Valuation Of Income Earning Property – Financial Data, Net Operating Income And Due Diligence
The Importance of Financial Data in Valuation
Discuss about the Valuation Of A Commercial Property.
Valuation of an income earning property depends largely on the income generated by the property and for determining the value, financial data is essential. In this context due diligence is essential for collecting the required information for calculating accurately the property’s Net Operating Income (NOI), which is the most essential data for evaluating the accurate value, as per Baum & Baum, (2015). The value of the property can be based only on how well its operations conducted. This is done by constructing an accurate data from the operations as they exist on date, say Kao, Sung & Chen (ed), (2014). A verification of all items of income and expense is carried out and after adjusting the data collected, the collected data is used for accurately projecting the performance of the property. This collective data is represented as an income statement, assert Ashworth & Perera, (2015).
Whenever an initial offering of sale is made, it is accompanied by a pro-forma income and expenses statement. Such an income statement usually shows income and expense with certain assumptions which may not reflect the actual data of rent and expense required for determining the current NOI, as per Sandercock, (1990). The most inaccurate data in a pro-forma statement can be found under the head ‘Gross Potential Income’. In a typical pro-forma statement, the income is shown as, says Haydon, (1846) –
Gross Potential Income: $100,000
Vacancy loss (5%): $ (5,000)
Gross Rental Income: $ 95,000
Here, the Gross Rental Income is based on an assumed Gross Potential Income which is derived by assuming that occupancy of the building is 100%. This income is then reduced by an arbitrary vacancy loss which, like the assumed Potential Income, does not show the actual performance, as per Tomlinson (ed.), (2012).
Actually, the most recent Net Operating Income should be the governing rule for evaluating the value. For making a Financial Analysis, the requirement is of using data for the last three operational years, according to Davis, (2007). If the analysis is done using data of a lesser period, many of the long-term anomalies may not be reflected. Similarly, a period longer than 3 years may show lot of irrelevant data. Hence, one year data is minimum requirement for valuation purposes and three year data for analysis, speaks Davis, (2007). Authenticated data is available from the seller’s property tax returns as expenses cannot be understated in a tax return. However, in case there are still major discrepancies while comparing the tax returns and the operating statement, one must get it clarified from the seller, according to Luck, Race & Black (ed.), (2010).
The Role of Due Diligence in Collecting Financial Data
Leases executed by the seller with the existing tenants are also an important source for determining the property’s income. The current leases are the authentic source of income, hence it is essential for a buyer to review each lease, as per Christensen & Duncan, (2004). Note down the discrepancies, any concessions being offered and areas which require improvements, say Emerald Gems (ed), (2015). In case the improvement or concession is not met by the seller, the buyer will inherit that obligation and hence must be considered while arriving at projected buying price, according to Gruis & Nieboer (ed), (2013).
If made into a concise report, this data can be counterchecked with the terms of the lease, as per Barnes & Doidge, (2010). The basic Rent Roll Report must reflect the unit number, chargeable area of the unit, name of the tenant, the rent charged, past dues if any and the date of expiry of lease, assert Baum & Baum, (2015). This data serves as the buyer’s opening balance for preparing the income projections for first year after purchase. Areas of caution are the information about recent additions in rent roll. These must be cross-checked with the leases, as detailed by Tomlinson (ed.), (2012).
The files on tenants maintained by the seller can also reveal important financial information, assert Ashworth & Perera, (2015). The buyer must examine the completeness of each file and also note whether compliance was carried out appropriately with the applicable regulations, according to Kao, Sung & Chen (ed), (2014). Files which have records maintained poorly or have non-existent credit reports are to be thoroughly verified. A tenant without reference from the previous landlord can be the source of trouble in the future, explain Luck, Race & Black (ed.), (2010).
Developers and investors have to be cautious with the feasibility study during the preliminary stages of a deal, since a building deal requires huge investments of capital, as per Emerald Gems (ed), (2015). In order to prevent the deal from failure, an office development scheme, particularly in the current turbulence property market. Hence, a feasibility study can play an important role in successfully implementing the project, as per Christensen & Duncan, (2004).
Because there is involvement of huge amount of funds, whichever approach of assessment is used, it is essential to take into account factors such as location, rental incomes and operational expenses of the office development, say Gruis & Nieboer (ed), (2013). As is discussed in this paper, there are two approaches used while assessing the financial analysis of the office development. In Australia, Capitalisation of Income Approach is the most widely used methodology, according to Barnes & Doidge, (2010). The biggest flaw in this methodology occurs when the analysis has to be used for determining a single capitalisation rate which has to represent all the assumptions in the market, explain Emerald Gems (ed), (2015).
