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Commercial Valuation for Dummies – Part 1: Capitalisation

We love commercial property at Pure. It’s a fantastic asset class that has some very important characteristics for investors:

  • It’s often considered a hedge against inflation. This is because a lot of the annual rent reviews are linked to inflation (CPI). Therefore, as inflation goes up, so does your rent. Even if your property isn’t linked to CPI reviews, there are enough that are in the market that the overall market rent changes, and this helps partially protect the value of your investment in a rising interest rate environment.
  • Commercial property is often negatively correlated to other classes such as equities. We often see equities fall due to an economic shock, which in-turn sees interest rates fall. In a falling interest rate environment, commercial property values normally increase. The converse is true, when we start seeing interest rates rise, commercial property values can take a hit, especially if interest rates rise ahead of, or more rapidly than, inflation.
  • Overall, the phases of the property cycle are often different to the sharemarket cycle. Therefore, commercial property provides good diversification.
  • There are some drawbacks too: The transaction costs (purchase and selling) are expensive, which normally makes commercial property a long-term investment. While cashflow is often high, capital gain is normally lower than residential property; and as commercial property isn’t traded on an exchange and each asset is different and specific, it’s considered less liquid (i.e. harder to buy and sell).

As with most investments, you make your money when you buy, not when you sell. This is because you have a lot more control when you’re buying. When you’re selling, it’s the market that has control over what your asset is worth, so it’s important to understand how to value the asset and make the correct offer in the first place.

 

Here’s an example from over 20 years ago: I’ll join the crowd at the moment and pick on the big banks.

 

The banks found themselves wanting to exit rural markets. They had a bunch of big sandstone buildings in the high-street of town that were expensive to maintain and staff, and didn’t do that much business, especially with the growing online banking services. So what was their best strategy? They could have just sold their building and maybe got $1 million dollars for vacant possession. Let’s say market rent was about $100,000 per annum in the town for that size retail floorspace. Therefore, the rent they would have been paying was around 10% ($100,000 ÷ $1,000,000)

Here’s what they did: they offered to sell the building with a lease-back in place for 3 years, plus two 3-year options. i.e. 3 + 3 + 3. The starting rent was $250,000 per annum. I hear you ask, why would they pay so much when the market rent was only $100,000 per annum? Let’s look at it. An unsuspecting buyer looks at the investment, and says, ‘these guys have been here forever and it’s a very specific building for them, with a big safe, and giant marble counter. They aren’t going anywhere. Who else could even use this building? These guys will be my tenant for 9 years.’

So the investor looks at the 10% market yield and agrees to buy the building for $2,500,000. Oh, now we see what the bank is doing, but they’re still paying too much rent. Let’s consider the 3 year lease at $250,000. It totals $750,000 for the full term (slightly more with annual rent reviews but we’ll ignore that to keep it very simple). More importantly, the rent is $150,000 above market, so they are overpaying by $450,000 during the 3 years. When you consider that they received $2.5m up front on sale, which was $1.5m above market value, and they are only losing $450k off the additional $1.5m in over-rent, it looks like a great strategy for the bank. i.e. this simple strategy allowed them to make an additional $1m profit over the three years (or double the value they received from their asset). Sneaky right. 

It gets worse for our unsuspecting purchaser: after three years, the bank didn’t exercise their option (remember it’s the tenant’s option, not the landlord’s). They probably never intended to, but it sure made the purchase look more attractive. So, the bank move out (exit strategy complete), and the landlord is left with an empty sandstone bank with an enormous steel safe. He puts it on the market, and no-one wants to rent it because it’s too specific in layout. While other sites would get $100,000 p.a. in rent, he has to discount his rent to $80,000 and spend a lot on re-fit to get a tenant.

His lending bank (actually the same bank that was his tenant) now turns around and says we think the value of your building is only $800,000. Although we agreed to lend you 60% of the $2.5m you paid ($1.5m mortgage), we now only want to be at risk for 60% of $800,000. i.e. we need you to reduce your mortgage to $480,000. Can you please deposit $1m into our account by Tuesday.

Unfortunately, our buyer doesn’t have $1,000,000 lying around after just completing a re-fit and he’s just lost $1.7m in value from his investment. But don’t worry, the bank did OK. They always seem to…

It’s a hard lesson but important for all of us, and I’m very happy to learn it indirectly.

Valuation

This article wont make you a valuer, but I hope it helps you think about the basics in a different way and I also hope it makes your valuer’s report more meaningful to you. Perhaps, you’ll even ring him up and challenge some of his comments or data. And remember, commercial property is very much buyer beware compared to residential property, so the more you know, the less risk you have.

There are many available valuation concepts for commercial property and some are specific to the type of commercial asset, such as childcare that’s valued on a per/child basis, or large-format retail that might include turn-over rent, or hotels that need to factor in occupancy, but in the following blogs, I’ll just concentrate on the three basics: Capitalisation Rate, Discounted Cash Flow, and Direct Comparison.

