How to measure property value
Measuring property value across the life of an investment is a complicated process. Before making the decision to invest in commercial property, it’s essential to understand how a property is valued. Here are ten common components of a commercial property valuation.
Rent paid by tenants is the primary source of income for a property investment. It’s important to make sure that the property has high-quality tenants, with good financial track records, and that the lease terms are appropriate for market conditions. Lease terms impact ongoing net property income in the form of the obligation for tenants to pay increases in rent in order to offset increases in a building’s outgoings (expenses). Incentives are often offered to attract tenants to a property, and can be in the form of a reduction in rent, a rent-free period or a fitout contribution.
2. Weighted Average Lease Expiry (WALE)
A Weighted Average Lease Expiry (WALE) represents the average time period when all leases in a property will expire, and is an indication of the security of future income streams to investors. It’s calculated using the rental income from each lease but weighted by the amount of income or space within the asset. A longer WALE is generally more attractive to investors, as it prolongs the possibility of exposing their money to risks created by costs associated with vacancy. A longer WALE also limits the opportunity to reset rents to market levels.
3. Vacancy rates
A vacancy rate measures the untenanted proportion of the property and quantifies a potential risk and opportunity to investment earnings. Unless a property is tenanted on a long-term lease with a blue-chip client, some vacancy rates should be expected — particularly in assets that have multiple tenants and lease agreements. National averages give an indication of reasonable vacancy rates given market conditions. For example, the national office vacancy rate is currently 9.1%.
Yield is expressed as a percentage and is based on the net property income of the asset at a point in time divided by the property’s cost or market value. It’s a measure of the ongoing future income investors are likely to receive during the investment term at the asset level, before gearing and transaction costs.
5. Risk premiums
When investors take on higher risks, they expect to be compensated with greater returns. They generally seek a return equal to a minimum or ‘risk-free’ rate (usually calculated on the current yield of a ten-year government bond), plus a premium based on the risk inherent in different investment types. For example, the risk premium on shares is generally considered to be around bond rates plus 4%, while property is closer to bond rates plus 2%.
6. Capitalisation rate
The capitalisation rate (or ‘cap rate’) is an indicator of investment value and is one of the main tools used by property valuers to understand the overall risk of a property. While the cap rate contextualises how the potential investment stacks up against similar properties, a thorough comparison needs to consider other factors like tenant quality and asset condition.
7. Net Present Value (NPV)
Focusing on cash flow, the net present value (NPV) is a capital budgeting tool that measures the cash flow in and out over a period of time. It’s based on the idea of the ‘time value of money’, which means that money is worth more in the present than it is in the future. Assumptions are made about projected returns and a big influence is the discount rate used to “discount” the future cash flows.
8. Internal Rate of Return (IRR)
Another capital budgeting tool is the Internal Rate of Return (IRR). This estimates the annual rate of return over the life of an investment. Whilst a higher IRR may indicate a better return, consideration also needs to be given to the inherent risk in the investment.
9. Terminal value risk
Terminal value is the expected sale price of an asset in the future. The risk with terminal value is that changes beyond the immediate future, like changes to macroeconomic or market conditions are very difficult to predict. Terminal value risk can impact the NPV of a cashflow and therefore result in a lower or higher IRR.
10. Compare the market
Market rents can also influence a property valuation. For example, if a tenant signed a lease a number of years ago, the passing rent (that is – the rent a tenant is currently paying) may not reflect how much rent an owner could get if they were to re-tenant the property at the time of the valuation.
Comparing different property types, such as residential property valuations to commercial properties, likewise will not reflect what a building may be worth. This is because the valuation basics for residential property and the emotional drivers with owning a home aren’t as relevant to commercial property assets.
Indications of possible future earnings can be generated by making assumptions and calculations based on available information. Ultimately, the value of a commercial property is best derived from the quality of the incoming tenant cash flows and the terminal value or potential value accretion of the asset over time.