Commercial Valuation for Dummies – Part 3: Direct Comparison

So far we’ve looked at Capitalisation and Discounted Cash Flow.

This month we’ll take a look at Direct Comparison method of Commercial Valuation, and also some adjustments to valuation. In a lot of respects, Direct Comparison is the simplest method of valuation. It’s very useful as a gross-error check against other valuation methodologies or if they aren’t available, then it may become the primary method of determining value. It’s the most straight forward method and can easily be used when there are sufficiently similar properties to compare against, and it is also the most reliable and favoured approach when valuing non-income producing properties.

We’ll also look at adjusting our valuation for reversionary changes.

By the end of this article, you’ll be able to bring all three methods together and form an overall checklist for assessing your prospective purchases.

 

Summation of Land and Building Value:

An estimate of land and building values is a simple way of determining underlying value. You’ll often find that this is very consistent for residential property but may be a little different for commercial property. I’ll explain why in a minute but let’s start with a simple residential example:

A couple of points on the above table:

Land value can be obtained from a number of sources and you should use the most reliable or appropriate source. For example, you could use the latest amount shown on the Land Tax valuation, or if there is direct comparison from sales evidence, that may be more current and appropriate to reflect realistic market valuation. You would simply average out some recent sales to determine a $/m2 price and then apply it to your land. You may wish to adjust that amount by a small percentage to reflect if your land is slightly better or worse than the comparison sales, but if there are sales that are almost the same then they are best to use without modification.
The improvements should be valued at a depreciated amount to reflect their age and remaining useful life. People often over-value a building by thinking about replacement cost at current building rates, not when it was built 20 years ago, and the remaining value. If you planned on bulldozing the house, then it has no value for you. It might even reflect a discount to the land value because of the cost of demolition and removal (especially if it has asbestos or other potential costs).

With a commercial example, we often look at land value, replacement cost, and current value. The problem is that this may not reflect the current price we are willing to pay based on the current cashflow. For example:

• There is a building on a commercially zoned block of land that the most recent land tax assessment said was worth $4,000,000
• The Insurance Estimator says the replacement cost of the existing building, which is $3,000m2, is $6,000,000. This can vary widely, but your insurance broker is a very good source for this as they have models that calculate replacement value quickly.
• From the above we would think the value of the purchase is $10,000,000.
• However, what if the rent for the $3,000m2 is $300/m2 net = $900,000 per annum net rent. If we capitalised this at 7%, the vendors expectation might be: $12.86m.

This is where it gets a bit difficult. Commercial property is most often valued on cashflow, not replacement cost. This is simply because we are purchasing a future income stream. Please see Valuation for Dummies Part 2: Discounted Cash Flow for further explanation.

You may also find sometimes that it goes the other way, particularly for older buildings. For example, you pay $12.86m for the above investment and then find that the insurer says the replacement cost is $20m and your insurance premium is much higher than expected. This is because the building is older and has been depreciated. If it was newer, you might find that the price is much higher reflecting a longer term of expected cashflow, and less capital expenditure during the first 10 years. You may have noticed that newer buildings (A-Grade), often reflect a tighter yield (i.e. lower capitalisation rate), than older B-Grade or C-Grade buildings.

Direct Comparison

Direct Comparison is the simplest method, however, it’s mostly used as a gross-error check against other methods (rather than the primary commercial valuation tool), or when the property is non-income producing (i.e. vacant) it can give us a good idea of price.

If you have a look at a recent commercial valuation report, you will see that the last section is Direct Comparison. The bank will always want to confirm that the Capitalisation Rate, and DCF approaches are consistent with recent sales to ensure that the purchase price isn’t over market.

Market data is normally readily available and can provide a useful starting point for you. Don’t be afraid to ask the selling agent for recent comparable sales (Comps). He will have this data available and it may be very useful to help you make an offer that will stack-up for valuation.

Below is a table for Sydney as an example from a research report. These are published frequently.

Source: Colliers International

Let’s say you want to buy a small office in North Sydney. The office is $1000 m2 but it is currently vacant, so we don’t know how to value it using a Capitalisation or DCF approach.

From the above, you can see that we could assume net face rent could be around $785/m2. Incentives are running at 20% and current yield is 5.13%. However, not all office space is equal so we might try and find some additional commentary in their report. We assess that the space we are looking at is B-Grade office. Below is an extract from the same report: (Source: Colliers International)

A grade gross rents in North Sydney have increased by 6.7 per
cent YoY to average around $920/sqm as at September 2018. Incentives have declined to 20 per cent from 21 per cent a year ago, resulting in a solid effective rental growth rate of 8.2 per cent. B grade gross face rents have increased by 5.4 per cent over the past 12 months to average at approximately $780/sqm whilst incentives have declined by two percentage points to 18 per cent over the corresponding period. Looking forward, the strong rental growth is expected to be maintained on the back of restricted speculative supply and solid tenant enquiries yet to be fulfilled.

