Evaluating a Commercial Property Investment

The value of a commercial property is mostly driven by the rental return of the asset and by the potential for capital growth. There are four main methods to evaluate commercial property which include:

1. Comparable Sales
2. Market capitalisation
3. Summation Coast approach
4. Replacement cost

Comparable Sales
Very similar to the residential property investments, the comparable sales method involves analysis of similar type properties that have recently sold in the area. Also referred to as CMA (Comparative Market Analysis), this method directly relies on actual market sales data, and whilst very effective for comparing industrial style strata units, this method can get less reliable for other ‘unique’ type of assets that where recent sales data is unavailable.

Market Capitalisation
This method is based on the income of the property and is mainly used to value or appraise the net income of the asset. The ‘net’ calculations are used (not gross) due to outgoing expenses for most property differing greatly.
The Cap Rate (capitalisation rate) is worked out as a ratio and expressed as a percentage to indicate the rate of return that is expected to be generated by the commercial property. It is calculated by dividing a property’s net operating income by the current sales price or market value and is an estimation for an investor’s potential net return on the investment.

The formula is straight forward:

Capitalisation Rate = (Net Operating Income ÷ Current Market or Sale Price) x100

An example:
Property sale price – $1,500,000
Net Annual Operating Income – $111,200
Cap Rate = 7.41%

Summation cost approach

Summation by definition means adding the values of the various parts of a commercial property to calculate its full value. The summation method is the process of determining the value of the land (its size, shape, location, surrounding infrastructure and changes), and then adding the value of improvements of the premises – building age and style, renovations, additions like a mezzanine level, parking, fencing & landscaping and so on. All these costs are then added up to provide a value.

The summation method is based on current cost less depreciation and is also referred to as the ‘cost approach’ method. On most occasions when the cost approach is involved, the overall methodology is a combination of the sales and cost comparison approaches.

Replacement cost

The replacement cost method is usually used by property managers who are managing commercial properties and assisting their clients with reviewing their insurance cover to ensure covered values are up to date. The valuations, performed by certified valuers, generally is an inaccurate way to value a property because in most cases replacement cost has little bearing on the market price of property. The building/structure itself is what depreciates, and the land is the component that appreciates. In addition, information about current construction costs can vary substantially between urban and rural areas.

One good takeaway though with knowing the replacement value of a property is – are you buying the property at or below this replacement value? Why? Because if there is land available a developer could build a new building right next door to yours, and offer that premises to a tenant at a cheaper rent than you can.

Ideally you want to be buying under this replacement value every time.