Commercial vs residential property valuations

Most Australians are familiar with how valuing residential property works and understand the importance of considering comparable sales, location, renovations, and school zones. But when it comes to commercial property, the rules are entirely different. 

Australia's residential market is around $9 trillion, compared to commercial's $1 trillion. That means residential has more buyers, more sales, and more comparable data, making it easier to analyse. 

Commercial, by contrast, is less liquid and more nuanced. Value isn't based on how modern the kitchen is or how nice the street looks. It's all about income, functionality, and future tenancy potential. That can make valuation harder, but it also creates more opportunities for investors who understand the details. 

If you're thinking about investing in commercial real estate, here's what you need to know about how value is assessed and why the usual residential methodology doesn't apply. 

1. Net Lettable Area (NLA) drives the value 

In commercial real estate, value starts with determining how much of the space is generating rent. The block size or street frontage is not as important and it comes down to the usable, lettable square metres inside the property. Different areas within a site attract different rents. Office space, workshops, and open yard space each have their own distinct value, depending on location and use. 

For example, 100m² of office might lease at $200/m², while 300m² of warehouse may rent for $150/m², and yard space only $25/m². The combined income from these areas is what determines the property's valuation. 

Importantly, only council-approved space counts. If a mezzanine or office fit-out wasn't approved, valuers won't include it, even if it's leased. That can create a gap between perceived value and real value, especially if the purchase price is based on unapproved space. 

2. Two core valuation methods 

While valuers use multiple tools, two methods dominate in commercial, the Capitalisation (Cap) Rate Method and the Direct Comparison Method. 

The Capitalisation Rate Method is the most common approach for income-producing properties. It values the property based on its rental return: Value = Net Rental Income ÷ Cap Rate. 

So, if the net rental income is $90,000 and the cap rate is 6%, the property's value would be $1.5 million. 

The Direct Comparison Method is more relevant for vacant or short-leased properties. It compares recent sales of similar assets in the same area. 

For most occupied commercial properties, the cap rate method will carry more weight. But investors need to watch out for inflated lease terms, particularly those padded by incentives like rent-free periods or above-market rents. These can artificially boost the perceived value. 

3. The lease has a major impact 

Unlike residential property, where the lease has little bearing on value, the lease in commercial property is everything. Tenant strength, the remaining lease term, and whether the rent is at, above, or below market all impact a property's appeal. 

A tenant with a long trading history, solid financials, and a new five-year lease is highly attractive. In contrast, a property with only a few months left on the lease, or one leased back to the vendor at inflated rates, warrants caution. 

Leasebacks, in particular, can be misleading. A vendor might agree to pay high rent to boost the sale price, but once the lease ends, the real market rent may be much lower. That puts the buyer at risk of overpaying for income that won't last. 

Always investigate any incentives, too. If the tenant received significant rent-free periods or fit-out contributions, that lease income may not reflect the property's true long-term yield. 

4. Fit-for-purpose 

Another major difference in commercial property is how specific a property is to the tenant's needs. On one hand, tailoring the fit-out can increase rent and improve occupancy. On the other hand, over-customising can make it hard to lease once the tenant leaves. 

For example, a mezzanine built inside a warehouse might lift rental income now, but if it reduces ceiling clearance or access, future tenants may walk away. The key is to add improvements that enhance flexibility, not restrict it. 

Smart investors look for balance, including features that meet current needs while still appealing to a broad tenant base in the future. 

Key takeaways

Valuing commercial property is about understanding income, risk, and flexibility, not just physical space. With the right knowledge, commercial property can deliver strong yields, solid capital growth, and better control over your investment. But don't approach it like residential, because in commercial real estate, it's the numbers, not the emotions, that matter.