We decide to adopt the following metrics:

• Rent will be $750/m2 (slightly conservative – lower).
• Incentives will be 20% (slightly conservative – higher).

For our 1000m2 office, we think the market rent will be $750,000. If we used 6% (again, better to be conservative) to capitalise this rent, then the value would be: $12,500,000.

We get some recent sales research and find that B-Grade office has been selling between $11,000 and $13,000 per meter. Our example above puts our office at $12,500/m2, which we think is acceptable due to its location, presentation, CAPEX requirements etc. You will note that we only used the Direct Comparison of other sales to check if our assumptions were correct and acceptable. We don’t really know what we will lease the space for or how much incentives we’ll have to offer at this point. From last month’s Valuation for Dummies: DCF, you could factor in the incentives and vacancy period to see if this changed your purchase price offer.

Distortions to Valuation

From a buyer’s point of view, I also find Direct Comparison very useful to make sure that the rent is not overly inflated. This is most risky if the vendor has been creative in his leasing structure. Here are some examples:

The owner is selling the building with a lease-back to his business. Companies often sell their premises if property ownership isn’t part of their core business and they don’t want the asset and liability on their balance sheet, but buyer-beware if the rent is above market. Let’s say that the above $3000m2 building should rent for $300/m2 net, but he is selling it with a lease-back at $400/m2. From our Valuation for Dummies Part1, you should be able to quickly determine the two different values with the same 7% capitalisation rate. For example:

• The owner is selling the building with a lease-back to his business. Companies often sell their premises if property ownership isn’t part of their core business and they don’t want the asset and liability on their balance sheet, but buyer-beware if the rent is above market. Let’s say that the above $3000m2 building should rent for $300/m2 net, but he is selling it with a lease-back at $400/m2. From our Valuation for Dummies Part1, you should be able to quickly determine the two different values with the same 7% capitalisation rate. For example:
  1. $300/m2 x 3000 m2 = $900,000 net rent at 7% = $12.86m (900,000 / 0.07)
  2. $400/m2 x 3000 m2 = $1,200,000 net rent at 7% = $17.14m (1,200,000 / 0.07)
• From the above, we can see the large difference. If we used a Direct Comparison, we could see that example 1’s $/m2 gives $4287/m2 (12,860,000 / 3000), while example 2 equals $5713/m2, which might raise alarm bells and tell us something doesn’t add up. This is how we use Direct Comparison as a gross-error check.
• As a different form of market variance you may find that the vendor has secured a new lease by paying a significant contribution to the tenant’s fit-out. Let’s say the net rent is $300/m2 again, and market incentives are running at 20%. On a 5-year lease this would be equivalent to 12 months of rent (20% of 60 months is 12). However, the tenant needs a significant fit-out (more than the $900,000: being a year’s rent) but doesn’t have the cash to pay for it. The vendor agrees to fund the tenant’s fit-out. Let’s say the fitout is $1,250,000, but they want the tenant to pay for the increased incentive over the five year lease, with an extra $50,000 put onto the base rent. It will actually add up to more than $250,000 due to the annual increases, but we’ll ignore that for simplicity. The first year’s rent is now $950,000, which equates to $316.67 /m2. This is 5.6% above the market rent. And if the new rent of $950,000 is capitalised at 7% the assumed value could be: $13.57m.

You can see why some landlords may prefer this contribution to fitout option, rather than a rent-free period if they have the cash available. There are a number of potential benefits:

• The cash upfront they have parted with costs them an extra $250,000 (compared to the market 20% incentive), but they pick up over $700,000 in additional valuation (as long as the valuer thinks the rent is still reasonable and doesn’t apply a reversionary discount – to be discussed shortly).
• They would also get a good depreciation allowance, which is tax effective, and
• They receive rental income from day one. Remember, the market incentive was 20%, which may mean that instead of a contribution to fit-out the landlord would have had to offer 12 months rent free, or 2 years at half rent, or a 20% discount to the face rent for the whole lease (resulting in an effective rent of $240/m2 for the first year).