Pro-Forma Income Statement and Gross Potential Income
The second methodology in use is the Discounted Cash Flow (DCF) Method. This requires some periodic net cash flows which are to be forecast over the life of investment and are discounted at a discount rate, for arriving at their present value, as detailed by Luck, Race & Black (ed.), (2010). For successful implementation of the DCF method, income and expense projections have to be established along with the discount rate for accurate evaluation of the development, assert Kao, Sung & Chen (ed), (2014). This paper is evaluating the given office development in five steps and is also making comparative analysis between the use of both the methodologies discussed above, say Barnes & Doidge, (2010).
The first step of this report will look at the office development in general.
Currently, the traditional commercial building format is under challenge, as per Ashworth & Perera, (2015). Challenge is about the expensive energy sources which are forcing the architects in designing efficient buildings, assert Tomlinson (ed.), (2012). Limitations of capital expenditure is forcing the developers in seeking higher and reliable returns from their investments, assert Gruis & Nieboer (ed), (2013). Because of these factors, each new building decision is becoming more difficult and requires constant re-evaluation. Investors and builders of office development are initiating processes for understanding the basic project variables, as per Christensen & Duncan, (2004). Under such circumstances, it is essential for the stakeholders to understand the important factors which affect the office development, as per Sandercock, (1990).
Among the important factors, the first one is location and is thoroughly analysed by the stakeholders as well as the tenants for fulfilling their objectives, assert Baum & Baum, (2015). It is common for business to pay a premium for that office space which is in right location. The location factors does not affect alone but works in tandem with other important factors such as the transportation system available, the design of the office, the rental rates and factors which contribute to the overall success of the office development, as explained by Luck, Race & Black (ed.), (2010).
Second step evaluates the major factors influencing the office development.
Location
Selection of a prime location is the most important criteria for office development. A prime location is usually earmarked for a better public transport system, shopping centres and hotels etc., which create high demand and also have labour proximity, as detailed by Emerald Gems (ed), (2015).
Authenticating Financial Data through Property Tax Returns and Leases
Transportation System
Good connectivity to suburban areas through an efficient transportation system increase efficiency for the employers and is a major factor in promoting office development in a prime location, as explained by Baum & Baum, (2015).
Building Design
Design of an office development is considered from two perspectives. From landlord’s perspective the design should fulfil specific needs of occupiers, whereas from developer’s perspective it should increase efficiency, effectiveness and the market value of the office development, assert Gruis & Nieboer (ed), (2013).
Amenities and Services
Facilities such as convenience retail, food service, professional services, parking facilities and conference/meeting halls are considered essential for attracting tenants to the development, according to Tomlinson (ed.), (2012).
Rental Rates
Rental rates of an office development are dependent on its location design and age of the building, as per Davis, (2007). Rental rates are charged per rentable square meter on an annual basis. An office development is referred to as Class A, B, C, or D and are based on the guidelines published by Building Owners and Managers Association International (BOMAI), explains Gruis & Nieboer (ed), (2013). The following formula is used for calculating the minimum Rental Rate = (operating expenses + mortgage payments + owner’s return on equity) / (net rentable area).
Third step reviews the office market and provides basis for projection of current market situation to achieving marketability of the project
Main purpose of marketing analysis is to analyse the size, characteristics and future potential of the existing rental market, details Barnes & Doidge, (2010). In its final result, the market analysis should provide a determination about the rent-ability at the given rent levels along with the time period required for accomplishing this, assert Gruis & Nieboer (ed), (2013). The data obtained from market analysis comprises of business profile of tenants, their space requirements and duration of tenancies. Market analysis should also include space allocation information in other comparable projects. Table 5.1 below, shows the comparison of offices, as detailed by Christensen & Duncan, (2004).
Fourth step looks at analysis of the project’s financial aspects
Development Yield
The development yield is the total annual return which the developer receives and is expressed as percentage of total income and total cost incurred in creating the income.
Development Yield = (Expected Annual Income) / (Cost of Scheme)
In this case the developers annual profit is 11.5% – 9% i.e. 2.5% p.a. which is a profit mark up of 27.8% (i.e. 2.5/9 x 100% = 27.8%), as per Luck, Race & Black (ed.), (2010).
