There are three broad categories of these types of properties, each which have their own set of valuation complexities.
(a) Owner occupied properties
(b) Investment properties
(c) Special Purpose properties
A. Owner Occupied Properties
This category is often distinguished by specific layout and design which might only suit the specific requirements of a particular occupier. They might include ‘monumental’ type properties used as headquarters by large corporations. The investment return for these are often low compared to their exceptionally high replacement cost.
Other Industrial examples may include freezing works, food processing plants, breweries, etc.
When assessing these categories of properties, the Valuer needs to consider whether the property has:
- Alternative Uses – if the answer is “yes” then normal valuation methods apply. Sometimes the cost of conversion to an alternative use needs to be deducted, if this is appropriate.
- Existing Use only – certain types of highly specialised commercial properties have few other uses beyond their present function. Some of the examples given above, are dependent upon their continued existing use and the economic soundness of the occupier. The replacement cost approach less a discount for obsolescence is the favoured approach.
B. Investment Rental Properties
By far the majority of commercial and industrial properties are leased from the owner who holds the property as a long term investment. Most owners have three main objectives:
- Maximise income
- Maintain income security
- Capital Growth
General valuation techniques used are as follows:
- Direct Comparison
This approach involves comparison of the property to be valued to completed sales of similar properties.
Comparisons can be made in many forms including straight comparison, or analysis on a rate per area basis (i.e. so much per square metre). Adjustments are made to account for differences in quality, location, age of the building, etc.
Direct comparison is the usual means of valuing residential property, but it is generally used only as a secondary or check valuation method for Commercial properties
- Investment Approach
This is the primary approach used for Commercial & Industrial investment properties.
The two mathematical models used are either, (i) Income Capitalisation and/or (ii) Discounted Cash Flow analysis (DCF).
- Income Capitalisation
The market rental (this can differ from the contract rental) of the property is capitalised in perpetuity to arrive at the market value of the property.
The capitalisation rate (also known as Rate, Yield or Return) is derived from analysis of completed sales of other investment properties. The central concept for selection of the Capitalisation rate is consideration of the Risk premium. Simply stated, the higher the risk the higher the return demanded.
The resultant capitalised value may be adjusted to reflect immediate capital maintenance expenditure required to sustain the current income, ‘letting up’ allowances to fully lease the property, or the value of the difference between the passing (contract) rental and the market rental. Sometimes the current rent may be above or below market in which case the calculation becomes a bit more complicated and the Valuer needs to apply a ‘shortfall’ or ‘excess rental’ technique
- Discounted Cash Flow (DCF)
The previous capitalisation method has some limitations. It has an inherent assumption that the income and expenses are frozen in time. The DCF method involves forecasting future cash flows over a specified period (this usually ranges between 5-10 years), estimating the market value of the property at the end of the term of projection, and discounting these amounts back to arrive at the Net Present Value (“NPV”).
It allows the model to take into consideration ‘one-off’ expenses (e.g. replace a structural element such as a roof, or a mechanical element such as a lift) at some future time over the holding period. This is not easily done using simple capitalisation.
The NPV is calculated using a discount rate which is assessed in comparison to returns indicated by the analysis of other completed sales using similar methodology.
Discounted cash flow analysis is most frequently used for the valuation of substantial commercial premises which are subject to long term lease arrangements. It is also used for valuation some Special Purpose properties such as Self-Storage facilities and Forestry
- Depreciated Replacement Cost (DRC)
This involves the assessment of the value of the underlying land.
The replacement costs of the buildings are then assessed having regard to current construction costs. The result is discounted back to account for depreciation and/or obsolescence. The latter takes into account the remaining economic life of the building, which is a combination of the functional, economic and physical obsolescence of the structure.
The value of the land plus the deprecated replacement cost of the building are then added together.
The DRC method is either used as a secondary ‘check’ method for investment property or as a primary method for valuations of specialised assets for financial reporting.
C. Special Purpose Properties
Examples of special purpose properties are Service Stations, Shopping Centres, Hotels, Motels, Health Care Establishments, Large Volume Pubs, Cinemas, Self-Storage Facilities, and Churches, etc.
Then there are the larger industrial types of complexes such a Freezing Works, Heavy Industrial type of buildings, etc.
What differentiates these types of premises are the limitations on alternative uses. We are all familiar with derelict main highway Service Stations which are no longer supported by the various oil companies.
Where are the alternative tenants?
When carrying out a normal Commercial or Industrial valuation it is common to draw sale or rental evidence from similar types of properties in close geographical proximity. In other words, if you were looking at premises in Wellington it would be unthinkable to use a sale from Palmerston North and visa versa.
However, with Special Purpose properties it is common to draw on evidence from a much wider geographical spread.
Depreciated Replacement Cost
Depending on whether there is any available evidence or the purpose of the valuation, the replacement cost approach may be a valid approach when assessing these types of premises.