Property Watch (Part II) - Valuation of Commercial and Industrial Property

PART II - THE CAPITALIZED VALUE OF RENTALS

An accepted method for calculating the investment value of a property is based on the capitalized value of the gross income, minus all expenses in year 1.

Applying a capitalization is an objective exercise and is essentially an indication of risk. The higher the risk the higher the capitalization rate and the lower the value, conversely the lower the rate the lower the risk and the higher the value.

Masterbond, Supreme Bond, Owen Wiggins are proof of the neglect of this fact, and more recently Capital Properties, Bluestone, the King empire and Sharemax.

Investors often look at return only, without a proper investigation of risk. Capital growth and steady income are investment fundamentals.

A 10% return in a blue chip, R 500 000 investment is R 50 000, is, in theory, a nil risk.

The investor is tempted by an extra 5% return, an additional R 25 000 per annum. This additional income of 5%, R 25 000, puts the entire investment at risk. At R 50 000 income a nil risk, for R 25 000 income and the capital investment of R 500 000 could be at risk.

These high return schemes will eventually collapse, leaving statistically 88% queuing for whatever liquidators are able to recover.

A High Court judgement illustrates the danger of investing in any scheme that looks suspiciously profitable, even if the investment is made entirely innocently.

Ordering an investor to refund the liquidator all monies that the scheme had distributed prior to liquidation the Court commented that it was irrelevant whether the investor “may have been aware that an offence was being committed by the payer”. The whole business of the scheme being unlawful, payments could never have been made “in the ordinary course of business”

When applying a capitalization rate sellers and buyers and valuers often tend to apply a “blanket” rate when considering selling or buying. Our view is that this is incorrect, every tenant, every shopping centre, office block, commercial building or industrial investment should be individually assessed and a different capitalization applied to the different categories of buildings and tenant type.

All expenses relating to ownership of the property must be taken into consideration. The following are some of the more common examples.

  • Administration/Management 
  • Audit and Accounting Fees 
  • Bank Charges
  • Cleaning Contracts 
  • Supervisor/Caretaker 
  • Electricity
  • Sewerage Fees 
  • Water 
  • Refuse removal
  • Landscape Contract 
  • Insurance 
  • Meter reading
  • Pest Control 
  • RSC Levies 
  • Security
  • Repairs and maintenance 
  • Municipal rates 
  • Garden Services
  • Body Corporate levies 
  • Improvement district levies 
  • Hygiene
  • Services

Leases relating to the property must be analysed to establish the extent, if any, expenses paid by the tenant and in addition consideration of at least the following when doing a valuation.

  1. Checking Title Deeds, restrictions, servitudes and zoning conditions.
  2. Valuing a property with a lease where rentals are below or higher than market rentals.
  3. A short lease where vacancies will affect the income stream and cash flow. Is the assumed rent for renewals or new tenants market related?
  4. An income stream that is growing at a constant rate, where future rentals may be higher or lower than current market rentals.
  5. An income stream that is growing with variable escalations, where future rentals may be higher or lower than current market rentals.
  6. Is the rental gross or net, what is the escalation on rentals? If rental is separate from operating costs what are these operating costs? What are the municipal rates, how much are the levies? Escalations on operating costs and rates and levies sometimes vary, often more than escalations on rental.
  7. The liability for any contractual obligations, cleaning, lifts, security etc.
  8. The existence of building management, and employee contracts.
  9. The cost of new tenants in terms of, commission, refurbishment, tenant installation costs and possibly no rental income for a number of months.
  10. Property management contracts stipulating, in detail, the rights and duties of both the property manager and the owner.
  11. Are the buildings on the property the same buildings that are on the passed plans, does the use of the property comply with Town Planning regulations, is the building a “listed” building as prescribed by the SA Heritage Resources Agency?
  12. If undercover and/or outside parking provided, what is the cost?

An alternative to the capitalized value of the 1st year’s rentals an alternative valuation calculation is the Internal Rate of Return (IRR). The Internal Rate of Return is defined as the discount rate that equates the present value of cash inflows of the initial investment and the probable selling price at the end of a predetermined period.

Care must be exercised in the application of IRR as the underlying assumptions make it possible to have more than one IRR rate in cases where the cash flow sign (positive/negative) changes more than once over the period of evaluation. It is also a guess, for the calculation to work properly an assumption as to a selling price at the end of say, 10 years must be made. The IRR calculation is better used with the net present value (NPV) calculation.

Where the appropriate parameters are in place, investors, are becoming more sophisticated, and are applying the NPV calculation in addition to the year 1 calculation for long-term investment projections. NPV calculates the current value of estimated cash flows, discounted at a given interest rate. Using the above as an example, and applying a 10% discount rate, the NPV of the 10 year cash flows would be R 4 794 954, compared to the 1st year value of R 6 398 400

It is helpful in determining how much the 10-year cash flows are worth now, assuming the projected income and value will actually be achieved over the projected lease period.

Consider as well the practical aspects, of which the following are some of the more important,

  1. The value of parking, for both clients and staff can never be overestimated;
  2. The structural integrity of buildings checked by a structural engineer;
  3. Roofs and gutters, particularly flat roofs and box gutters;
  4. An electrical inspection, prior to the issue of a clearance certificate, should include central air-conditioning, lifts, fire protection, electric fencing and any specialised installations;
  5. In the case of central air-conditioning ensure that the coolant, for example, used is in accordance with applicable legal specifications;
  6. Compliance with fire, beetle, and gas installations regulations;
  7. If any doubt exists as to what is considered an “installation” in a building, separate detailed schedules must be drawn up;
  8. Extent of any contractual obligations for staff, security, cleaning, hygiene and pest control services etc.

Selling a good property investment takes time, selling a bad property investment can be financially debilitating.

Property valuations are becoming more sophisticated, comprehensive assessments are vitally important.

Potential purchasers can investigate these and other important aspects during a period of due diligence.

Courtesy: Reg Wall

Contact: Reg Wall

Tel: 021 797 2552 / 083 261 0563 

Email: [email protected]

Web: www.coreproperty.co.za

Disclaimer: The information in this email is confidential and legally privileged. It is intended solely for the addressee. If you are not the intended recipient, please delete the email. You may not copy, distribute, or disclose the included information to anyone.  Whilst all reasonable steps have been taken to ensure the accuracy and integrity of all data transmitted electronically, Christies Property Brokers cc t/a Core Property Group and its subsidiaries do not accept liability if the data, for whatever reason, is corrupt or does not reach its intended destination. No representation or warranty, expressed or implied, is or will be made and no responsibility or liability is or will be accepted by Christies Property Brokers cc t/a Core Property Group, or its subsidiaries, employees, or agents in relation to the accuracy, completeness or fitness for any purpose of this information or for any loss, liability, damage (whether direct or consequential) or expense of any nature whatsoever which may be suffered as a result of or which may be attributable, directly or indirectly, to the use of or reliance upon any of this information. Past performance is not a reliable indicator of future results. The information stated, opinions expressed and estimates given are subject to change without prior notice. This information is for informative purposes only and does not constitute investment advice or any other advice, or a personal recommendation. All aspects of any transaction would need to be reviewed by the client’s preferred advisor prior to implementation. E.O.E

Search By Reference


NEWSLETTER SUBSCRIBE

Stay updated on the latest Property News

Property Management Banner