If you are on the fence about putting money in industrial or commercial real estate, knowing how to value commercial property in Australia can help you decide.
Below we will explain the five different methods used to calculate the value of commercial properties and help you understand what contributes to a property’s value so you can make an informed investment decision.
What Is a Commercial Property?
Before getting started in the Australian investment property market, it is important to differentiate between commercial and residential real estate.
Commercial properties include offices, warehouses and shops, rather than apartment buildings.
They can be a great investment option since they
- Tend to yield higher returns (5% to 10%);
- Are leased for longer periods (usually 5 years unlike the 12-month lease commonly found among residential properties).
Plus tenants usually pay for taxes and insurance, charges which are normally covered by the landlord in houses and buildings.
There are some downsides, though, that might make commercial properties unsuitable for inexperienced property investors.
For one, the cost of a commercial or industrial property is two to three times higher than residential real estate, which in turn means a larger initial capital is required.
What’s more, lenders will only let you borrow up to 70% of the property value, unlike residential mortgages where LVR can go as high as 80%. In other words, you will have to provide more equity to buy the property, and you are likely to pay higher interest rates on the loan.
Tip: Before investing in property, check how much banks are willing to lend you.
Secondly, the value of a commercial property is more affected by economic conditions, such as unemployment rates, migration, and inflation, which means you will need to keep track of all these factors when it comes to valuing a commercial property and its potential returns.
Finally, it is much easier to get into the residential real estate game—most investors have purchased or rented homes for themselves and understand what residential buyers or tenants want, So, unless investors have run a business from a commercial property in the past, they will know little about the requirements of potential buyers or tenants.
How To Value Commercial Property in Australia
Commercial property appraisals can be done by using various methods—some giving you an estimated value of the property and others helping you calculate potential returns.
The two most common commercial property valuation methods are the Income Cap Rate Method and the Comparable Sales Method.
Income capitalisation
This is one of the most common methods used in valuing commercial property—it is simple to implement and allows you to compare your property to similar ones on the market.
To use it you need to
- Calculate the net operating income of the property, which is the yearly income from rent minus expenses
- Calculate the capitalisation or cap rate, which you determine by dividing the net operating income by the sale price
Let’s say your commercial property can make $70,000 in gross income. Costs should amount to $13,700 (vacancies, capital expenditure, building insurance, maintenance, agent fees, etc), which means your net operating income is $56,300.
Based on other sales in the area, you have calculated a cap rate of 5.8%.
You then divide the net operating income by the cap rate to get to the value of a commercial property.
Using the same commercial property valuation example, the value of the property is around $970,000, i.e. your net operating income ($56,300) divided by the cap rate (5.8%).
Comparable Sales Method
The comparable sales method, also known as a direct comparison, relies on comparing the property in question with similar properties sold recently. The factors you usually consider include:
- The location and size of the property (including the size of the land and structures on it)
- When the property was sold
- Zoning of the property
- How close it is to various amenities (public transport, CBD, etc)
- Physical characteristics (age, condition, access etc)
This method is not as accurate or specific as the Income Capitalisation Rate, as it doesn’t give the value of potential returns. It does, however, give you a good idea of what price the property could go for in an open market.
Other commonly used commercial property valuation methods include:
Summation
As the name suggests, the summation method relies on totalling the value of each component of the property and thus assessing its full value. The method is also known as the cost approach as it involves adding up the current cost of each component of the property (land costs, improvements, fencing, landscaping) minus the depreciation (loss in value).
Hypothetical Development Method
This method is mostly used on subdivided land and development sites as it shows if the value of the property can cover the costs involved in the development of the project.
The value of the land is calculated by subtracting the development costs, interest/charges on loans, and the profit and risk margins from the gross total sales of the finished project.
Property developers then use this figure to determine whether the project is feasible or not.
Replacement Cost Method
This calculation is most commonly used for insurance purposes and can provide an estimated price range for the buildings located on the property by subtracting the value of the land from the overall property value.
Since this method considers the value of buildings alone (which depreciates over time) and not the value of the land (the element of the property that actually appreciates), it is not commonly used by property investors when calculating their commercial property value.
What Affects Commercial Property Prices?
The real estate market is subject to price changes, so to protect yourself from potential losses, it is essential to analyse the factors impacting property value.
The most important aspects include:
- Economic factors, such as GDP growth, migration, wage growth and unemployment rates and most importantly loan interest rates;
- Location, including proximity to public transport, proximity to CBD, changes in area population;
- Property factors, such as physical characteristics of the property and the potential for developments in the area.
Other factors to consider when calculating commercial property value:
- The length of the lease: Tenants with longer leases are typically less risky and thus more valuable than those with a short lease;
- The type of property: Recent stats reveal that offices are the most in-demand commercial properties in Australia;
- Parking space: This requirement is often seen as a must-have by buyers and tenants alike.
Bottom Line: How to Value Commercial Property?
There are a lot of factors that determine the value of a commercial property and with the real estate landscape changing all the time, it can be difficult to calculate the precise value of your investment. You could try one of the methods described above, but your best bet would be to get a commercial property appraisal undertaken by a professional who can tell you exactly how much the property is worth.
FAQs:
1. What is a good ROI for commercial property?
Investors should expect a 5 to 10% return on a commercial or industrial property, which is a bit higher than the expected 1 to 3% return on residential real estate.
2. What value method is most commonly used for commercial property?
The most widely used methods for the valuation of commercial property are the income capitalisation method and the comparable sales method, with the first providing the most accurate assessments of a property’s value and the second giving a solid comparison base to other similar properties in the area.
3. How do you calculate the value of a commercial property?
To truly understand how to value commercial property in Australia, you should take some time to research the appropriate and most applicable methods depending on the property type. Alternatively, you could engage the services of a professional surveyor and get your property appraised by an industry expert.
