Blog - Commercial
FACTORS AFFECTING VALUE IN COMMERCIAL REAL ESTATE
Whether you are looking to invest in commercial office space, warehouse space, retail space or another type of commercial property, getting to grips with factors that affect property value is crucial to get more bang for your buck!
The three main drivers of property value
The factors which affect value in commercial real estate can be broadly divided into three categories:
- Economic factors
- Location factors
- Property factors
1) Economic Factors
Economic factors that affect property valuation include both supply and demand operators, such as:
- interest rates (obviously!)
- real GDP growth
- wage growth
- the unemployment rate
- the household savings rate
- migration rates and changes in the overall population
Migration rates and changes in the Australian population
For example, since 2005, net overseas migration has averaged 200,000 people per year, up from 100,000 in the previous decade. And the latest figures from the Australian Bureau of Statistics show that there was a net increase of 237,200 to Australia’s population in 2018. The Grattan Institute estimates that somewhere between 450 and 550 new homes are needed for every 1,000 new residents, after accounting for demolitions. With this increased population pressure, commercial real estate becomes more valuable for two reasons:
- Increased consumption in the economy
- Potential redevelopment into much needed residential property.
It’s no surprise that interest rates (i.e. the cost of credit) are the largest driver of commercial property prices.
Since the peak of the Global Financial Crisis (GFC), the Reserve Bank of Australia (RBA) has engaged in highly expansionary monetary policy – progressively cutting the cash rate from 7.25% to a record low of 1.5%, where it has remained for nearly two years. At its meeting on the 7th May 2019, the RBA decided to leave the cash rate on hold (again) at 1.5%. This means that the RBA is trying to stimulate the economy by increasing the money supply and lowering interest rates.
Cheaper credit has consequently flowed into capital expenditure and commercial property investment. Now, commercial real estate currently attracts a higher yield than residential when compared to bond yields. After the GFC, commercial yields were at around a 2% premium to the average of sharemarket dividend yield, real bond yield and housing yield. And, naturally, these types of returns spurred further investment into this asset class.
Wage growth in Australia has averaged 3.27% from 1998 until 2018. At the end of 2018, it was reported that wages had grown by 2.3% over the past 12 months, delivering the highest annual growth rate in three years. With more disposable income, an individual/family is increasingly likely to allocate capital to commercial property investment.
Wages as a whole are also key indicators of how ‘cheap’ or ‘expensive’ a property is relative to the past or other countries. For example, the average Sydney house price currently sits at a median of $840,000. The average wage of those living in Sydney is $67,854. This makes a property in Sydney priced at around 12.4x the average annual individual income.
Manchester house prices, on the other hand, are circa 5x the UK average income. This implies that houses in Manchester are better value for money.
2) Location Factors
In 1968, Lord Samuel took over City Centre Properties with assets of £155 million in what was then Britain’s biggest ever property deal, establishing Land as the UK’s largest company.
He is also known for coining the phrase, “Location, Location, Location”, regarding location as the most critical factor impacting property values. (In 1983, City Centre Properties’ assets had risen to over £2 billion … so he must have been onto something.)
Now, a property’s location may not be the only driver of value, but we know it’s important. Things like population growth, zoning, transport quality, services and population demographics are all significant factors.
For example, migration to NSW and VIC (and consequently, Melbourne and Sydney) has been considerably higher than migration to any other part of Australia. In 2018, Sydney’s population grew by 2.05% to 5.48 million, while in Melbourne the population grew by 3.73% to 5.00 million. And that has significantly boosted all property values in the two largest Australian cities, relative to the rest of the nation.
Continued discussion of a potential high-speed rail linking, primarily to significant commercial centres like Sydney, Canberra and Melbourne, is an excellent example of how the quality of transport systems impact commercial property valuation.
We have already seen the impact of improved transport quality after the launch of various government projects throughout Sydney. For example, as Liverpool has continued to grow as a transport hub for Sydney’s south-west, property prices in the suburb have increased. House prices in Liverpool have appreciated 134% since 2009, nearly double the average for Sydney.
With increased activity in an area such as Liverpool, the direct impact on commercial property is an increased demand for traditional retail property and strata with small businesses attempting to capitalise on increased foot traffic. And, as an area develops further, services such as law firms and accountancy practices are increasingly demanded, thus supporting an increase in commercial office prices.
Large infrastructure projects such as the $12bn development of Sydney Metro with 8 new stations (some located in the CBD) and 30 km of new track, which will start to open in the first half of 2019, will further improve access to commercial property centres.
3) Property Factors
At the individual property level, the most crucial factor in determining a property’s value is its specific attributes. Obviously, the age of the building, as well as its services (e.g. lifts, and lobby) and how it presents matter. But zoning and neighbouring buildings (which tend to overlap with location) are also important.
For instance, if a traditional retail property sits in an area dominated by apartments, and there is a shortage of restaurants to service the residents in the area, the value of the retail property could increase as restaurants compete for the space.
Another driver is development potential. As development potential increases with FSR (floor space ratio), valuation often follows suit.
(FSR e.g. a 1000m2 site with an FSR of 0.5:1 allows a gross floor area of 500m2.)
In some councils, sustainable buildings and other eco-friendly proposals are rewarded with increased FSR, subsequently increasing valuation in most cases.
Alongside the 3 major factors listed above, there are other important factors that can affect commercial property valuations. These include:
- Urgency to rent or sell the property
- Current / best use
- Credit scores
- Sales or leasing method used
Urgency to sell or rent a property
How urgently the property owner needs to sell on the asset or find a tenant makes an impact.
For example, if a current owner is in a rush to sell or has been looking to offload a property for a long period of time, it may persuade the owner to take a lower offer and therefore influence the price. Those without an urgent need to sell or lease the property, on the other hand, may hold out and wait for their valuation to be matched.
Current / Best use
Whether a commercial property is operating with a tenant that uses the building to its best (or most lucrative) use for the area can also affect the lease or purchase cost.
Duncan & Brown define ‘highest and best use’ as the “… reasonable, probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value”.
This, of course, can change over time for a building, depending on other changes in the local area. Investors that see a better use for the building – for example, if an area is underserved in dining options, or some other amenity, and can change the kind of tenant to add more value – may be able to realise better rental rates or sales figures.
Credit scores / Financing / Rates
While interest rates are currently low and set at 1.5%, this does not mean every borrower can get such low rates to buy or lease. The creditworthiness and credit history of the business or individual will be taken into account.
Those with lower credit ratings will generally be asked to pay higher interest rates meaning they’ll pay back more in the long term. And this makes the commercial property purchase more expensive.
Considering leasing? Read more about commercial leasing guarantees.
Sales or leasing method used
There are a number of ways a commercial property can be sold or leased and this will have an impact on the value achieved. Auctions, trades, exchanges, sale or leaseback are some of the methods that can be used.
Another related factor is how much marketing time and effort will be spent promoting the property, this is generally where professional commercial agents can help to promote the property to the right kind of potential tenants.
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