The biggest risk to this fit-out contribution plan is that the tenant’s business model is flawed and they go broke in a year or two and you’ve spent a lot on their customised fit-out. So as long as you’ve got a good tenant, and put in a generic fit-out that could be used by others without additional cost, then this plan should be fine and even advantageous.

 

Reversionary Adjustments

So how do we deal with a property that is overrented (or under-rented). i.e. above or below market rent (from our Direct Comparison check)? You may hear the following terms in this discussion:

• Reversionary Rent/Yield
• Current or Initial Rent/Yield
• Market Rent/Yield
• Passing Yield
• Fully lease equivalent Yield

Very simply, Passing Yield tells you the current income (normally taking into account vacancy) against purchase price. This is also referred to as Current or Initial Yield, which tells you what the actual rent being received is against purchase price.

Fully leased Yield tells you what the estimated net income would be against purchase price if all vacancies were leased (make sure this calculation is using market rent, not an overstated rent).

Similarly, Market Yield tells you what the property would yield if the rent was at market rent instead of passing. It’s important to note that current or passing rent may be above or below market rent. If there was a vacancy this would normally utilise the agent’s expected market rent and you could compare this against the passing rent of other tenancies, but beware of the agent overstating market rent to try an inflate the value and exaggerate the potential upside.

Reversionary Rent and Yield refers to what the new income/yield will be after the rent reverts to market rent. Remember it could be higher or lower. A building below market rent often occurs when the market has gone up significantly and the tenant has benefited from a long-term lease that hasn’t had a market review. Similarly, a tenant may be paying much more than market rent if the market has recently collapsed and landlords are discounting rent or offering large incentives to try and secure new tenants. For example, Perth at present.

Let’s look at an example:

• A property of 3 tenancies has the following leases and rents:
  • T1 of 500m2 @ $300/m2 net rent, which is at market.
  • T2 of 300m2 @ $320/m2 net rent, with market rent for this smaller tenancy assumed at $350/m2. This lease has a market review in 12 month’s time.
  • T3 of 150m2, which is vacant and the agent thinks the tenancy should rent for $350/m2.
  • Purchase price agreed is: $4,250,000
• Passing Rent and Yield:
  • T1: $150,000 (500m2 x $300)
  • T2: $96,000 (300m2 x $320)
  • T3: $0
  • TOTAL Passing Rent: $246,000
  • Passing Yield: 5.79% (246,000 / 4,250,000)
• Market Rent and Yield:
  • T1: $150,000 (500m2 x $300)
  • T2: $105,000 (300m2 x $350)
  • T3: $52,500 (150m2 x $350)
  • TOTAL Market Rent: $307,500
  • Market Yield: 7.24% (307,500 / 4,250,000)

So, you can see that our initial purchase might be on a low passing yield, but we’re doing this because we think there is rental reversion to market and therefore capital gain upside. We determined our market rental amount by a Direct Comparison method. i.e. we compared it to other recent leasing activity to determine what our reversionary rent will be.

We might also take this one step further and say that the current market yield is 6.5% when fully leased with a good Weighted Average Lease Expiry (WALE), therefore, once we’re at our reversionary rent of $307,500, then our investment will be worth: $4.73m (307,500 / 0.065). That’s a nice capital gain of around $480,000, which is 11.3%.

 

Adjusting for Incentives or Reversions

Let’s go back to our previous example where the rent is above market. How do we adjust the purchase price to take this into account? This adjustment may be called a reversionary amount, because it takes into account the fact that the current or passing rent is different to market rent. Remember we are normally trying to find the Market Value, because once the current rent reverts to market, that’s what the property will be worth. Having said that, we also need to try and factor in an adjustment to make the purchase price fair and reflect the extra income we’ll receive or lose up until it reverts to market.

You may need to make an adjustment for:

• Current versus Market rent
• Outstanding Incentives
• Expected changes to use
• Regulatory changes etc
• Anything else that will change your valuation metrics moving forward.

These adjustments can be made to a Capitalisation or DCF approach using a consistent methodology.

