Commercial Property Valuation: Methods and Case studies

PROPERTY INVESTMENT
VALUATION OF A COMMERCIAL PROPERTY
Valuation of an income earning property depends largely on the income generated by
the property and for determining the value, financial data is essential. In this context due
diligence is essential for collecting the required information for calculating accurately
the property's Net Operating Income (NOI), which is the most essential data for
evaluating the accurate value, as per Baum & Baum, (2015). The value of the property
can be based only on how well its operations conducted. This is done by constructing an
accurate data from the operations as they exist on date, say Kao, Sung & Chen (ed),
(2014). A verification of all items of income and expense is carried out and after
adjusting the data collected, the collected data is used for accurately projecting the
performance of the property. This collective data is represented as an income statement,
assert Ashworth & Perera, (2015).
Whenever an initial offering of sale is made, it is accompanied by a pro-forma income
and expenses statement. Such an income statement usually shows income and expense
with certain assumptions which may not reflect the actual data of rent and expense
required for determining the current NOI, as per Sandercock, (1990). The most
inaccurate data in a pro-forma statement can be found under the head ‘Gross Potential
Income’. In a typical pro-forma statement, the income is shown as, says Haydon, (1846)
–
Gross Potential Income: $100,000
Vacancy loss (5%): $ (5,000)
Gross Rental Income: $ 95,000
Here, the Gross Rental Income is based on an assumed Gross Potential Income which is
derived by assuming that occupancy of the building is 100%. This income is then
reduced by an arbitrary vacancy loss which, like the assumed Potential Income, does not
show the actual performance, as per Tomlinson (ed.), (2012).
Actually, the most recent Net Operating Income should be the governing rule for
evaluating the value. For making a Financial Analysis, the requirement is of using data

for the last three operational years, according to Davis, (2007). If the analysis is done
using data of a lesser period, many of the long-term anomalies may not be reflected.
Similarly, a period longer than 3 years may show lot of irrelevant data. Hence, one year
data is minimum requirement for valuation purposes and three year data for analysis,
speaks Davis, (2007). Authenticated data is available from the seller’s property tax
returns as expenses cannot be understated in a tax return. However, in case there are still
major discrepancies while comparing the tax returns and the operating statement, one
must get it clarified from the seller, according to Luck, Race & Black (ed.), (2010).
Leases
Leases executed by the seller with the existing tenants are also an important source for
determining the property’s income. The current leases are the authentic source of
income, hence it is essential for a buyer to review each lease, as per Christensen &
Duncan, (2004). Note down the discrepancies, any concessions being offered and areas
which require improvements, say Emerald Gems (ed), (2015). In case the improvement
or concession is not met by the seller, the buyer will inherit that obligation and hence
must be considered while arriving at projected buying price, according to Gruis &
Nieboer (ed), (2013).
Rent Roll Reports
If made into a concise report, this data can be counterchecked with the terms of the
lease, as per Barnes & Doidge, (2010). The basic Rent Roll Report must reflect the unit
number, chargeable area of the unit, name of the tenant, the rent charged, past dues if
any and the date of expiry of lease, assert Baum & Baum, (2015). This data serves as
the buyer’s opening balance for preparing the income projections for first year after
purchase. Areas of caution are the information about recent additions in rent roll. These
must be cross-checked with the leases, as detailed by Tomlinson (ed.), (2012).
Tenant Files
The files on tenants maintained by the seller can also reveal important financial
information, assert Ashworth & Perera, (2015). The buyer must examine the
completeness of each file and also note whether compliance was carried out
appropriately with the applicable regulations, according to Kao, Sung & Chen (ed),
(2014). Files which have records maintained poorly or have non-existent credit reports

