How Commercial Property Is Valued

Commercial property is usually valued on its income. The valuer works out the net income the property can reliably earn, converts it to a value using a capitalisation rate taken from sales of similar properties, then checks the result with a discounted cash flow or with sales analysed per square metre.

That is why two buildings that look the same can be worth very different amounts: one may be leased to a strong tenant for ten years while the other sits vacant. This guide explains each method in plain English, with worked examples and the state rules that change the numbers in New South Wales, Victoria, the ACT and the Northern Territory.

What methods do valuers use for commercial property?

The International Valuation Standards group valuation methods into three approaches: market, income and cost. Commercial valuers commonly draw four methods from them: capitalisation, discounted cash flow, direct comparison and summation.

Valuers often use more than one method and reconcile the results. Where a site is worth more for redevelopment than for its current use, the valuer also looks at it as a development site.

How does the capitalisation method work?

Capitalisation turns one year of sustainable net income into a value. The valuer:

1. Reads the leases and works out the passing rent: what the tenants pay now.
2. Assesses market rent from recent leasing deals, to see whether the property is over-rented or under-rented.
3. Deducts the outgoings the owner pays and cannot recover from tenants, such as some rates, insurance, land tax, management and repairs, to reach net income.
4. Analyses sales of comparable leased properties to find the capitalisation rate buyers accepted: the net income of each sale divided by its price.
5. Divides the net income by that rate, then adjusts for anything a buyer would allow for: vacancies and letting-up time, incentives still to run, capital works that are due, and rent well above or below market.

Here is the arithmetic for a property earning $100,000 a year net. The rates are chosen to show the arithmetic, not as current market rates.

A change of half a percentage point in the capitalisation rate moves the value by about 7 to 9 per cent. That is why a good report shows the sales evidence behind the rate, not just the rate itself.

How do the leases change the value?

For an investment property, the lease is a large part of what a buyer is paying for. The valuer reads every lease and looks at:

• The tenant: how financially strong it is and how likely it is to stay.
• Term remaining and options: a long lease to a strong tenant is worth more than a short one. Across several tenants, the weighted average lease expiry (WALE) sums this up.
• Rent reviews: fixed increases, reviews to CPI or reviews to market.
• Who pays the outgoings: under a net lease the tenant pays most of them; under a gross lease the owner does, which lowers the net income.
• Incentives: rent-free periods or fit-out contributions, which mean the face rent overstates the real income.
• Fit-out and make good: who owns the fit-out and what the tenant must do when it leaves.

A simple example: two shops are each leased at $80,000 a year. One tenant pays its $15,000 of outgoings; at the other shop the owner pays them. The net incomes are $80,000 and $65,000, so at the same illustrative 6 per cent rate the values are about $1.33 million and $1.08 million. Same rent, different lease, $250,000 apart.

Do state retail leasing laws affect the value?

Yes, because they control what a landlord can recover from a retail tenant, and so the net income. Each jurisdiction has its own law.

Whether a lease is covered depends on the use, the size of the premises and the lease itself, so the valuer reads each lease rather than assuming.

How is a vacant or owner-occupied building valued?

With no lease to capitalise, the valuer leans on direct comparison: sales of similar vacant or owner-occupied buildings, analysed per square metre of building and land and adjusted for location, size, condition, access and parking.

The valuer may also value it as if leased: assess a market rent, capitalise it, then deduct what a buyer would allow for finding a tenant, including the months of vacancy, the incentive needed to sign one and the leasing fees. Depending on the building, the strongest buyers may be owner-occupiers rather than investors, and the report says which market the value reflects.

Market value, fair value or going concern: which basis does the report use?

• Market value is the price a willing buyer and a willing seller would agree on at the valuation date, both acting knowledgeably and without compulsion. The High Court set out the principles behind this idea in 1907, in Spencer v Commonwealth, and the ATO’s guidance on market value still refers to that case. It is the basis commonly used for tax, duty, SMSF and family law purposes. Market value and sale price are not always the same thing.
• Fair value is used where an accounting standard requires or permits it, for example for investment property. AASB 13 Fair Value Measurement sets out how to measure it, and the report uses that standard’s definition.
• Property or business. For property sold with the business operating from it, such as a hotel, the report says whether it values the property alone or the business as well (specialised property).
• GST. The report should say whether the figure includes or excludes GST. The sale of a leased building can be GST-free as the supply of a going concern if the conditions in section 38-325 of the GST Act are met, so the basis matters.

Why do people get commercial property valued?

• Buying or selling, or testing an agent’s price.
• Self-managed super funds, for annual reporting and for business real property acquired from a related party (SMSF valuations).
• Transfers between related people or entities, where capital gains tax can look to market value if the parties are not dealing at arm’s length, and stamp duty is generally charged on the greater of the price and the market value (in New South Wales and Victoria, for example).
• Family law settlements and partnership exits.
• Financial reporting and rent reviews.

How much does a commercial property valuation cost?

Commercial valuations start from $1,980 including GST. The fixed quote depends on the property, the number of tenancies, the documents and the purpose, and you see it before anything is booked or charged. Special-use property is quoted on scope, from $2,750. Leases, a tenancy schedule, outgoings and floor areas all help the valuer scope the work.

Property Valuations Australia takes requests for property in New South Wales, Victoria, the ACT and the Northern Territory. See commercial, industrial, retail and specialised property valuations, or request a commercial quote.