An introduction to property valuations - Cromwell Funds Management
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May 1, 2024

An introduction to property valuations

Cromwell’s Investment Manager, Lachlan Stewart, is an experienced commercial real estate professional, who has spent more than 20 years working for highly respected organisations, including Colliers International and GE Capital Real Estate. He specialises in property valuations and financial modelling.

The importance of valuations

Section 601FC(1)(j) of the Corporations Act imposes an express obligation on a commercial property owner to ensure that the scheme property, which includes any real estate, is valued at regular intervals appropriate to the nature of the property. A company can decide to internally value or externally value a property.

As such, a commercial property valuation is the most reliable way of determining the market value of an income-producing property – it serves as an important, professionally backed tool for owners, investors, banks, regulators, and other interested parties.

Unlike residential property, commercial properties can be complex in the way that they are valued, given that every commercial opportunity is driven by a different set of needs and unique contributing factors. These factors will be explored in greater detail below.

Types of valuations

External valuation services

To undertake a property valuation of an asset, building owners engage external, independent commercial property valuers. These valuers generally:

  • are independent of the property owner
  • are authorised to practice as a valuer
  • have experience in valuing properties like that owned by the property owner</li
  • are registered or licensed in the relevant state, territory, or overseas jurisdiction in which the property is located
  • subscribe to a relevant industry code of conduct in the jurisdiction where the property is located
  • should have no conflict of interest in relation to the valuation.

Internal valuations

In some instances, building owners may choose to conduct an internal valuation. A company’s Board may value a property itself where, in its reasonable opinion, it is not necessary or not practically possible for a valuation to be obtained from an external valuer. This valuation type typically uses the same methodology and metrics as independent, external valuations.

Commercial property valuation is the most reliable way of determining the market value of an income-producing property – it serves as an important, professionally backed tool for owners, investors, banks, regulators, and other interested parties.

How properties are valuated

There are two main methods of valuation that are routinely applied to the asset valuations in Australia – the income capitalisation approach and the discounted cash flow approach. It should be noted that there are other methods of valuation, but, for the purposes of this article, we will examine these two most common methods.

Income capitalisation approach

The income capitalisation approach to property valuation examines the net income a property would achieve in an open market – regardless of whether it is leased or vacant – divided by the appropriate capitalisation rate, to give the core value of the asset.

The capitalisation rate (cap rate) (yield) is the component that moves with market forces, such as interest rate changes, economic growth, vacancy rates, inflation, and lease covenants. The capitalisation rate is similar to the price-earnings multiple, often used when valuing shares. Valuers will also look at the capitalisation rates of comparable sales over the previous 12 months when calculating the market value of an asset.

In example 1 consider a property, which produces income of $100,000, is capitalised at 6.0% – the market value would be $1,666,666.

If, due to market forces, the capitalisation rate tightened to 5.0%, and the income remained the same, the market value of the property would increase as per example 2.

Example 3 demonstrates if the capitalisation rate rose to 7.0%, and the income remained the same, the capitalised value would decrease.

 

 

As you can see, market value moves inversely from capitalisation rates.

Once an asset value is determined, valuers can adjust for certain variables.

For instance, the valuers would make an adjustment for how much the current tenants are paying, compared to what the market rent of that property should be. Likewise, there would be adjustments made for any discount or tenant incentives that a building owner is applying to that space for the duration of those tenants’ leases.

As part of this approach, valuers also look forward over the immediate horizon – which might be anywhere between 12 and 36 months – to consider any near-term lease expiry and will make an adjustment to reflect the costs associated with that downtime and re-leasing. They will examine whether there is any vacant space, as well as the costs associated with leasing that space out.

Valuers also look at any capital expenditure (capex) considerations that there might be. For example, if there’s a broken lift, and it’s estimated that $5 million will be required for a replacement, adjustments will be made to the core value, to end up with the market value. That value is applied to a point in time – “as at” the day of valuation.

Discounted cash flow approach (DCF)

More assumptions are involved in a DCF when compared to the income capitalisation approach – including the target return or discount rate, rental growth, lease expiry allowances, renewal probability, capital expenditure, and a hypothetical sale profit– but it has the potential to provide a more accurate picture of the cash flow horizon over a longer period.

Using this method, valuers typically forecast a 10-year cash flow, with a hypothetical sale profit at the end of year 10. All the income over 10 years is discounted back to a present-day value at an appropriate discount rate. An exit terminal value at year 10 (for the hypothetical sale, using an appropriate terminal yield) is also discounted to a present-day value. To derive the net present value of the property, it becomes the sum of the discounted property cash flows and the discounted terminal value.

Determining an appropriate discount rate

To determine an appropriate discount rate, a comparison is made with returns from alternative investments, the most common comparison being the 10-year government bond rate, as it is considered ‘risk-free’ and matches the investment horizon. A premium is then applied to reflect the risk of a property investment when compared to the ‘risk-free’ rate.

