Commercial Property Valuation - A Comprehensive Guide

Commercial property valuation is a complex and multi-faceted process that is essential to understanding the value of a commercial property. The purpose of commercial property valuation is to provide a reliable estimate of the market value of a property, which can be used for a variety of purposes, including buying, selling, financing, refinancing, and investing. In this article, we will explore the key factors that affect commercial property valuation, the different methods used to value commercial properties, and the importance of accurate commercial property valuation in commercial property loans.

Factors That Affect Commercial Property Valuation

The value of a commercial property is determined by a number of factors, including:

  • Location
  • Land zoning and land use regulations
  • Building size and structure
  • Lease agreements
  • Rental income
  • Market conditions
  • Comparable sales data

Location

Location is a key factor in commercial property valuation. Properties located in prime locations with high foot traffic and easy access to transportation are typically more valuable than properties located in less desirable areas. A more central location also means a higher demand, which results in potentially a shorter selling period. This in turn helps with providing you with more comparable sales data which lenders prefer. As such, lenders in general have a better appetite for properties that are more centrally located.

Zoning and Land Use Regulations

Zoning and land use regulations can also have a significant impact on the value of a commercial property. Properties located in areas with favourable zoning and land use regulations, such as those designated for commercial or mixed-use development, are typically more valuable than properties located in areas with restrictive regulations.

Building Size and Structure

Building size and structure also play a role in commercial property valuation. Properties with large, well-maintained buildings are typically more valuable than properties with smaller or poorly maintained buildings.

Lease Agreements

Lease agreements and rental income are also important factors in commercial property valuation. Properties with strong lease agreements (including the lease terms and the quality of the tenants. For example, a commercial property leased to a reputable large company with a five-year lease would be valued higher than being leased to a small business with a one-year casual lease) and high rental income are typically more valuable than properties with weak lease agreements and low rental income.

Market Conditions

Market conditions are also critical components of commercial property valuation. The current market conditions, including supply and demand, can greatly impact the value of a commercial property.

Comparable Sales

Comparable sales data is arguably the most critical factor in determining the final valuation figures. It provides insight into the prices paid for similar properties in the same market, allowing valuers to make more informed estimates of value. Lenders typically prefer to see comparable sales data when assessing commercial property.

Commercial Property Valuation Methods

There are several methods used to value commercial properties, including the comparative sales approach, income approach, cost approach, hybrid approach and the development feasibility approach.

Comparable Sales Approach

The Comparative Sales Approach is the most common method of commercial property valuation that involves comparing a subject property to similar properties that have recently sold in the same market. This method is based on the premise that a property’s value is determined by what a buyer is willing to pay for it, and that similar properties should sell for similar prices.
The Comparative Sales Approach involves three steps:

  1. Selecting comparable properties: The first step is to identify comparable properties that have recently sold in the same market as the subject property. These properties should have similar characteristics, such as location, size, age, and condition.
  2. Adjusting comparable properties: The next step is to adjust the sale prices of the comparable properties to account for differences between the subject property and the comparable properties. For example, if the subject property has a larger square footage than one of the comparable properties, the sale price of that comparable property may need to be adjusted upwards to account for the difference in size.
  3. Calculating the property’s value: The final step is to calculate the estimated value of the subject property based on the adjusted sale prices of the comparable properties. This can be done by taking an average of the adjusted sale prices, weighting the adjusted sale prices, or using another method that is appropriate for the specific market and subject property.

The Comparative Sales Approach is not a one size fits all valuation method for commercial property. For example, if a property has unique characteristics that make it difficult to find comparable properties, the Cost Approach or Income Approach may be more appropriate. Additionally, the Comparative Sales Approach may not be appropriate for properties in markets with limited sales activity or properties that are not similar to any recently sold properties.

Income Approach (Income Capitalisation Method)

The Income Approach is a method of commercial property valuation that determines the value of a property based on its potential to generate income. The Income Approach is often used for properties that have a strong income-producing component, such as rental income from tenants, as it takes into account factors such as rental rates, vacancy rates, and operating expenses.

The Income Approach involves the following:

  1. Estimating the net operating income (NOI): The first step is to estimate the net operating income of the property, which is calculated as the property’s gross rental income minus its operating expenses. The appraiser will consider factors such as rental rates, occupancy rates, and operating expenses, such as property management fees, utilities, and property taxes, when estimating the NOI.
  2. Determining the capitalisation rate (cap rate): The next step is to determine the capitalization rate, which is used to convert the net operating income into an estimate of the property’s value. The cap rate represents the expected rate of return on investment for a similar property and is typically based on comparable sales data or market analysis.
  3. Calculating the property’s value: The final step is to calculate the property’s value by dividing the net operating income by the cap rate. This calculation represents the appraiser’s estimate of the market value of the property based on the Income Approach.

The Income Approach only works for certain types of commercial properties as it relies on an existing lease in order to determine its value. For example, if a property has a significant component of physical value, such as the cost of construction, the Cost Approach may be more appropriate. Additionally, the Income Approach may not be appropriate for properties with limited rental income or properties that are not yet generating income.
The Income Approach is typically used in conjunction with other methods, such as the Comparative Sales Approach or the Cost Approach, to arrive at a comprehensive estimate of the property’s value.