Today, we’ll discuss the Capitalisation Method, but first let’s look at the golden rule of investment:

 

The Risk Premium

Let’s start with the Risk Free Rate of Return. If we assume that the Australian government won’t fail like Venezuela or Zimbabwe, then we can safely assume there is no risk in Government bonds. The easiest proxy for this is the RBA cash rate, currently sitting at 1.5% and reviewed on the first Tuesday of every month. If you’re interested you can see it on the RBA website front page at www.rba.gov.au , which also shows inflation (CPI); another useful figure for us in commercial property. If you’re interested, you may also like their economic snapshots: http://rba.gov.au/snapshots/economy-indicators-snapshot/

Assuming that there is no risk in the 1.5% government cash-rate, then any return above this entails some level of risk. The higher the return the higher the risk. By default, if you’re getting 15%, you are taking more risk that someone getting 5%. Or to reverse the equation, if a corporation has to offer 15% to the market to get people to buy their debt, then this reflects their risk. If there was no risk, they would offer 2% and people would take it over the government rate of 1.5%. NB: they will only offer the lowest rate required by the market to get the debt away. The difference between the Risk Free Rate of Return and the expected, desired or required rate of return is the Risk Premium.

The overall Risk Premium for Commercial property does vary with the economic cycle and the outlook, but there is always a risk premium. i.e. people are only willing to take the risk to gain the return if it is above the Risk Free Rate of Return. Let’s say this averages out at a 5% premium. i.e. when cash rates are at 4% we would expect to see commercial property yields around 9%. At present, with the cash-rate at 1.5%, we see commercial yields compressed to around 6.5%. The risk premium is still roughly the same, but yields are much tighter (lower) because the Risk Free Rate of Return is lower.

 

Capitalisation Rate

One of the simplest ways to value a commercial property is to capitalise the income. When we hear people talk about yield, they are really referring to the Capitalisation Rate. The income of a commercial property is generally set in the lease and doesn’t change except for annual reviews (normally fixed or CPI) or market reviews. Ignoring reviews for a second, the value of the property is simply the rent divided by the Capitalisation Rate (market yield).

 

Net Income per annum

———————————–            =         Value

Capitalisation Rate

 

Remember the Capitalisation Rate (yield) is the component that moves with market forces such as interest rate changes, economic growth, vacancy rates, inflation, lease covenants, tenant quality etc, not the rent during a lease (which is normally fixed).

Here’s an example: A property rents for $100,000 per annum, and the market yield for that type of property, with that quality of tenant and that length of lease is say: 6.5%. We calculate the value as follows:

 

$100,000

———————————–            =         $1,538,462

0.065

 

If the interest rate falls, then the market yield (Cap.Rate) may tighten too. Even though the rent doesn’t change, this will affect the value of your property. Let’s see what happens if interest rates fall to 6.0%:

 

$100,000

———————————–            =         $1,666,666

0.060

 

We just picked up $130,000 in value (at least on paper anyway). Of course, you could go to the bank with your new valuation in hand and ask for more money to buy another property, or you could sell and realise the gain, but otherwise it’s just a snapshot in time of the current value.

Unfortunately, a move in the other direction is possible too. If the interest rates rise, then the market yield (Cap.Rate) would rise too. Even though the rent doesn’t change, this will affect the value of your property. Let’s see what happens if interest rates rise 1% to 7.5%:

 

$100,000

———————————–            =         $1,333,333

0.075

 

The value of our property just went down around $200,000 from our starting point of 6.5% and nothing changed, other than the market yield. The rent was the same, the tenant didn’t move, outgoings didn’t change, but our value sure did.

You might even find that your bank starts getting concerned with this increase in Loan to Value Ratio (LVR). i.e. the debt that they gave you hasn’t changed, but your value has gone down, meaning your LVR has gone up. For example, if you had a 50% LVR at $1.538m ($769,231 in debt) and the value of your asset dropped to $1.333m, your LVR has gone from 50% to 57.7% ($769,231 ÷ $1,333,333). This might be OK if your loan facility has a 60% LVR available, but might be problematic if your loan only goes up to 55%. The banks can call this a technical default and charge additional interest.

Beware of leveraging up to the maximum when interest rates are low.

It’s easy for us to produce a simple sensitivity matrix in Microsoft excel so you can see how the value of the above property changes with interest rates. For example:

It’s important to see the inverse relationship that commercial property values have to interest rates. The higher the rate, the lower the value that people are willing to pay. NB: their risk premium hasn’t changed, but the market value has.

Remember earlier when I said that commercial property can be a hedge against inflation. Here’s where this fits in. Let’s say that your annual rent reviews are tied to CPI and the RBA is raising rates to try and slow inflation. If inflation was running at 4%, which caused the current  interest rates to rise to 2.5% (and the Capitalisation Rate to rise to 7.5%), then this loss of value is partly offset by the increase in rent. In this example, rent goes to $104,000, and with the rent capitalised at 7.5% we have the following value:

 

 

$104,000

———————————–            =         $1,386,666

0.075

 

This is $53,000 better than our previous 7.5% example. While it doesn’t prevent the market value change in full, it helps protect against Interest Rate Risk, which is one of the main risks in commercial property.

As a side note, the cash-rate cycle is generally considered to be 4-5 years from trough to peak to trough again. Some investors are very sensitive to interest rate risk and choose to lock in their mortgage rates to try and mitigate the impact, but this is to do with their own cashflow, not the market value, which is based on the Risk Free Rate of Return plus the Current Risk Premium to determine the Capitalisation Rate for valuation purposes.

Next month, we’ll talk about Discounted Cash Flow, which is another very important methodology for valuation. Normally, we wouldn’t rely on a single method, but rather look at all three. Often, we’ll rely more heavily on one or the other, but most times we’ll just average out the three. Hopefully they’ll all be roughly consistent to give us comfort and make sure we’re paying the correct price.

 

Happy investing,

 

Andrew Glen
Pure Property – Commercial Management Re-Defined

 

 

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