When most people want to sell their home, the valuation process is pretty straightforward. They choose an estate agent, who then visits the property and uses their local knowledge to assess how much they think they will be able to sell it for. Sometimes they overestimate; sometimes they underestimate. But ultimately, the property is worth what somebody is willing to pay.
In theory, that last point applies to commercial property too, but the process of valuation is far more complicated. Indeed, a landlord has a variety of valuation methodologies available to them. Determining which is most appropriate and then actually conducting the valuation requires specialist skills and inevitably involves employing a chartered surveyor specialising in valuation and, later, an agent, both with deep local knowledge.
“Working this out may seem like a complex task and, with many different approaches, we can understand why,” according to ASL Chartered Surveyors and Valuers. The key to an accurate and functional valuation is to think about a property from both a landlord’s and tenant’s perspective, while also considering the different factors at play in the market.”
It’s a complex process, but in multiple situations it is also essential. “If you are interested in buying a commercial property with a commercial mortgage, you will need an accurate commercial property valuation,” according to Commercial Trust.
“Knowing the property value is essential for a fair transaction and to secure favourable commercial mortgage rates. The property value will serve as the foundation of your investment, ensuring that you are not overpaying or making an unprofitable investment decision.”
Below, we provide a run down of the key considerations and different valuation methodologies.
Income capitalisation approach
The income capitalisation approach is one of the most common methods for valuing commercial property. “This technique is particularly useful for properties that generate income, such as office buildings, retail shops and rental complexes,” says ASL. “This method is favoured for its direct correlation to the income a property can generate, making it highly relevant for investment properties.”
At the heart of the approach is net operating income, which calculates by adding up the income derived from the property minus operating expenses. The figure is then divided by the market rate value or cap rate. The idea is to help investors understand how quickly their investment might be recouped based on the property’s income.
“A market study for the sales of similar properties in the same neighbourhood are collected to get the cap rate,” says Phoenix and Partners. “The resulting cap rate is then adjusted based on your property’s specific features. You can make it higher or lower if your property has certain advantages or disadvantages for your tenants. Usually, this adjustment does not go beyond half a percentage point.”
It adds: “This approach has the advantage of being able to consider its potential for income and recent sale activity of similar properties. It can also be adjusted for certain factors through the cap rate.”
Cost approach
The cost approach involves totting up the value of the land a property is built on and the current cost of constructing an equivalent building – minus depreciation. Both land value and construction costs can vary wildly depending on the factors such as location and the general state of the economy or how individual sectors are faring.
“This approach is especially useful when dealing with newer properties or those without clear income data,” according to ASL. “It’s particularly applicable for unique properties that don’t have many comparables in the market. This method ensures that the property’s value reflects the current replacement cost, adjusted for its age and condition.”
According to Phoenix and Partners, cost is the simplest and most intuitive approach in determining the value of a commercial property. “This is basically the same as determining the value of a residential property,” it says. “It is simple and straightforward but it has a disadvantage of not being able to take into account the potential of the property for generating income.”
Commercial Trust provides an example. “Imagine you are considering purchasing a warehouse on a plot of land and you want to determine the value,” it says. “You evaluate the sales of similar vacant plots of land in the area and you determine the land value is £200,000. Based on current construction costs, it would cost £500,000 to build an identical warehouse. The depreciation value is £100,000.”
Sales comparison approach
This is the approach that most closely resembles the valuation process for individual residential properties. Simply put, it involves looking at how similar properties have performed in the market in recent months and years. Adjustments are then made for differences in size, location and condition.
“The sales comparison approach is widely used by appraisers and valuers, and involves comparing the property to similar properties that have recently sold in the same area,” says ASL. “This approach is highly effective in active markets where numerous comparable property sales data are available, providing a realistic value based on current market trends.”
Crest Chartered Surveyors adds: “Start by listing out the detailed characteristics of your commercial property specifically and make sure to include the number of floors, number of rooms and the floor area in this listing. This will help you to then find the prices of any similar properties which are currently listed on the market.”
However, Phoenix and Partners has a caveat. “This approach has a disadvantage that it is not very accurate,” it says. “For example, even though your commercial property has similar characteristics with one that is available in the market, it may also still have features that are unique to it. An experienced appraiser, however, has the skills and knowledge to adjust the market values for similar properties to accommodate for unique features of your commercial property.”
Value per square foot approach
“Assessing a property based on its value per square foot is particularly useful in densely populated or urban areas where space is at a premium,” according to ASL. “It’s a really effective way to compare properties with similar uses in the same geographic area, providing a straightforward metric that can quickly indicate a property’s market value relative to its peers.”
The approach involves calculating the value per square foot and then multiplying that figure by the total square footage of the building. The value per square foot is assessed by comparing a property to similar properties in the same location and that operate in the same sector – so, offices, retail, industrial and so on.
“Factors such as location, property condition and the quality of finishes are also taken into account to adjust the price per square foot, making this method highly practical for ensuring that valuations are both fair and reflective of current market conditions,” ASL adds.
Rateable value
A commercial property’s rateable value is assessed by the Valuation Office Agency (VOA) and represents the open market rental value of a property as of a specific date, set by legislation. The rateable value also determines the business rates that a property owner is liable to pay.
“This approach takes into account factors such as the size, location, and potential profitability of commercial premises,” ASL. “As such, it can also influence the financial planning and operational costs associated with property ownership.
Value per door
The value per door method is calculated by dividing the total cost of a property by the number of units – apartments, say, or office spaces. This provides a cost per unit or ‘per door’ in industry parlance. The method allows vendors and investors to compare properties that are otherwise very similar but that differ in size. “[It] is particularly useful for evaluating multi-unit properties such as apartment complexes or shared office spaces where units are of comparable quality,” according to ASL.
Key factors that influence valuation methodologies
While the methodologies for calculating the value of a commercial property are many and varied, they are all influenced to one degree or another by two crucial factors: location and the potential to produce income. It is the latter that provides the key difference between commercial and residential property valuation.
Location
One of the main factors that determine the worth of a commercial property is its location. “A good location usually boils down to proximity with other commercial facilities like shopping malls, apartments, condominiums and so on, and its accessibility,” according to Phoenix and Partners.
“Tenants of commercial properties will benefit more from renting a property that is closer to other establishments, their suppliers, employees and, most importantly, their potential customers. Locations that meet the above qualities of a good location are called prime locations. These are usually commercial locations in the heart of cities.”
Potential for income
Commercial properties that have a higher potential for generating income are also valued more. “For example, the more space it has for tenants, the more potential for income,” says Phoenix and Partners. “This property will also be valued more. Another example for this is that office spaces that are located in central business districts have a large potential for rental increases and thus will also be valued more.”
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