How to Evaluate a Commercial Property - A Brief Overview

How to evaluate a commercial property is an often asked question by commercial real estate agents, potential commercial property buyers or commercial property vendors. The agent requires the commercial property valuation to advise their buyer or vendor client; the buyer requires the same valuation to know that he is not overpaying; and the vendor requires the valuation to know that he is not selling below what the commercial property is worth.

So, how do you evaluate a commercial property? Although not mandated in the International Valuation Standards (IVS), when two of the three primary methods of valuation used by commercial property valuers are combined, a sound estimate of the value of a commercial property can be evaluated. These two methods are:

Income Capitalisation Approach
Sales Comparison Approach

When there is little sales data, a commercial property valuation can also use a third method of valuation, that is, the Summation Approach or also known as the Cost Method as a check method to determine the value of the commercial property.

How to Evaluate a Commercial Property - Income Capitalisation Approach

This method bases the property valuation on the projected future rental income plus any recoverable outgoings, and then deducts all unrecoverable outgoings and expenses, including suitable allowances for vacancies, to arrive at the net income from the property. This net maintainable income is a forecast of earnings that are assumed to last in perpetuity and is discounted using an appropriate capitalisation rate (or cap rate) derived from comparable sales evidence.

When addressing the question on how to evaluate a commercial property, when using the income capitalisation method, these two crucial considerations must not be overlooked:

If the commercial property is considered to be vacant at the date of valuation, an allowance is included in the vacant possession assessment to for costs associated with letting-up and lease incentives.
If the passing rental of the commercial property is not equal to its market rental, adjustments must be made for under- or over-rents.

The Income Capitalisation Approach is frequently used as the primary method in a commercial property valuation.

Sales Comparison Approach

Sometimes referred to as a Market Comparison Approach, using this method of commercial property valuation, the value of a commercial property is determined by examining sales data from comparable properties (a.k.a. comps) and comparing those comps with the property being valued.

When assessing the value of commercial real estate using the sales comparison approach, two key considerations are:

Only consider settled (fully paid) sales; commercial properties that are under contract or currently on the market should only be taken into account when there is little to no other market evidence.
In practice, properties are rarely comparable, necessitating adjustments in the comparison process that introduce some degree of subjectivity.

The Sales Comparison Approach is frequently used as a secondary method by commercial property valuers when preparing a commercial office valuation.

Cost Method or Summation Approach

This method of commercial property valuation involves the summation of the depreciated replacement cost of improvements (that is, comprising the main commercial building and other ancillary structures and built areas) to the underlying vacant land value to determine the property's value.

This method of commercial property valuation is affected by these three main issues:

The rate of depreciation and cumulative depreciation.
Construction costs
The added value of the improvements may be quite different from their replacement cost.

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