Updated: Sep 18, 2018
As an investment advisor, I am often asked for my opinion on value by property owners or clients looking to purchase a commercial property. Some of these questions are: how do we decide on the value of the property? What makes a property more valuable than the other? What are the key factors we should pay attention to while we are assessing the value of a property? How can we increase the value of a property? Is having a good credit, corporate backed-up tenant good enough to increase the value of a property?
The answer to all of these questions is: first decide on the type of the property and what its highest and best use is. After deciding on the type of the property, there are three approaches you can follow: Replacement Cost Approach, Sales Comparison Approach, Income Capitalization Approach.
Replacement Cost Approach
The Replacement Cost Approach is often used when appropriate comparable properties are difficult to identify. The investment advisor determines the property’s value based on the land value plus the current replacement cost of improvements less depreciation. The cost approach is most accurate when applied to a relatively new structure with no functional deficiencies. Investment analysts usually use this method when appraising special–purpose buildings that do not produce income or when there are few comparable sales around the building being evaluated.
Sales Comparison Approach (Market Approach)
Sales Comparison Approach uses the data of comparable properties’ sales prices to estimate the value of the property. This method is commonly used for valuing residential real estate. To make the properties more comparable, prices are divided by the number of square feet, then the adjustments to each of those alternative properties are made based on its age/condition, location, time, and other factors.
Income Capitalization Approach
The Income Capitalization Approach is typically used in appraising income-producing properties. This approach requires the estimate of future gross income and future operating expenses. Anticipated future cash inflows and outflows are discounted by expected cap rate based upon the market indicators and comparable properties. Consequently, the value of the property is derived from those discounted cash inflows and outflows. In Income Capitalization Approach, estimating the future incomes, expenses and market cap rates are key factors in the reliability of the valuation.
Depending on the highest and best use of a property, an investor might prefer one method over the others or might rely on the results of all of these methods for his/her evaluation. However, in order to get a better picture of the investment and identify the problems and potentials as an investment advisor, my suggestion is to follow a wholistic approach in commercial property valuation.
By wholistic approach, I mean, understanding the real dynamics defining the demand & supply for the type of property valued. Namely, in our evaluation process, we need to take into account the answers to the following questions: What is the total stock of that type of building in the area? What is the vacancy rate? Is there any new construction coming into the market? Is there anything happening in the local/international market affecting the construction raw material prices? What is the trend in population growth? What is the unemployment rate? What is the median income? Is government infrastructure expenditure increasing/decreasing? Is there any tax cut/tax increase foreseen? What’s the trend in the interest rate? What is the traffic count?
For instance, if the total stock for that type of building is low and there is no future new development coming to market, vacancy rates are low and the construction raw material becomes more expensive due to new tariffs imposed upon steel imports then we can expect an increase in property values. On the other hand, if the demographic data indicates that there is a decline in the population and decrease in household income, increase in unemployment rate, then one can assume that the property prices will go down. Foreseen tax cuts/increases or government infrastructure expenditure increases/decreases will also have a considerable impact on property prices.
What can we do to increase the value of our property?
Location of the property is a major factor in deciding the value of the property. As we already own the building and we can’t change the location, then there are only three factors left for us to play around to increase the value of a property. You can increase the income, reduce the expenses or secure a low-interest loan.
Increase in Potential Income
You may increase the income by increasing the occupancy rate and the rent for new tenants through renovation, adding new amenities to the building, i.e. coffee shop, gym, daycare or cafeteria. Running a marketing campaign and reaching out to new potential tenants might also increase the occupancy rate of the building. You may also generate new income by adding vending machines, washer/dryer room, rentable meeting spaces etc. Repurposing the building might be another option to increase the occupancy. Old warehouses used as microbreweries are a good example for repurposing.
The other point you might like to pay attention to is zoning, the change of zoning can make your building more desirable, might allow you add more space or open it to a new type of usage or it might limit the usage. Therefore following the changes in city planning is very important in increasing your future return from that property.
Having tenants with good credit rating and corporate back-up might also make the building attractive to buyers. However at this point, one needs to be careful about the lease terms. As seen in the market now, longer-term leases with minimal to none increase in rent might take away the benefits of having a tenant with good credit rating. For more detail you may read the book on "The Income Approach to Property valuation" written by Andrew Baum, David Mackmin & Nick Nunnington. https://amzn.to/2NTKwi3
Decrease in Operating Expenses
Reducing the operating expenses will also have a very positive impact on Net Operating Income of the property. Having NNN lease with your tenants makes it preferable for the buyers as this type of lease makes future expenses more foreseeable for the buyers as it passes the CAM charges onto its tenants.
Securing Low-Interest Financing With Low Down Payment
Last but not least, helping the future buyer to secure low-cost financing and lower down payments would make your investment more attractive to the buyers and make them be willing to accept a higher sale price with lower cap rate.
That said, we should always keep in mind that the valuation of commercial property has a subjective component and each buyer values property differently based on his experiences, knowledge and future plans. At the end of the day, the value is in the eye of beholder and it is determined by the purchaser and seller at a certain time when they agreed to go with the sale transaction.