Valuing commercial properties is a fundamental practice in the real estate industry. In this blog, we will delve into the core principles and formulas used to determine the value of freehold commercial properties. This blog is taken from our “Getting to Grips with Commercial Course” and presented by John Mansfield (who is one of our awesome team). Understanding how commercial properties are valued is crucial for anyone interested in the world of real estate investment.
The Calculation Principle
When it comes to valuing freehold commercial property, the process revolves around a fundamental calculation principle: discounting. Discounting involves converting future rental income streams into their present-day value, also known as the present value. The ultimate goal of a property valuation is to establish its capital value, which represents the estimated transaction price. It’s important to note that this value is not necessarily the price one should pay; rather, it’s the likely transaction price based on logical and objective considerations.
The Role of Discounting
Discounting plays a pivotal role in property valuation. It allows us to determine the present value of future rental streams. The core formula for this process is one divided by one plus “I” to the power of “N,” where “I” represents the market yield, and “N” represents the time period of the rental stream. This formula forms the basis for various years purchase multipliers used in property valuation.
Throughout this presentation and subsequent calculations, a standard scientific calculator is employed. While software and valuation investment tables are viable alternatives, a handheld calculator suffices for our purposes. Let’s explore a practical example of how this discounting formula is applied in the valuation of a property.
Calculating the Purchase Multiplier
Imagine you have a property with a rental income stream that will last for three years, and the market yield is 5%. The calculation process involves several distinct stages, which are colour-coded for clarity:
- Stage A: Begin by inputting the market yield (5%) and the time period (3 years) into the formula: 1 divided by (1 + 0.055)^3.
- Stage B: Calculate the result of 1.055^3.
- Stage C: Insert this result (approximately 1.171742) into the formula: 1 divided by 1.171742.
- Stage D: Calculate the final result, which is approximately 0.8524.
Conventional valuation practice rounds this multiplier to four decimal places, resulting in a multiplier of 0.8524. To determine the property’s capital value, simply multiply the annual rent by this multiplier. For instance, if the annual rent is £65,000, the capital value would be £65,000 x 0.8524, equaling approximately £55,314.
Year’s Purchase Multipliers
In some cases, properties are recently let at the full market rent, known as the rack rent. To calculate the multiplier in these scenarios, use the formula 100 divided by the market yield. For instance, if the market yield is 6.5%, the multiplier is 100 / 6.5, resulting in a multiplier of approximately 15.3846 when rounded to four decimal places. This multiplier is then used to determine the capital value.
Understanding Commercial Property Valuation
In summary, valuing commercial properties involves a systematic approach that relies on discounting future rental income streams to their present value. The years purchase multiplier is a critical component of this process, and it varies depending on the property’s circumstances. By mastering these principles and formulas, investors and real estate professionals can make informed decisions in the complex world of commercial property.
This presentation by John Mansfield is just one example of the valuable content available within our Members Club. If you’re interested in diving deeper into the world of commercial property, consider joining us. Understanding these fundamental principles is the first step towards success in the field of real estate investment.
Thank you for taking the time to explore the intricacies of commercial property valuation with us. We look forward to sharing more insights with you in the future.