are to be thoroughly verified. A tenant without reference from the previous landlord can
be the source of trouble in the future, explain Luck, Race & Black (ed.), (2010).
ANALYSIS OF A COMMERCIAL PROPERTY INVESTMENT
Developers and investors have to be cautious with the feasibility study during the
preliminary stages of a deal, since a building deal requires huge investments of capital,
as per Emerald Gems (ed), (2015). In order to prevent the deal from failure, an office
development scheme, particularly in the current turbulence property market. Hence, a
feasibility study can play an important role in successfully implementing the project, as
per Christensen & Duncan, (2004).
Because there is involvement of huge amount of funds, whichever approach of
assessment is used, it is essential to take into account factors such as location, rental
incomes and operational expenses of the office development, say Gruis & Nieboer (ed),
(2013). As is discussed in this paper, there are two approaches used while assessing the
financial analysis of the office development. In Australia, Capitalisation of Income
Approach is the most widely used methodology, according to Barnes & Doidge, (2010).
The biggest flaw in this methodology occurs when the analysis has to be used for
determining a single capitalisation rate which has to represent all the assumptions in the
market, explain Emerald Gems (ed), (2015).
The second methodology in use is the Discounted Cash Flow (DCF) Method. This
requires some periodic net cash flows which are to be forecast over the life of
investment and are discounted at a discount rate, for arriving at their present value, as
detailed by Luck, Race & Black (ed.), (2010). For successful implementation of the
DCF method, income and expense projections have to be established along with the
discount rate for accurate evaluation of the development, assert Kao, Sung & Chen (ed),
(2014). This paper is evaluating the given office development in five steps and is also
making comparative analysis between the use of both the methodologies discussed
above, say Barnes & Doidge, (2010).
FIRST STEP: OFFICE DEVELOPMENT-CHARACTERISTICS
The first step of this report will look at the office development in general.

Currently, the traditional commercial building format is under challenge, as per
Ashworth & Perera, (2015). Challenge is about the expensive energy sources which are
forcing the architects in designing efficient buildings, assert Tomlinson (ed.), (2012).
Limitations of capital expenditure is forcing the developers in seeking higher and
reliable returns from their investments, assert Gruis & Nieboer (ed), (2013). Because of
these factors, each new building decision is becoming more difficult and requires
constant re-evaluation. Investors and builders of office development are initiating
processes for understanding the basic project variables, as per Christensen & Duncan,
(2004). Under such circumstances, it is essential for the stakeholders to understand the
important factors which affect the office development, as per Sandercock, (1990).
Among the important factors, the first one is location and is thoroughly analysed by the
stakeholders as well as the tenants for fulfilling their objectives, assert Baum & Baum,
(2015). It is common for business to pay a premium for that office space which is in
right location. The location factors does not affect alone but works in tandem with other
important factors such as the transportation system available, the design of the office,
the rental rates and factors which contribute to the overall success of the office
development, as explained by Luck, Race & Black (ed.), (2010).
SECOND STEP: OFFICE DEVELOPMENT- INFLUENCING FACTORS
Second step evaluates the major factors influencing the office development.
Location
Selection of a prime location is the most important criteria for office development. A
prime location is usually earmarked for a better public transport system, shopping
centres and hotels etc., which create high demand and also have labour proximity, as
detailed by Emerald Gems (ed), (2015).
Transportation System
Good connectivity to suburban areas through an efficient transportation system increase
efficiency for the employers and is a major factor in promoting office development in a
prime location, as explained by Baum & Baum, (2015).
Building Design
Design of an office development is considered from two perspectives. From landlord’s
perspective the design should fulfil specific needs of occupiers, whereas from

developer’s perspective it should increase efficiency, effectiveness and the market value
of the office development, assert Gruis & Nieboer (ed), (2013).
Amenities and Services
Facilities such as convenience retail, food service, professional services, parking
facilities and conference/meeting halls are considered essential for attracting tenants to
the development, according to Tomlinson (ed.), (2012).
Rental Rates
Rental rates of an office development are dependent on its location design and age of
the building, as per Davis, (2007). Rental rates are charged per rentable square meter on
an annual basis. An office development is referred to as Class A, B, C, or D and are
based on the guidelines published by Building Owners and Managers Association
International (BOMAI), explains Gruis & Nieboer (ed), (2013). The following formula
is used for calculating the minimum Rental Rate = (operating expenses + mortgage
payments + owner's return on equity) / (net rentable area).
THIRD STEP: OFFICE DEVELOPMENT- MARKET REVIEW
Third step reviews the office market and provides basis for projection of current market
situation to achieving marketability of the project
Main purpose of marketing analysis is to analyse the size, characteristics and future
potential of the existing rental market, details Barnes & Doidge, (2010). In its final
result, the market analysis should provide a determination about the rent-ability at the
given rent levels along with the time period required for accomplishing this, assert Gruis
& Nieboer (ed), (2013). The data obtained from market analysis comprises of business
profile of tenants, their space requirements and duration of tenancies. Market analysis
should also include space allocation information in other comparable projects. Table 5.1
below, shows the comparison of offices, as detailed by Christensen & Duncan, (2004).
FOURTH STEP: FINANCIAL ANALYSIS
Fourth step looks at analysis of the project’s financial aspects
Development Yield
The development yield is the total annual return which the developer receives and is
expressed as percentage of total income and total cost incurred in creating the income.
Development Yield = (Expected Annual Income) / (Cost of Scheme)

