Valuation Methods. Comparison

Of all the 5 methods of Real Estate valuation, the Comparable method (also known as the Comparison Method) is king.  It underpins all other forms of valuation to some degree.

I like to be able to work with a definition of a term so that I can truly understand it.  So I will attempt to define the term ‘Comparable Valuation’:

‘The establishment of a Property’s Capital or Rental value using recent, similar transactions as a guide’.

The first thing to mention about this valuation method is that it is not rocket science.  It is essentially the method that not only residential Estate Agents (Realtors) use to establish an initial property asking price, but also potential buyers.  That means that if you have ever got a particular ‘feel’ for the market in an area and felt that a house or flat is over or undervalued, you have used this method too.  This is because all it is is comparing one property value to another.  This might be oversimplifying slightly, because there are certain considerations to look into:

  1. The difference between the asking price and the eventual sale price (or asking rent compared to eventual agreed rent) is quite likely to be significant. This is down to the negotiation between vendor and purchaser (or landlord and potential tenant).  An example of this is when residential Estate Agents are very optimistic when placing an initial asking price on a property.  It’s very important when researching recent transactions that actual sale or ‘let at’ values are used.  Asking prices and rents can be ignored.
  2. The recent transactions should be as recent as possible. It’s far easier to use the comparable method when the commercial property market is active and stable.  This is because information is far easier to gather.  Sometimes it’s just not possible to find sale or let figures that have been produced in the preceding weeks or even months; however you must understand that the older the information on other transactions, the less accurate it is.  Property is hugely influenced by changes in demand and supply; this means that if (for example) an office building was sold 3 years ago for £1.35m (Approximately $2.025m) it does not necessarily follow that it would sell for more than that now.
  3. Transactional information should ideally be based upon properties that are located very closely together. In Central London and (presumably) other similar large cities, buildings should be on the same side of a particular street and preferably within a few hundred yards of each other before they can be considered closely comparable.  However, that leads us on to the final consideration:
  4. All properties are different in some way. This could be different Use (offices, industrial or retail plus sub-uses such as financial and professional services, general business or light industrial etc), Grade (the high profile, well-equipped and modern offices are known as Grade ‘A’, grades then go to B & C depending upon condition, level of amenities and pleasantness of the building in general), Size (the difference in sizes of buildings is addressed by dividing the rent or sale price of a property achieved by the area.  This produces a value per square foot or square metre) and Location (this might be the difference between (for example) a building in Central London and a building in Warrington; or even different areas in the same city, such as a building in Streatham, London and a building in St James’ Square, London).   These will all have an influence on value to some degree.  If rent is being negotiated, 2 apparently identical buildings side-by-side could have different rates negotiated.  This could simply be because a particular business tenant presents a lower risk to the landlord and was therefore able to negotiate a slightly lower rent than the neighbouring tenant.
  5. Economic conditions can affect the demand for property, and subsequently the agreed rent or price. The cost of borrowing is a big factor in property sales; likewise the general level of confidence in the macro-economy will affect investor’s appetite to acquire what amounts to a highly illiquid asset.  In economic downturns, businesses are much less likely to expand or move premises and this increases an investor’s exposure to risk.

It’s often said that Real Estate valuation is an art, not a science.  In relation to the considerations above, establishing a property value is not difficult.  However, establishing an accurate figure is where the skill comes in.  Determining an approximate rate per square foot or metre is not difficult; however it’s knowing where to adjust a figure and how to account for differences between apparently similar property transactions that sometimes produces unexpected results.

In the case of commercial tenancies, lease terms will have a substantial affect on the agreed rent:

  1. The lease Term (length of tenancy). A long term is normally of benefit to the landlord, except (for example) if he plans to redevelop the site in the mid to long-term.
  2. Break Clause. This allows one or either party to bring the lease agreement to a premature end.  In the UK, it is often placed into the lease terms in 3 or 5 year intervals.  It will be subject to around 6 months notice usually and might involve some reward if it isn’t exercised (such as a rent-free period).
  3. If the tenant has some Security of Tenure. In the UK this means that the landlord can only insist the tenant leaves the premises under certain circumstances.  All commercial leases in the UK are automatically subject to this unless both parties agree to exclude it at the beginning of the Term and this is specifically mentioned in the lease contract.
  4. The financial standing of the tenant. 3 years of company accounts are normally required for the landlord to consider.  This is because if the company has an excellent credit rating and has been established for quite some time, it will present far less of a risk to the landlord than a company that is in its infancy or has defaulted on some payments to creditors.
  5. Ease of use of the premises. If for example, a tenant is unable to access premises outside normal working hours, this can have an effect on agreed rent as it might be a significant inconvenience.  Likewise if an out-of-town office building does not have sufficient car-parking spaces for the staff, this is also likely to reflect in the agreed rent.
  6. Obligations regarding repairing and maintaining the building. If a tenant is obliged to take on responsibility for all building maintenance and repair, the rent is likely to be lower as the terms of the agreement are simply less favourable for him.  The same can be applied to insurance.  If the tenant is obliged to pay for insurance, it represents a burden for him.  Insurance payments are collected from the tenant by the landlord.  The landlord usually takes responsibility for arrangement and ensuring that insurance payments are made, as this way he knows that cover is in place.  The payments are recharged to the tenant under a separate arrangement.

An example of the Commercial use of the comparable valuation method is as follows:

To establish the rental value of Building A, three further buildings (B, C and D) can be considered for comparable evidence.

Building A is 3,000 Sq M office building.  It is established that rents in the area have increased by 7% in the last 12 months.

Building B is 2,000 sq M and is of poorer grade than Building A.  It was let around 2 months ago at £400,000 per annum (around $600,000).  This works out to £200 per sq M but this value would be below that expected for Building A as the grade is poorer.

Building C is also 2,000 sq M and is similar grade to building A.  It was let 12 months ago at £600,000 per annum (around $900,000).  This works out to be £300 per sq M for a similar quality of office but rents have increased since this was completed.

Building D is 1,000 sq M and is also a similar grade to building A.  It was let 1 month ago for £350,000 per annum (around $525,000).  This works out to be £350 per sq M and the information is quite recent.

It could be determined that Building A could be worth around £300 per sq M.  The justification for this is that it is a larger unit than C & D and although rents have increased since Building C was let, Building C would command a higher rent because smaller units are in higher demand.  If Building C was being valued now, it could be justified to value it at a slightly higher rate than Building A.

Clearly this example is very simplified.  However it demonstrates the technique, additional factors such as location and lease terms would have to be considered.

 

 

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