Valuation Methods. Profits

In the case of most types of commercial property such as retail, office and industrial, it will be a reasonably straight forward job to establish a rent or a capital value (for when being sold on the open market).  The rent or capital values will likely be set by close comparison with similar property transactions in the immediate area.

Sometimes however, it’s just not possible to compare similar properties, because the information might simply not be available.  This might be because the property is very unique or because similar transactions have not occurred recently enough to be of any use.  This is often the case for leisure properties such as pubs, restaurants and hotels.  These are often sold on the open market but because they’re a specialised investment field, you probably haven’t seen them unless you’ve been looking out for them.  In fact, it’s not just professional investors  who would have an interest in how these properties are valued, prospective tenants planning on running the business themselves should also know how the valuation process works.   If you understand how the property is valued, you will have far more leverage when it comes to negotiation on the eventual rent figure.

If no comparable information is available, the only alternative is profits.  Obviously this means that the property has to have an operational business currently running from within.

I personally feel that the profits method is a far better way to place a rental value on this type of property, even if accurate and relevant information on comparables is available.  This is because these types of properties can be a similar size and closely situated but make extremely different levels of profit.  The business that’s been more shrewdly run might appear to be worth more.  It should be mentioned however that the business itself is not being valued, rather the ‘facility’ to run a business from the property.

To begin to establish the profits, the past 3 years accounts must be looked at.  It’s very important that these are accurate enough to be relied upon; a good indication is if a reputable accountancy firm have prepared them.  A very basic way of estimating the net profit figure is by the following summation:

Gross Earnings

Less Purchases

Equals Gross Profit

Less Working Expenses

Equals Net Profit

Gross Earnings is the total annual revenue that the business earns, before anything is subtracted.

Purchases are the ‘raw material’ that must be purchased in order that the business can operate.  In the case of a restaurant for example, this would be food, beverages and equipment.

Gross Profit is the resulting figure that is produced from subtracting the business purchases from the gross earnings.

Working Expenses are the everyday costs involved in running a business such as electricity, staff wages and insurance.

Net Profit is the final figure left after all expenses and purchases have been deducted from the Gross Earnings.

The valuer who establishes the rental value based on profits is obliged to use his judgement in deciding if the net profit figure is accurate enough.  Company accounts can only show what has been recorded.  However if the business has been underperforming for some time, the valuer might consider the net profit figure too low compared to what might be achievable.  Likewise if the business has been run exceptionally well, the net profit figure might be reduced for the purposes of the calculation to give a more realistic figure.  In practice, the Property Professional who values a property based on profits will be a specialist in this particular field of commercial property.

It is common practice to divide the net profit figure in half (or thereabouts) to produce an annual rental value.  One half is known as the ‘Tenant’s Share’ and is intended to account for the Tenant’s work and enterprise in running the business.  The other half would be regarded as the annual rental value.

So for example:

Gross earnings – £100,000

Less Purchases – £35,000

Equals Gross Profit – £65,000

Less Expenses – £25,000

Equals net profit – £40,000

Tenant’s share of 50% – £20,000

Annual rental value – £20,000

When calculating the net profit figure, the Tenant’s wages should not be included as an expense.  This is because the Tenant’s share is included at the later stage and must not be considered twice.

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