Book Report on "Market Value of Commercial Property"

Book Report 7 pages (1937 words) Sources: 7

[EXCERPT] . . . .

Market Value of Commercial Property

In this paper, we discuss the reasons as to why the market value of commercial property can rise and fall over a period of time. Our analysis is focused on the last 3 years. We detail how the proactive management can and does improve returns.

Commercial property is a term used to refer to properties that are occupied by firms in order to do business like office buildings, warehouses, factories, distribution centers, stores, logistics center, restaurants, shopping center, food outlets, bowling alleys, cinemas as well as other types of entertainment facilities. This category also includes research and development (R&D) facilities (Property-Investing, 2010). The definition of Commercial Real Estate by the Complete Real Estate Encyclopedia explains that it is "typically office or retail space, or multifamily residential properties such as apartments."

The commercial property market has been facing its worst years ever since its recent crash in the early 90s.This is according to forecasters like CB Richard Ellis, who is amongst the biggest property consultants in the world (Times, 2007). It was predicted that returns in this property segment would plunge to almost zero by the end of 2007.The level of plummeting returns were also predicted to go down from 18.1 the previous year. This was noted to be following a very steep correction in terms of the commercial property that already had wiped out close to £14 billion from the £350 billion of the investment market share between the month of July and October 2007 (Times, 2007).Several factors can contribute to the movement of the market value of commercial property. There are several factors that can influence the market value of commercial property over a period of time. Various methodologies exist for calculating the market value of commercial property. The basic and fundamental components of the market value calculation are indeed relatively familiar. These components (fundamental) basically address the market condition and income generation (Forsyth, 2010).

Background

The existing appraisals usually value the real estate assets by means of three distinct methodologies. These are;

Cost Approach

This approach estimates the cost required to build a new building which is identical to the one being appraised, at the current market price while subtracting the accumulated amount of depreciation and adding the estimated value of the land on which the subject is build (BC,2011).In other words, this approach estimates the replacement value of a given property. Pratt, Reilly and Schweihs (1998),further adds that then adjustments are made to the fee simple value which is indicated of the given property in order to reflect of the property interest that is being appraised. The controversy that surrounds this methodology is that it does not indicate the fee simple market value (Jones, 2005).

The Sales Approach

This approach is generally the methodology that provides a comparison of prices of sales for comparable assets that exists within the same property market.

O'Connor (2010) describes the sales comparison approach is one of the most intuitive and yet best understood of the three main appraisal techniques. Companies who rent office space, home buyers and real estate investors are the main users of this approach. The process of performing sales comparison approach does include the selection of sales comparables while making the appropriate market adjustments. The process of selecting the comparables if a very daunting one since there are very minor nuances that usually are not obvious. Therefore the process of accurately making these adjustments does require a lot of research, experience and skill. The selection of the comparable sales is the most critical aspect of this approach. The comparable sales values must be used for the process of value indication to make sense and impact the final outcome for less than the sales which by themselves are not comparable. It is worth pointing out the fact that appraisers usually focus on the type of property (land use), its location, date of sale and size when selecting the comparable sales. The selection of the sales comparables does involve the selection of which features (date of sale, age, size or location) are more meaningful. Due to the fact that the real estate market is never fungible and the level of sales fluctuates periodically, the comparables are never in any way identical to the property being appraised.

The income approach

The income approach does provide a projection of the property's cash flow. This is the most preferred approach used in the evaluation of commercial real estate whenever the reliable property rent and operating expenses are readily available. The sales data is another requirement for the development of the income multipliers as well as the overall capitalization rates (SAMA, 2001).

Fig 1.The income approach

Source: SAMA (2001)

It must be noted that although of the approaches above is considered in the calculation of the market value of a given commercial real estate (CRE), the most emphasized approach for an income producing property is the "Income Approach." This is because the cash flow analysis just provides the basis for an expected investment return or income stream for a given property.

Calculations of market value

The calculation of Market value using the Income Approach is done by Net Operating Income (NOI) being divided by the Capitalization Rate (Cap Rate):

Estimated Market Value = Net Operating Income / Capitalization Rate… (Forsyth,2010)

The net income can however have a number of variations. It will basically be calculated as the annual gross income of the property less the annual operating cost. The Cap rates are usually derived by means of the investment return assumptions or the cost of borrowing and this usually varies by the property type, location and the overall risk in the property market. An appraiser or an investor who needs to calculate the market value would generally view the cap rates that are used for the most recent comparable asset in the same location as the subject property.

Example

We can use a commercial property that had an annual net operating income of $5,000,000 and a comparable sales property in a region that has a cap rate of 7%.

$5,000,000/7% =$71.4 Million

Market Value for the commercial property is estimated to be $57.1 Million.

In case the annual vacancy is increased and therefore the net operating Income decreased to $4,000,000, while assuming all other factors are held constant, $4,000,000 / 7% = $57.1 Million

The market value for the given commercial property would be estimated to be $57.1 Million.

The changes to the value of property

It is worth noting that the actual or the projected change to the cap rate or the net operating income would result in a substantial change to the already evaluated market value of a given commercial property. It is clearly stated in the Federal Reserve Bank of Dallas Economic Letter that in any efficient market, the price that investors are willing to pay for a certain building does depend on the amount of rental income and the expected yield (Forsyth,2010).Therefore, the specific commercial property that is for sale or that is asking for a price may be considered to be either above or below its market value as carefully derived ny a valuation approach.

Some considerations

The amount of market value can greatly be impacted by certain specific occurrences like increase in the cost of operation, repairs and insurance. The market value can also be greatly be affected by the trends in the overall condition of the market which includes the changes in the costs of borrowing, the increase and decrease in the level of local market vacancies, the fall and rise of the market rent levels. As an example a construction or a specific expansion can effectively result in an oversupply of space to be used for commercial property .This would in the end create a decrease in the level of occupancy, reduction in rents and then ultimately leading to the reduction of the market value of the property.

Recession and the commercial property markets

A research by the Deutsche Bank (2008) revealed the true impact of recession on the commercial property market. It indicated that recession was to weigh heavily on the European and U.S. commercial property markets and the key industries would cut back in the level of production. The report suggested that the financial industry would need to reinvent itself in order to recover from the effect of recession. One of the moves would be downsizing. The office markets in Europe and Americas would experience a substantial level of drop in the level of take-up space and the level of vacancies would increase while the prime rent would fall. The recession also caused a decrease in prime office rent by double digits as was recorded in Paris, London and Madrid (Deutsche Bank, 2008).

Proactive property management

Proactive property management involves the putting in place of various actions meant to keep the property from suffering the consequences of certain risks. It is actual a form of risk management in property markets. For example it can be used in the reduction… READ MORE

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