Cost Approach (Summation Method or Replacement Cost)

The Cost Approach is based on the principle that a buyer would be willing to pay the cost of constructing a similar property, plus an amount to compensate for the value of the land. In essence, the Cost Approach determines the value of a property by estimating the cost to replace or reproduce it.
The Cost Approach involves the following steps:

  1. Estimate the cost to replace or reproduce the physical structure of the property: This step involves calculating the cost to build a similar structure, including the cost of materials, labor, and fees such as permits and inspection costs. The appraiser will consider factors such as the size, quality, and design of the property when estimating the cost to replace or reproduce it.
  2. Determine the value of the land: The value of the land is determined by estimating its market value, which may be based on comparable sales data or market analysis. The appraiser will consider factors such as location, zoning and land use regulations, and the size of the lot when determining the value of the land.
  3. Add the value of the structure to the value of the land to arrive at an estimate of the property’s value: The final step is to add the estimated cost of replacing or reproducing the physical structure to the value of the land. The resulting value represents the appraiser’s estimate of the market value of the property based on the Cost Approach.

The Cost Approach is a common valuation method for lenders to use to value commercial property. For example, if a property has a strong income-producing component, such as rental income, the Income Approach may be more appropriate. Additionally, the Cost Approach may not be appropriate for older properties or properties that have unique or complex features.

Feasibility or Hypothetical Development Method

The Feasibility or Hypothetical Development Method is a type of commercial property valuation that uses a hypothetical development scenario to estimate the value of a property. This approach is used when a property is being considered for a specific use or development and the existing use is not representative of the property’s highest and best use. The hypothetical development method evaluates the potential value of a property by estimating the costs and expected income of the proposed use or development.

This method is commonly used in construction loans where the value of a property is dependent on its potential use or development and the existing use does not accurately reflect its true value. For example, if a property is being considered for a multi-unit residential development and the existing use is a single-family home, the hypothetical development method would be used to estimate the value of the property based on the potential income from the proposed development.

The feasibility or hypothetical development method considers various factors, such as land and development costs, expected income from the proposed use, market conditions, zoning regulations, and economic trends. The appraiser will create a financial pro forma to estimate the costs and income of the proposed use and use this information to estimate the value of the property.

Hybrid Approach (Combined Approach)

The Hybrid Approach, also known as the Combined Approach, is a type of commercial property valuation that combines two or more methods of valuation to estimate the value of a property.

This is used when a property has characteristics that are not well represented by a single valuation method, and a more comprehensive evaluation is needed.

For example, if a property has both a strong income-producing component, such as rental income, and a significant component of physical value, such as the cost of construction, a Hybrid Approach that combines the Income Approach and the Cost Approach might be appropriate. By combining two or more methods, the Hybrid Approach provides a more accurate and comprehensive valuation of a property.

How lenders use a commercial property valuation in assessing commercial property loans

Commercial property valuation plays a crucial role in commercial property loans. The value of a property is used to determine the loan-to-value ratio, which is the ratio of the loan amount to the value of the property. This ratio is used by lenders to determine the terms and interest rates of a commercial loan.

Accurate commercial property valuation is critical for loan approval. Lenders rely on commercial property valuation to determine the risk associated with a loan, and to ensure that the loan is secure. If the valuation of a property is too high, the loan may be considered riskier, and the lender may require a higher interest rate or a larger down payment to compensate for the added risk. On the other hand, if the valuation of a property is too low, the loan may not be approved, as the lender may view the property as insufficient collateral for the loan. Common loan-to-value ratios used in commercial property loans range from 60% to 80%

Best Practices in to get the best outcome in commercial property valuation

To ensure accurate and reliable commercial property valuations, it is important to follow best practices. Some of the key best practices include:

  • Hire a professional appraiser: An experienced and qualified commercial property appraiser should be hired to carry out the valuation. They have the necessary knowledge and expertise to provide an accurate and comprehensive assessment of a property’s value.
  • Use multiple approaches: A combination of different valuation approaches should be used to determine the value of a property. This helps to provide a more comprehensive understanding of the property’s value and ensures that the valuation is not overly reliant on a single approach.
  • Consider market conditions: The current market conditions should be taken into account when valuing a property. Market conditions can have a significant impact on the value of a property and should be factored into the valuation.
  • Take into account the property’s unique features: The unique features of a property, such as location, zoning and land use regulations, building size and structure, lease agreements, and rental income, should be taken into account when valuing the property.
  • Consider comparable sales data: Comparable sales data should be used to compare the subject property to similar properties that have been sold recently. This helps to provide a more accurate understanding of the market value of the property.
  • Keep up-to-date with industry standards: It is important to stay up-to-date with industry standards and best practices in commercial property valuation to ensure that the valuation is accurate and reliable.

How can Reservoir Finance help you with your commercial property valuations?

Different lenders have different approaches to valuing a commercial property. As a result, the same commercial property can have vastly different values due to each lender’s different criteria. This combined with the lender’s appetite and lending policies is the difference between getting a pre-approval or an approval for a commercial loan and getting rejected by a lender.

By working with Reservoir Finance, you are choosing to partner with an experienced commercial property loans mortgage broker. We can help you guide through the ins and outs of lender policies, your personal goals, your financial situation in order to find the best lender for your circumstances. We pride ourselves in being independent (not owned by a bank) and following a unique mantra of “responsible borrowing” (not responsible lending which the mainstream media pushes).

To give you certainty of our confidence, we also do not charge fees for 99% of our clients. This means no unnecessary “upfront fees” or “administration fees” or “complex loan fees” if you choose to work with Reservoir Finance. Speak with us today by filling in the form below, book an online meetingemailing us or call us on 02 8288 9123. We would love to hear from you and partner with you in your next commercial property purchase!

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