do you value a commercial property?

How to work through a valuation

1. Work out the net income.

   Start with the yearly rent. Take away the costs the owner pays and the tenant does not, such as some rates, insurance, repairs and management. What is left is the net operating income.

2. Find a capitalisation rate.

   The capitalisation rate (cap rate) is the yearly net income divided by the sale price, taken from recent sales of similar buildings. Lower rates usually mean buyers see less risk.

3. Divide income by the rate.

   Net income divided by the cap rate gives a value.

4. Check it against sales by area.

   Compare the price per square metre of similar recent sales.

5. Test the lease.

   Read who the tenant is, how long is left, how rent rises and who pays outgoings.

6. Use a cash flow model when the income will change.

   If a lease ends soon or the building is part vacant, forecast the income, the costs and the gap between leases, then bring it back to today's value.

Two main ways to calculate commercial property valuation: income approach and sales comparison

The two main methods are the income approach and the sales comparison method. The first uses rent after costs. The second uses prices paid for similar buildings. Both give a starting point, then the valuer checks the lease, the site and the quality of the evidence.

The income method is the most common way to value a leased commercial property. It asks one question: what will a buyer pay for this stream of rent? The valuer starts with net income, not gross rent. Rent the owner never keeps, because it goes on costs, does not count. The cap rate comes from what buyers recently paid for similar income in the same market.

Small changes in the rate move the value a lot. That is why valuers explain the sales they used to pick it. A building leased to a national tenant for 10 years will usually attract a lower rate than the same building with a local tenant on a one-year lease. The rent may be equal. The risk is not.

Net operating income is measured before loan payments and income tax. It describes the property, rather than how one buyer funds it. A cap rate based on gross rent will give a different result, so keep the income basis the same across each sale you compare.

When are comparable sales or cash flow models used instead?

Comparable sales work well when similar buildings have sold recently nearby. The valuer adjusts for size, condition, parking and location. This method is often used for small shops, offices and vacant buildings, where a buyer may plan to use the space themselves.

A discounted cash flow is used when income will change in the next few years. A lease may expire, or rent may be reset to market. The model forecasts each year's income and costs, allows for time with no tenant, and turns those future amounts into a value today. It needs more assumptions, so check each one.

What makes two similar buildings worth different amounts?

The lease often explains the gap. Look at the time left on each lease, often summed up as the weighted average lease expiry (WALE). Look at how rent rises each year, and whether the tenant pays outgoings under a net lease. Also look at any rights to leave early. A building with strong leases can sell for more than a newer building with weak ones.

Location and use still matter. Zoning can limit who can lease the space next. Access, parking and exposure to passing traffic affect demand from tenants. The Australian Taxation Office notes that no single valuation method is required. A valuer picks the most suitable method and supports it with evidence.

What can other valuation checks tell you?

A cost approach adds the land value to the cost of replacing the building, then allows for wear and age. It can help with a special site that has few similar sales. Replacement cost and insured value are different from a price a buyer will pay.

A gross rent multiplier is a quick screen: sale price divided by yearly gross rent. A hypothetical $1 million sale with $100,000 in yearly rent has a multiplier of 10. It leaves out costs and lease risk, so it cannot replace a full valuation.

An automated valuation model uses sales data to make an estimate. Check whether the data reflects the zoning, condition and lease of the actual building. A model may miss those details. Use it as one check, rather than as a formal valuation.