Here are some capitalisation examples:

1. You are looking at a property which is rented at $300/m2 and is 3000m2 in size. Face Rent is: $900,000.
   1. Valuation at 7% is therefore rounded to an agreed purchase price of: $12,86,000 ($900,000 / 0.07)
   2. However, you note that the incentive is a 20% discount to face rent, which means the rent is effectively only $240/m2. The discount of $60/m2 over the 5 years is: $900,000 ($60 x 3000m2 x 5 years).
   3. You negotiate for outstanding incentives to be adjusted at settlement. i.e. the contract reflects $12.86m but you get back $900,000 cash on settlement.
   4. Therefore, your effective purchase price is $11.96m because we have made a bottom-line adjustment for the outstanding incentives.
   5. Alternatively, you could offer a net price of $11.96 with no adjustment on settlement. We may do this to reduce stamp duty, which is based on the contract amount, however, we need to remember that the cash available for our income will be less. i.e. first year’s passing rent will be $720,000 ($900,000 less the 20% discount as incentive).
2. Let’s use the same example of $300/m2 for a property of 3000m2.
   1. Current Rent is: $900,000
   2. Valuation at 7% is: $12.86m
   3. However, we believe that Market rent is only $275/m2 and there is a market review coming up in 6 months (without a ratchet clause), so we expect rent to go down.
   4. Our assumed Market Rent at $275/m2 = $825,000 (275 x 3000 m2).
   5. Market Value at 7% is: $ 11,785,714.
   6. The over-rent for the next six months = $37,500 ($25 x 3000m2 = $75,000 for one year. 6 months = $37,500)
   7. We offer to purchase the property for: $11,825,000 (Rounded), to reflect the additional income.
3. If the same property was under rented:
   1. Current Rent is: $900,000
   2. Valuation based on passing rent at 7% would only be: $12.86m
   3. Market rent is $350/m2 = $1,050,000 p.a.
   4. Market Valuation based on market rent at 7% is: $15.0m
   5. The current lease expires in 12 months.
   6. You could approach this by starting with Market Value and discounting for the reduced income until reversion. For example, $15m – $150,000 = $14,750,000.
   7. There are a couple of risks in this approach. What if the tenant doesn’t agree to pay the increased rent and leaves at the end of their lease. To adjust for this risk we could also add in 6 months vacancy and a 20% incentive amount for a new tenant as adjustments:
      6 months vacancy = $525,000
   8. 20% incentive on a 5 year lease (12 months): $1,050,000
   9. We could then reduce our valuation further by another $1,575,000 to make an offer of: $13,175,000.
   10. If we compare this to our passing rent valuation of $12.86m, we can see that we are willing to offer $315,000 more than current valuation due to the expected reversion in 12 month’s time.
   11. My recommendation is to be conservative on how much of a premium you’re willing to offer based on future assumptions. Do we really know what rents, mortgage rates, capitalisation rates, incentives, and vacancy periods will be in 12 months? What we really know is the current lease and passing numbers. It’s also hard for the vendor to argue a premium over passing so you may be able to get a bargain, without paying a premium.
   12. As a gross error check to our offer of $13,175,000, we could compare it to the passing rent to see if our yield is still reasonable. For example, $900,000 / $13,175,000 = 0.0683, or 6.83%. This helps us understand how much of a premium over “passing” we would be paying to secure the property.
4. And, here is a DCF example:
   1. There are 6 years left on a 10 year lease, which has a market review at commencement of year six (i.e. after 5 years, which is in 12 month’s time).
   2. Current rent is $900,000.
   3. At 7% cap. rate, the property value on passing rent is $12.86m.
   4. We believe that the property is well under-rented and rent will go up by 10% in 12 month’s time.
   5. Market rent at 10% higher is: $990,000
   6. Market Valuation if at market rent would be: $14,142,857 (Capitalisation approach).
   7. Our DCF table would look like this below. NB: discount rate of 8% and terminal yield of 7%.
   8. Our Net Present Value based on our assumed cashflow is: $14,457,120. i.e. a premium of $1.59m. It seems a lot, but remember a 10% increase in rent could be significant.
   9. Ideally, you would buy on passing rent (i.e. at $12.86m in this example) and benefit from the market rent reversion in the future, without paying for it now. The DCF therefore helps you understand the value uplift that you could achieve by buying well.
   10. Again, be careful of paying for something now that is based on future assumptions. There are lots of risks that your assumptions won’t turn out as expected.
   11. We’d also normally like to run a sensitivity model. See below:
   12. You can see above that our current market value and purchase price ($12.86m) is approximately equivalent to a Terminal Yield of 7.5% and a Discount Rate of 9.5%. These seem quite reasonable and allow some fat in our offer compared to potential assumed reversion.

Summary

That’s the end of our three-part valuation series. We’ve covered:

• Capitalisation
• Discounted Cash Flow
• Direct Comparison, and
• Discussed applying reversionary adjustments.

You should now be in a position to not only fully understand your valuer’s report, but be able to make an informed assessment before purchase. You should now be able to put it all together for a realistic valuation of an asset. Please feel free to contact Pure if you’d like to discuss further.

Pure Property – Commercial Management Re-Defined