A buyer and his estate agent walk down a fast-becoming residential hotspot which has it’s own hashtag on Twitter, and the area’s X Factor is it’s buzzing high street and trendy hangouts..
The buyer say’s, “Mr Estate Agent, I want to buy that house,” pointing to a beautiful 5 bedroom, 3 bathroom development, “what should I offer?”
The Estate agent replies, “A similar comparable 5 bed-3 bathroom sold in the same street 4 weeks ago for £450,000, so I would offer around the same price”
The buyer agrees and buys his dream house for £450,000.
A few months later, the same buyer rings his agent and say:
“I love my new house, but my savings are getting eroded by inflation, and I would really like to invest in commercial office space. I saw one on high street which is up for sale and I saw one opposite just sold for £650,000 which was identical.
Should I offer £650,000?”
The agent replies, “Let me check the sales price with our commercial arm.”
The agent makes a few phone calls, checks out the particulars and rings the buyer to tell him the news. “Can I put my offer in, as I’m ready to buy now” says the buyer..
The agent replies, “The commercial office space is for sale at £1,000,000. So maybe we should try to look at another building, something a bit cheaper?”
The buyer looks confused.
“How is that possible?” “They are both identical in size and literally opposite each other, surely its either a very optimistic seller, or the agent hasn’t done their job properly and inflated the price. There is no reason why this building should be worth £350,000 more?”
We will get back to the estate agents reasoning in just a second, but before we do, let’s take a quick look at how property values are determined…
Residential Property Valuations
Residential properties are single family homes where traditionally, a large percentage are purchased by owner occupiers, and are based on the comparable method.
Many buy to let investors purchase these as rental properties too, but because these only make up a small percentage compared to first time buyers and owner occupiers, their valuation is based upon the same methods.
Usually house prices are determined by a few different comparable models.
The market value being determined by looking at similar properties taking account and making adjustments for location, size, condition and number of bedrooms.
Perhaps only 10% of London would apply a comparable method using cost per square foot, not the number of bedrooms the property has.
You see, using this approach is relatively easy…
A property in your street sells for £80,000 and has 2 bedrooms and 1 bathroom. It is similar in style, decor and size to your property.
There is a very good chance that when you put your property on the market, the agent will probably tell you it will sell for around £80,000 after looking at the evidence and comparable sales.
Although not an exact science, and we are making it seem pretty straight forward, you can quickly determine the ballpark figure of what something is worth by looking at similar sales.
Commercial Property is A Different Animal
Commercial property is one which produces income and consists of office space, retail, and any other complex where the buildings are primarily owned by investors.
Similar to buy to let in the residential sector, commercial tenants pay rent each month for their occupied space.
So What’s The Difference?
For starters, commercial property is determined by the income it generates, and (mostly) being valued with the benefit of immediate rental income i.e. the value is determined by how much an investor is willing to pay based on the return on investment, i.e the sales price.
Value = Rental income/Desired Rate Of Return (depending on type of tenant in situ)
Here’s a quick example.
Let’s say that an investor wants to purchase Unit 1 that has a yearly income of £30,000 with O2 as a tenant. In that locality, investors are buying properties like this for a 10% ROI.
In that case, the property would be worth £300,000 with a 10% yield. You now have the yield to apply to similar commercial properties with a similar tenant…
Consider Unit 1, Unit 2 and Unit 3 all renting for £30,000 per year with a 10 year lease.
- Unit 1 has a Barclays Bank as a tenant
- Unit 2 has a newly established Barber Shop as a tenant and
- Unit 3 has long established Barber shop as a tenant.
What Are They All Worth?
Firstly you need to decide on an appropriate yield based on comparables.
For instance, say commercial Unit 8 sells for £1M and the rent is £50k per annum. The yield is 5%. The tenant is Natwest.
- Unit 1 is worth £600k (£30,000 / 5% = £600,000)
- Unit 2 shows a 10% yield for units let to new businesses, so unit is worth £300k (£30,000 / 10% = £300,000 )
- Unit 3 shows 7.5% yield for units let to established local businesses which have traded for 30 years, so unit is worth £400k (£30,000 / 7.5% = £400,000 ).
Although, this is a very simplistic version of what can be a very technical process and more often than not, the property value calculation will have several layers depending upon the lease length and the income streams…
You now have a rough idea of how property values are determined whether the property is a residential or a commercial unit.
Lets now get back to see what Mr Estate Agent’s answer was to the investor of why the two property’s values could be so different…(Have a quick think for a moment)
“The answer lies in the difference of the quality of tenants and the less likelihood of the tenant going bust” answered the estate agent.
You see to the investor all he saw was bricks and mortar. What he failed to realise was he wasn’t just investing in the building, like you do with a residential buy to let. No.
Although the buildings were identical, he was actually investing in the quality of the tenant and the low yield income which that generated, giving it a higher capital value.
Once he realised this, he could understand why the values were so different, “because the second building had lower quality tenants than the first and second, and it was obvious that with a higher risk tenant, you would want a higher % yield per £ you spent on the building to compensate for possible bad debt, tenant not paying, something unlikely to happen with good tenants…”
“Yes” replied the estate agent.
“Lets grab some lunch and a Costa Coffee and go about finding you a suitable property to invest in?”