Examining Tenant Files and Conducting Feasibility Study
Capitalisation Rate
Capitalisation rate is a common practice in the Australian commercial property market as it does not differentiate between occupiers and owners of the office development, assert Kao, Sung & Chen (ed), (2014). Capitalisation rate is calculated as percentage rate at which the office development’s net annual rental income can be translated into real capital value, as per Luck, Race & Black (ed.), (2010).
Discounted Cash Flow
Discounted Cash Flow (DCF) is an alternative methodology which is used for making adjustments to cash flows and for reflecting the anticipated changes in the development’s prospects. DCF is used for converting the future costs and benefits to their present values, assert Kao, Sung & Chen (ed), (2014).
Net Present Value
Net Present Value (NPV) of a project is calculated as the total of all the discounted incomes after the total of all the discounted expenses have been reduced from it over the total life of the office development under the given interest rate, as per Christensen & Duncan, (2004).
Fifth part is case analysis and evaluates the application of different approaches
Sale 1: 363-365 Ferntree Gully Road, Mt Waverley
The development comprises of two freestanding buildings which are separately titled. The buildings contain office and retail space and are classified as Grade B with good fit-out. The overall building area is 2,593 m2 with car parking facility for 106 cars. The average rent projected for the building is $3,760 per m2 and has been applied at 80% efficiency on the buildings gross floor area, as detailed by Barnes & Doidge, (2010). This generates a net lettable income from tenancy of $8,882,624 per annum.
Sale 2: 753 Doncaster Road, Doncaster
The development comprises of two level, Grade-A building with ground level entry. The buildings contain office and retail space and are provided with good fit-out. The overall building area is 1,450 m2 with car parking facility for 50 cars, explain Emerald Gems (ed), (2015). The average rent projected for the total space let-able is $2,759 per m2 was applied to 80% efficiency on gross floor area, is generating net lettable income of $3,200,440.
Sale 3: 552 Blackburn Road, Doncaster
The development comprises of two level, Grade-A building which has entry from Blackburn Road with lift access to all floors, as detailed by Emerald Gems (ed), (2015). The building is occupied by five individual tenants and is earning a total rental of $634,210 per annum at the rate of $3,108/sqm.
Factors Affecting Office Development
Sale 4: 37-41 Prospect Street, Box Hill
The development comprises of five level, Grade-A building with ground level entry. The buildings contain office and retail space and are provided with good fit-out. The overall rentable building area has car parking facility for 130 cars, assert Barnes & Doidge, (2010). The average rent projected for the total space let-able is $3,242 per m2 was applied to 80% efficiency on gross floor area, is generating net lettable income of $1,465,714.
Sale 5: 290 Tram Road, Doncaster
The development comprises of three level, Grade-B building with floor space of 700 sqm on each level. Three tenants are occupying the office and retail space and are classified as Grade B with good fit-out, as detailed by Luck, Race & Black (ed.), (2010). The overall building lettable area (NLA) is 2,125 m2 with car parking facility for 85 cars. The average rent projected for the total space let-able is $3,882 per m2 was applied to 80% efficiency on gross floor area, is generating net lettable income of $830,000 per annum.
Conclusion
When a financial analysis is conducted, the first step taken by the analyst is to select a method for use in the analysis. The accuracy of the result depends on the method chosen, since the analysis involves lot of assumptions and projections. There are two methods used in practice, Capitalisation of Income Approach and Discounted Cash Flow (DCF) approach. In the first method, the important factor is selection of a capitalisation rate, explain Baum & Baum, (2015). This approach is widely in practice in Australia as it is given recognition by the courts. The DCF approach works on the perception of bringing the future cash flows to their present day value for determining the financial feasibility of an office development, as per Ashworth & Perera, (2015). Since different anticipated growth rates can be applied in this approach, this provides a more accurate result. Moreover, the DCF approach takes into consideration fluctuations of the market, such as inflation rate and occupancy rate, for calculating the results.
List Of References
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Baum, A. and Baum, Prof A. 2015 Real Estate Investment: A Strategic Approach, 3rd ed. Routledge, Oxon.
Christensen, S. and Duncan, W.D. 2004, Professional Liability and Property Transactions. Federation Press, Annandale, NSW.
Davis, T. 2007. The Real Estate Developer’s Handbook: How to Set Up, Operate, and Manage a Financially Successful Real Estate Development. Atlantic Publishing Company, Ocala, FL.
Emerald Gems (ed). 2015, Built Environment and Property Management: A Focus on Australia. Emerald Group Publishing Limited, Bingley.
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