The Value in Valuations

Valuers have a mountain to climb in 2023; valuing property in a falling market while lending parameters seize up.

And the stakes couldn’t be higher. An accurate valuation is a make or breaks when it comes to a borrower’s approval.

It begs the question, can you really trust property valuations?

Let’s dive into valuer’s methodologies and consider whether valuers are clairvoyants without a crystal ball, or bonafide property experts you can trust.

Income capitalisation is the first and simplest method for valuing the commercial property.

As commercial property is typically used to run a business or generate income, a valuer can use the estimated return on investment as a valuation tool. Using this method you would calculate annual income and do some mathematical wizardry to come to a valuation.

How would that work as an equation?

First, we would subtract operating expenses from rental income to find our net operating income. This gives you the expected income potential of the property. Then divide that by purchase price to find the capitalisation rate, which gives you the yield of a property over a 1 year horizon. Finally you divide the net operating income by the capitalisation rate to get the property value.

We all know that cash is king.

So while income capitalisation might not seem intuitive at first, it actually gives you a better sense of the going value of a property. It lets you convert income into value. This gives you a more reliable sense of the value as the owner or manager of a commercial property. If your property doesn’t quite stack up on paper, the income potential might push it over the line to give you the value that you need.

Let’s go through an example.

Vanessa wants to open a small winery near Kiama. She’s found the perfect vineyard. Views overlooking the coast, lush greenery, and a cosy little cottage. Are you jealous yet?

She knows the property will be expensive, so she is eager to get a strong valuation. Let’s see how a valuer would approach this from the income capitalisation method.

First, they would look at the net operating income. She expects to make $250,000 a year in gross income minus $80,000 in costs. That leaves Vanessa with a $170,000 operating income. The valuer has calculated a capitalisation rate of 10% based on comparable sales.

By dividing the net operating income of $170,000 by the cap rate of 10%, Vanessa is left with a property value of $1.7 million. This gives her lender confidence in not only the value of the site, but also of her serviceability once the property is acquired. Go Vanessa!

The second method is comparable sales.

This one does exactly what it says on the tin. A valuer will draw comparisons between the property you’re selling and recent sales of similar properties. This isn’t just a ‘spot-the-difference’ and smack a convincing price on it. This is a forensic investigation of why other properties sold for what they did, and what you could expect to pay for the property of interest.

They take every important factor into account, including the type of property, the location, the timing of the sale, size, zoning, fitout, and proximity to services and amenities.

While the calculations might not be as specific as with the income capitalisation method they still yield good results. If we bring it back to Vanessa’s case, a va luer would scour all the past sales of vineyards in Kiama and its surrounds, then compare them to the vineyard she wants to acquire. If similar properties are selling for $1.5 – $1.7 million, Vanessa could expect a valuation between those numbers.

As you can see, it is a simple method but it is anchored in real life results and data.

Our third method is summation, which treats a property valuation like a pie with many slices.

Summation takes into account each component of a business and adds them all together. It is a highly nuts-and-bolts, cost focused method of valuation. Under the summation method, a valuer would calculate the cost of land, improvements, fixtures, amenities, and landscaping. This would then be adjusted based on the property’s size, location, age, condition, and zoning – to get a more realistic appraisal.

The summation method gives you a defined value base which is supported by evidence. This can make it easier for valuers to adjust the final value of the property and produce a result closer to the actual sale price.

A key limitation with summation is that people are often willing to pay far above the true value of a home. This speculative push is especially bad in our capital cities. Properties in Sydney’s City and Eastern Suburbs are often bought for multiples of the physical value of the property. This makes the ‘summation’ part of the method somewhat redundant.

Bringing it back to Vanessa’s case, her valuer would take into account the value of the property’s cellar, vineyards, storage vats, and the construction improvements to the cottage before adjusting for the Kiama market.

Let’s say the cellar is worth $120,000, the cottage is worth $465,000, the vats are worth $80,000, and there are $100,000 of construction improvements. Summing this together we get a cost base of $765,000. Her valuer would then adjust this b ased on the specific factors of the market and the property. Let’s say the size of the land, the quality of the fitout, and the location add an extra $1 million to the property.

Vanessa would be left with a valuation of $1,765,000 – pretty close to the other methods!

Valuers can also use the ‘replacement cost’ method.

With the replacement cost method, a valuer considers how much it would cost to replace the existing property if it spontaneously disappeared. That means you only consider the value of the physical structure. The value of the land itself is excluded.

Replacement cost is typically used for insurance purposes, where the actual property is what needs to be covered.

The tricky part of replacement cost is that the cost of building, construction, and materials can be highly volatile. They change depending on the year and are sometimes very market dependent. Furthermore, the value of a property will typically depreciate over time with wear and tear, while the land could appreciate.

For Vanessa and her vineyard, the replacement cost method would consider how much the cottage is worth, along with any other physical structures on the property. A valuer probably wouldn’t use replacement cost for the acquisition of a property as it generates a lower nominal amount for the valuation. Vanessa needs a pretty strong valuation to get the right LVR.

Hypothetical development is our fifth and final strategy.

While the other valuation tools are looking at observable factors, hypothetical development calculates the value of the land if it was developed to fit the maximum number of dwellings. Then, the cost of priming the land for developing and any selling expenses would be subtracted.

The calculations would look like this:

Gross total sales of finished property – selling expenses = net realisation

Net realisation – developer’s profit and risk = total capital outlay

Total capital outlay – development costs = total value

This method relies on a very accurate calculation of expenses and property price projections. To give a true representation, everything has to be just right.

As you can see, valuers have many tools to get to the heart of a property valuation.

The property market is like a wild horse let loose in a daycare. Getting a grip on either is tricky and that’s what valuers are tasked with.

Luckily, they have an armada of tools and strategies to value properties. Whether it is relying on past sales data, income generating potential, building costs, or the value of a property’s components, valuers have a complete picture of a property and understand the factors which add value. Add in years of experience and the diverse perspectives of a valuation team, and you have a much higher chance of getting it right.

For Vanessa, her valuer went with the income capitalisation method and gave her a valuation of $1.7 million. Despite a shaky market in Kiama and some hesitancy from her lender, she got approved for a loan and acquired the vineyard for $1.75 million. Vanessa’s dreams came true and the valuer was nearly bang on. In fact, she’s probably enjoying g a nice glass of Cab Sav right now.

We asked you earlier, can you really trust property valuations?

As you can see from Vanessa’s story and the points above, you certainly can.

About the author

Ulrika Lobo

Ulrika Lobo is the lending specialist at Sparrow Loans and has over ten years of experience in the commercial business loan space. Ulrika co-founded Sparrow Loans to provide Australian SMEs with a faster and easier way to access finance. Ulrika is responsible for managing the lending process from underwriting to execution and settlement and post-settlement support.