In this case the developers annual profit is 11.5% - 9% i.e. 2.5% p.a. which is a profit
mark up of 27.8% (i.e. 2.5/9 x 100% = 27.8%), as per Luck, Race & Black (ed.), (2010).
Capitalisation Rate
Capitalisation rate is a common practice in the Australian commercial property market
as it does not differentiate between occupiers and owners of the office development,
assert Kao, Sung & Chen (ed), (2014). Capitalisation rate is calculated as percentage
rate at which the office development’s net annual rental income can be translated into
real capital value, as per Luck, Race & Black (ed.), (2010).
Discounted Cash Flow
Discounted Cash Flow (DCF) is an alternative methodology which is used for making
adjustments to cash flows and for reflecting the anticipated changes in the
development’s prospects. DCF is used for converting the future costs and benefits to
their present values, assert Kao, Sung & Chen (ed), (2014).
Net Present Value
Net Present Value (NPV) of a project is calculated as the total of all the discounted
incomes after the total of all the discounted expenses have been reduced from it over the
total life of the office development under the given interest rate, as per Christensen &
Duncan, (2004).
FIFTH STEP: CASE ANALYSIS
Fifth part is case analysis and evaluates the application of different approaches
Sale 1: 363-365 Ferntree Gully Road, Mt Waverley
The development comprises of two freestanding buildings which are separately titled.
The buildings contain office and retail space and are classified as Grade B with good fit-
out. The overall building area is 2,593 m2 with car parking facility for 106 cars. The
average rent projected for the building is $3,760 per m2 and has been applied at 80%
efficiency on the buildings gross floor area, as detailed by Barnes & Doidge, (2010).
This generates a net lettable income from tenancy of $8,882,624 per annum.
Sale 2: 753 Doncaster Road, Doncaster
The development comprises of two level, Grade-A building with ground level entry.
The buildings contain office and retail space and are provided with good fit-out. The
overall building area is 1,450 m2 with car parking facility for 50 cars, explain Emerald
Gems (ed), (2015). The average rent projected for the total space let-able is $2,759 per

m2 was applied to 80% efficiency on gross floor area, is generating net lettable income
of $3,200,440.
Sale 3: 552 Blackburn Road, Doncaster
The development comprises of two level, Grade-A building which has entry from
Blackburn Road with lift access to all floors, as detailed by Emerald Gems (ed), (2015).
The building is occupied by five individual tenants and is earning a total rental of
$634,210 per annum at the rate of $3,108/sqm.
Sale 4: 37-41 Prospect Street, Box Hill
The development comprises of five level, Grade-A building with ground level entry.
The buildings contain office and retail space and are provided with good fit-out. The
overall rentable building area has car parking facility for 130 cars, assert Barnes &
Doidge, (2010). The average rent projected for the total space let-able is $3,242 per m2
was applied to 80% efficiency on gross floor area, is generating net lettable income of
$1,465,714.
Sale 5: 290 Tram Road, Doncaster
The development comprises of three level, Grade-B building with floor space of 700
sqm on each level. Three tenants are occupying the office and retail space and are
classified as Grade B with good fit-out, as detailed by Luck, Race & Black (ed.), (2010).
The overall building lettable area (NLA) is 2,125 m2 with car parking facility for 85
cars. The average rent projected for the total space let-able is $3,882 per m2 was applied
to 80% efficiency on gross floor area, is generating net lettable income of $830,000 per
annum.
CONCLUSION
When a financial analysis is conducted, the first step taken by the analyst is to select a
method for use in the analysis. The accuracy of the result depends on the method
chosen, since the analysis involves lot of assumptions and projections. There are two
methods used in practice, Capitalisation of Income Approach and Discounted Cash
Flow (DCF) approach. In the first method, the important factor is selection of a
capitalisation rate, explain Baum & Baum, (2015). This approach is widely in practice
in Australia as it is given recognition by the courts. The DCF approach works on the
perception of bringing the future cash flows to their present day value for determining
the financial feasibility of an office development, as per Ashworth & Perera, (2015).
Since different anticipated growth rates can be applied in this approach, this provides a

more accurate result. Moreover, the DCF approach takes into consideration fluctuations
of the market, such as inflation rate and occupancy rate, for calculating the results.
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