Adjustments

Adjustments are made within the 10-year cashflow. For example, consider a multi-tenanted building. Realistically, not all tenants are going be there for the entirety of that 10-year horizon – so, these lease expiries are factored into existing lease cash flows.

The valuer considers what happens when each tenant’s lease expires, applying a renewal probability of that tenant remaining (or leaving) and applying associated costs for potential downtime, capex to refurbish the space and the costs associated with re-leasing (leasing fees, incentives, etc.).
If an expiry is in six years, for example, the valuer has an informed opinion of what the market rental should be as at today, and then they’ll apply a growth rate to get to the market rent at that point in time. They’ll also apply a tenant incentive and will have a hypothetical lease term at that point in time.

So, the valuer is making a lot more assumptions here than what they would do in a capitalisation approach – but they’re also getting a longer horizon of cashflows to look at.

Capital markets can also influence cap rates. If a particular asset class or sector becomes more desired, the price investors are willing to pay per unit of income will increase and vice versa.

Contributors to a property’s value

The two biggest contributors to determining a property’s value are: a) the net market income it can deliver; and b) the appropriate rate of return. An appropriate rate of return is the appropriate “multiple” or risk premium to apply to the income (like price-earnings) considering asset and market-level risk factors.

Both the net market income and the rate of return are affected by property and market-level considerations.

Property characteristics

There are all kinds of property characteristics that contribute to determining an asset’s value. This includes the physical and locational characteristics of the land itself – for instance, an office building in the middle of the Sydney CBD is going to be worth more than that exact same building and lease profile in a metropolitan or regional market.

There are several additional factors that are important, including access to transport, amenity, natural light, and physical characteristics of the building. The desirability of the building for tenants is important to consider – for example, in a residential context, properties on Sydney Harbour or Brisbane River are worth more than those away from the waterfront. For commercial property tenants, proximity to customers and suppliers is also important, as are end-of-trip facilities; operational efficiency/sustainability; design and ambience; and floorplate layout.

And then there is the tenant occupied characteristic – is a leased building worth more than an unleased building or a vacant building? Usually, the answer is that the leased asset has a higher value. Other factors, including weighted average lease expiry (WALE) are factored into the valuation – longer WALE is usually valued more highly, due to the security of the income and lack of capital expenditure (capex)/downtime assumptions. Spaces occupied by blue-chip tenants and government departments are generally valued more highly, due to the security underpinning the lease.

Similarly, costs associated with the property also come into consideration – a building that requires a heavy amount of capex is generally going to be worth less than a building that’s just had a large amount of capex spent on it.

Market conditions

Broader market conditions also play an important role in determining asset values at a point in time. As explained above, movement in the ‘risk-free’ rate influences the appropriate risk premium to be applied to a property’s cashflow, and is affected by interest rates, inflation, and other financial and economic conditions.

Surging inflation and higher interest rates have been a major driver of recent cap rate movements, with the cash rate target increasing by 4.25% since March 2022, and the 10-year government bond yield increasing by 1.69% over the same period. This has led to a similar rise in cap rates, in order to maintain the typical ‘spread’ between the risk-free rate and property. The table below highlights the shift using New South Wales/Sydney as an example.

 

Property Avg Equivalent Yield Prime CBD Office Outer Central West Sydney Industrial NSW Regional Shopping Centres NSW N’hood Shopping Centres 10y Gov Bond Yield
Mar-22 (%) 4.44 3.26 5.13 5.13 2.50
Dec-23 (%) 5.69 5.25 6.00 6.25 4.19
Change (bps) 125 200 87 113 169
Spread to Gov Bond (bps) 150 106 181 206 na
Historical (25y) Avg Spread (bps) 184 310 200 340 na

 

Uncertainty regarding the future can also be an influence on cap rates. This has been exemplified by office valuations, where the impacts of hybrid working on office space demand are yet to be fully understood. While some of the potential impacts may be reflected in rental growth assumptions, some may be reflected in the cap rate as a general measure of higher risk.

Capital markets can also influence cap rates. If a particular asset class or sector becomes more desired, the price investors are willing to pay per unit of income will increase and vice versa. This was seen over the last five years across the industrial sector. Institutional investors in particular viewed the sector more favourably than had been the case historically, contributing to a greater weight of capital pursuing an allocation – the magnitude of the capital shift outpaced the ability of the market to supply new stock, leading to higher valuations.

In summary

In the face of fluctuating markets, a commercial property valuation is the most reliable way of determining the representative value of Cromwell’s income-producing assets. As a business, we adhere very closely to the mythologies outlined above to provide investors with clear and accurate information on each of our assets. Cromwell will continue to provide transparency about the valuation process – and how our properties are valued, as the information is generated.