Ask what a house is worth and you compare it with recent sales of similar houses. A commercial building is a different exercise, because an investor who buys one is buying its income. The questions that decide value are how much the property earns, how secure that income is, and what a buyer would pay for that income stream. Once you understand that, the rest of commercial valuation is much easier to follow.
Income capitalisation and the cap rate
The primary method for most investment-grade commercial property is income capitalisation. The valuer establishes the property’s net market income, then divides it by a capitalisation rate, or cap rate, drawn from analysed sales of comparable investments.
The arithmetic is simple. A building producing $500,000 in net income, capitalised at 6.25 per cent, indicates a value of $8 million. The same income at 7.25 per cent indicates about $6.9 million. One percentage point in the cap rate moved the answer by more than a million dollars, and neither the building nor the tenant changed. That is why the real work goes into proving the net income and the cap rate.
A cap rate is extracted from sales evidence. The valuer analyses what investors paid for comparable properties against the income those properties were producing at the time, then adjusts for the differences. The rate is a measure of risk, so the more secure the income, the lower the cap rate and the higher the price. Riskier income pushes the cap rate up and the price down.
Net market income can also differ from the rent currently being paid. Where the passing rent sits above or below market, the valuer adjusts for the difference over the remaining lease term, because an investor is buying the income the building will produce over the years ahead, and the rent passing today may not represent that.
The lease is the asset
A commercial investor is, to a large degree, buying a contract. The physical building matters, but the lease behind it drives value more than almost anything structural. Three features of that contract do most of the work.
WALE: how long the income lasts
WALE is the weighted average lease expiry, the average remaining lease term across the property weighted by income or by area. A building with a WALE of seven years offers seven years of contracted income before the owner has to face the leasing market again. A WALE of eighteen months means the owner will soon be back in that market, facing downtime, incentives, agent’s fees and fit-out costs. Investors pay materially more for the first building, and the cap rate reflects it.
Tenant covenant: how reliable the payer is
A lease is only as good as the tenant behind it. A ten-year lease to a government department or an ASX-listed company is a very different asset from a ten-year lease to a two-year-old private business, even at an identical rent. Valuers call this the tenant covenant, and it feeds straight into the cap rate, because the market is pricing the likelihood that the contracted rent will be received for the full term.
Incentives: face rent versus effective rent
In most Australian commercial leasing markets, landlords offer incentives to secure tenants: rent-free periods, rent abatements or fit-out contributions. The rent printed on the lease is the face rent. The rent the landlord truly receives once incentives are absorbed is the effective rent, and in soft markets the gap between the two can be substantial. Capitalising face rents without adjusting for market incentives overstates value, sometimes badly. Analysing incentives properly, in both the subject leases and the sales evidence, is one of the more technical parts of commercial valuation.
Outgoings and the path to net income
Value is capitalised from net income, which is what remains of the gross rent after outgoings: council rates, land tax, insurance, management fees, repairs and maintenance. Lease structure decides who pays them. Under a gross lease the landlord carries outgoings; under a net lease the tenant reimburses most of them. Two buildings with identical gross rents can therefore produce quite different net incomes. Land tax deserves particular care in Queensland. Whether it can be recovered from a tenant generally depends on the type of lease and when it was entered into, and retail shop leases are treated differently from general commercial leases, so the lease documents and, where it matters, legal advice settle the point.
Vacancy and letting-up risk
No valuer assumes a building stays fully let forever. Where space is vacant or leases expire soon, the assessment allows for rent lost during the letting-up period, the incentive likely needed to secure a new tenant, leasing fees and any works required to present the space. For straightforward assets these are handled as specific deductions. For complex multi-tenanted properties, a discounted cash flow analysis is often run alongside the capitalisation approach so that the timing of expiries, reviews and incentives is modelled year by year.
Direct comparison as the check
Income methods dominate, but direct comparison still earns its place. Analysing sales on a rate per square metre of lettable area gives a sanity check on the capitalisation result, and for owner-occupier stock, vacant buildings and strata units it is often the primary method in its own right. When the two approaches disagree sharply, it usually means the income assumptions, or the sales analysis, need another look before the figure is signed.
Why two similar buildings can be worth very different amounts
Two buildings of the same size, age and construction, on the same street, can sit a long way apart in value because:
- one has a seven-year WALE to a national tenant, the other has eighteen months to a start-up;
- one lease passes outgoings to the tenant, the other leaves them with the landlord;
- one face rent is close to market, the other conceals a heavy incentive and sits well above it;
- one building is fully let, the other carries a vacant floor and the full cost of filling it.
The physical fabric is the smallest part of the difference. Most of the gap comes down to the income and the risk attached to it, which is why the leases have to be read line by line before any figure is put on the building.
If you are buying, selling, refinancing or reviewing a commercial property in Brisbane and want the income picked apart properly, call the practice on 07 5550 4055 and talk it through.
