How to Value Strata-Title Commercial Property

By Argus Software

On the back of low interest rates and strong market liquidity, transaction volumes of commercial strata-titled units in both the primary and secondary property markets have risen tremendously. Cooling measures in the residential sector have also diverted yield hungry investors towards the commercial property sectors. As a result, property developers have started to ride on the wave of investor interest and strata-sell units in commercial developments instead of leasing them out for recurring income.

Impact of the TDSR on commercial property sales

In June 2013, the Singapore government announced the implementation of a Total Debt Servicing Ratio (TDSR) framework, which requires the application of a 4.5% medium-term interest rate or the prevailing market interest rate, whichever is higher, to the commercial property loan that the borrower is applying for. According to DTZ Research, the number of strata-titled shop and factory resale transactions fell by around 67% and 50% quarter-on-quarter respectively in Q3 2013, partly due to the TDSR framework.

As the operating environment becomes more challenging with stricter financing rules, potential higher interest rates and large pipeline supply in the market, investors are more concerned about the future cash flows generated and the potential appreciation of their investment. Likewise, property agencies in charge of marketing such commercial strata-titled projects also feel a stronger need to provide more details in their analysis for clients.

Case study: Nine Residences

Huttons Group, a property agency in Singapore, has been appointed to market Nine Residences, an upcoming 99-year leasehold mixed development located at Yishun Avenue 9. The developer has decided to strata-title the two-storey retail component (Junction Nine) into 146 units for sale. The indicative pricing for the shop units is at least $3,000 per sq ft and the project is expected to complete in mid-2017.

Most marketing materials provide the snapshot above for potential property buyers, which may not provide sufficient details to make a rational investment decision. For example, the snapshot does not include projections of future cash flows of the property, which is required for potential buyers to assess their debt servicing abilities. As a result, agent representatives may expose investors to unintended future risk.

Predicting the future cash flows of the property

In order to predict the future cash flows of the property, an investor is required to make calculations based on assumptions and market trends (see Table 1 and 2 below). Just like a stock market investment, property investors need to develop basic valuation skills in order to make rational purchase decisions.

To value an investment property, it is important to understand how the signed leases determine cash flows. Operating expenses such as service charges and annual property taxes for strata units may be borne by the landlord in certain instances. All expenses pertaining to the strata unit needs to be deducted from the revenues to determine net operating income (NOI). Any additional capital expenses in maintaining the property are deducted from the net operating income to determine the future cash flows. Finally, a future sales price of the property is also projected in order to determine the overall present value.

Table 1: An example of forecasting future cash flows

Source: ARGUS Software (Asia Pacific) estimates only

Table 2: Analysing returns to make a Buy/Sell decision

Source: ARGUS Software (Asia Pacific) estimates only

Benefits of using cash flow projections

A projected cash flow statement will also allow the bank to accurately assess the income generating ability of the investment property, and depending on the debt service cover ratio (DSCR) achieved on the cash flow, a favorable loan quantum for the borrower could be considered by the lender. The bank will also be able to review the underlying assumptions used in these cash flow projections and make necessary adjustments, resulting in greater transparency of the loan review.

Another positive benefit of using cash flow projections is that the property agent can also track future leasing and sales activity and resulting commissions (Table 3). As a result, the agent can for example develop customised leasing and marketing strategies for their clients.

Table 3: An example of projecting leasing activity

Source: ARGUS Software (Asia Pacific) estimates only

Using cash flow projections versus traditional methods

A major data source for the real estate industry is historical transactional data based on caveats which several market data providers currently use. One limitation of using historical data is that it may not be indicative of future market trends and fails to provide projections for the investor. Unlike the cash flow analysis, comparing with historical transactions does not allow an investor to approximate the true value of the investment property and assess if the prospective sales price can be supported.

Another data source for the real estate industry is the certified valuation which all property transactions require. However, an investor’s valuation may differ from that of an approved valuer as they tend to lag the market, causing properties to be overvalued when market fundamentals are deteriorating and undervalued when property markets strengthen. There may also be significant differences in opinions among investors and valuers about the assumptions used when forecasting future earnings.

Creating a cash flow estimation and valuation of an investment property

Unknown to many, it is possible to create an accurate cash flow estimate and valuation of an investment property with limited access to sophisticated property valuation tools. The basic investment model is the same for all property types, although how income is generated and expenses are incurred may differ depending on the type of commercial property.

The investor will be required to include local market data in terms of rental rates, lease structures, leasing commission, capital allowances, tax rates and other market standards into the cash flow model to understand the market risk and achieve a better estimate of value.

Once the intrinsic value of the property has been determined, it can be compared with the selling price and other transactional data to arrive at a rational investment decision.

By ARGUS Software, which provides software and services to real estate owners, investors, developers, financial institutions, estate agents and REITS. Argus Solutions enable customers to improve visibility and to better manage financial and operational performance of their real estate portfolios.

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