A typical investor purchases an income producing property with the expectation of receiving future benefits from the property. Their objective is to fully recover the capital invested as well as to earn a profit. This seems straightforward - earning power is the critical factor affecting the value of a commercial property. But real estate is a complex product and the nature of the market is often uninformed and imperfect. This creates uncertainty for potential buyers, sellers, investors and others.
The income approach, one of three approaches used in the appraisal process and the focus of this discussion, is based on the expectation of future benefits or “anticipation” as it is described theoretically. This approach effectively attempts to mirror the thought process of a typical knowledgeable investor in a particular market.
Generally the value found by this approach for an income producing property is relied on most heavily in the final conclusion of value relating to a commercial property.
The most popular techniques include the “simplified model”: direct capitalisation and other more complex models such as: yield capitalisation (discounted cash flow analysis) or mortgage – equity valuation techniques.
Direct capitalisation equates one year’s potential net operating income to value and can be described as a one-time snapshot of stabilised net operating income. Discounted cash flow involves a multi-year analysis of a property whereby the discount rate is applied to a pattern of income flows and a future sale price (reversion). Discounted cash flow is often used in the case of multi-tenant properties such as office buildings and shopping centres.
The merits of direct versus yield capitalisation are often debated but generally, it is recommended that if adequate data are available both techniques be undertaken.
Inevitably the challenge for the appraiser is the task of determining the appropriate yield rate from the market. The rate can be influenced by many factors including the degree of risk, the stability of the income stream, the market’s perception of future inflation, prospective rates of return for alternate investments, rates of return earned by comparable properties in the past and the supply/demand for mortgage funds.
Capitalisation rates can be imputed from the market, if the required comparable sales exist. In other countries firms commission studies to derive cap rates for various types of commercial property and these are usually published. By contrast, discount rates generally cannot be extracted from the market since they involve a future investment holding period and the determination of a forecasted sales price. In recent times Ernst & Young Caribbean conducted an investor survey in order to give us additional guidance on appropriate cap rates and discount rates in Barbados.
The real estate market is complex and by comparison to organised markets like the stock market lacks market information with no recognised source of published info on sale prices, lease terms & financing and infrequent trades of certain types of property. As an example consider large office buildings where sales seldom occur and lease conditions and terms can vary significantly from one building to another.
In this imperfect market how can we evaluate the market value of a commercial property?
First and foremost, familiarity with criteria utilised by the typical investor in making investment decisions. Second, tracking market rents, lease conditions, supply of and demand for various categories of property, commercial mortgage rates and all available sales transactions. Further, monitoring various economic indicators such as inflation and seeking a broad knowledge of available alternate investments and prevailing market attitudes.
Therefore even in this environment typified by insufficient data the appraiser can be well positioned to analyse the available data, select appropriate rates and arrive at informed estimates of value.