Commercial Property purchase can seem daunting owing to complex due diligence process and is fairly specialised in nature. Traditionally it has been accessible to only Institutions and High Net Worth Individuals. But with the options available now, the market is open for all. So, it is understandable for investors to have less grasp of commercial real estate compared to other modes of investment like stocks and residential property.
At the same time, the “opaque” tag does great injustice to the sector given its status as a proven means of wealth creation all around the world. Commercial real estate purchase can be as simple as buying a stock, which we will explain in a series of articles. My hope is that, after reading the articles, you will understand about commercial real estate to see it as a viable investment option with the potential for high returns and stability.
Importance of Valuation
Valuation is one of the most important aspect of understanding commercial real estate. It is fundamental to grasping the workings of the commercial real estate industry as valuation is the key criteria to assess any commercial property to purchase. Valuation determines the soundness of an investment and helps in the identification of attractive assets.
Different Approaches to Valuation
Despite the importance of commercial property valuation in India, it can seem somewhat complex in the beginning but using simple financial assessment tools one can understand valuation and use it to their advantage. While shares are priced on the basis of demand and supply, and valuation of residential property is the result of market comparisons, commercial real estate has various micro market related parameters due to the nature of the asset and the market.
What differentiates commercial real estate from other investment options? First, its identity as a regular rental asset demands a financial valuation. Second, the pricing of commercial real estate is heavily influenced by numerous external factors over which one has no control like interest rate, economic outlook, population and demographics, supply & demand and property market performance, which might add complexity to the pricing.
Given this situation, one option for valuers is to view the property purely from an income generation point of view. This is called the ‘capitalisation rate approach’. This is one of the more popular commercial real estate valuation method in the context of income generating properties and investments, using hard numbers as its basis.
Capitalisation Rate Approach
The capitalisation rate approach is used to calculate the value of an income generating property by assessing likely future earnings. It is encapsulated in the following equation:
Total Value of the Property = Net Operating Income/Capitalisation Rate
where net operating income (NOI) is the net earnings generated from the property in one year and capitalisation rate is the ratio of NOI to property asset value.
- Net Operating Income: It indicates the income generated from the property on an annual basis which is very stable due to lease agreements in place and gives a frame of reference for future earnings. To derive NOI, several inputs are needed including total rent, CAM charges, insurance and property tax. All expenses are subtracted from the rent to obtain NOI.
CAM refers to ‘common area maintenance’, or building maintenance charges. Note that a distortion in any of the inputs like rent or CAM is likely to end up distorting the NOI and ultimately the valuation. A quick cross-check with similar properties in the area is thus recommended. This ensures that the inputs going into the calculation are in line with the respective market rates.
How do flawed inputs distort NOI and valuation? Let us take an example. If the rent of a certain property is higher than the market value, the investor may benefit for a short period but it will almost certainly lead to a correction whenever a vacancy arises and a new tenant moves in. Additionally, it will inflate the valuation precipitating a correction in the selling price of the property. So, while higher-than-market-rate rents may benefit the owner in the short term, it could be counterproductive in the medium and long terms. This can be avoided by ensuring that the inputs that go into the NOI, and consequently the cap rate method, are rational and in line with existing market rates.
- Capitalisation Rate: Capitalisation rate or cap rate is similar to the inverse of PE ratio in stocks. If PE ratio is derived from a division of price by earnings, dividing earnings by price will help you obtain the capitalisation rate of a property.
A lesser known fact is that cap rate is equal to the discount rate of a property which can be mathematically expressed as follows:
Cap rate (NOI/Purchase Price) = Present Value of Growing Property (D1/r-g)
where ‘D’ is the dividend or coupon at Period 1, ‘r’ is the discount rate, and ‘g’ is the growth rate.
Once cap rate and NOI are obtained, the price can be easily calculated using the formula provided at the beginning of this section. But the result still needs to be validated using alternative valuation measures.
Sanity Checks & Adjustments
How do we know that the results obtained through the cap rate approach are credible? Here, sanity checks play an important role. These are useful in determining whether the real estate property valuation is on the right track and also in fine-tuning the result to arrive at the final outcome.
Two types of sanity checks are applied in this case to ensure that the values are in line with market rates.
In this instance, a comparable property is selected to assess whether the building in question is being overvalued or undervalued as compared to prior transactions in the area.
Neither overvaluation nor undervaluation is desirable as they do not reflect the true market value of the property. An overvalued property will encourage future buyers to forego your premises affecting your overall return. An undervalued property based on the cap rate on the other hand, would imply that the building is rented at below market rates and one must investigate further for why this is the case.
Replacement Cost Approach
If you were buying or selling a property, wouldn’t you like to know what it would cost to construct that same building from scratch in today’s context?
The cost of constructing a property today would naturally be higher than what it was in the past. The replacement cost measure gives valuers an idea of the present-day cost of construction of the property and facilitates alignment between the two prices.
As a last step, the different results are compared and a subjective approach is adopted to arrive at the final outcome. For example, if it is observed that the cap rate method puts the value of the building at Rs 9,000 per sq ft, while the transaction of a comparable building happened at Rs 10,000 per sq ft, it could mean our valuation is below market rate and the price is revised upward to bring it in line with market levels.
Getting the Valuation Right
Valuation is a fundamental aspect of the commercial property business and spells the difference between a good investment and a bad one, and between making money and losing money. Several factors hinge on the valuation of a property giving it the power to affect your income in the long term. Reliable valuation lies at the heart of the commercial property business. It is the starting point of every prudent investment. Using a sound valuation technique enables one to purchase right commercial property and start on the journey of wealth creation.