The profit method is the most commonly used approach to determine commercial properties value. This method analyses the profitability of the businesses that occupy a certain building, rather than the value of the building or the land itself.
Property investors do not use this valuation method on residential properties, but for bars, restaurants, hotels, as well as nursing homes.
Despite the financial “facts and figures” practicality of the profits method however, one of the most popular techniques used to value commercial property is still the comparable method.
Comparable Method of Property Valuation
The comparable method of property valuation, is comparing and contrasting the values of similar properties in similar locations in an attempt to establish an approximate value for the property under consideration.
This valuation method is easy to understand and more importantly, appears to work well under most situations. But this valuation method really can only be used if there is sufficient comparable information of a suitable quality readily available, and there are plenty of similar properties to compare it against.
If you do not have sufficient or good quality comparable evidence available, it will be hard for valuers to value the property. If this happens, you may need to use a profit method instead of a comparable method.
The Advantages Of Using Profit Method
This method not only determines the accurate value of a commercial property, it is also a very useful method for investors to better understand the current market rental prices and the overall rental market.
For example, you can use the profit method to calculate a value estimate even though there are no other similar properties that could serve as a benchmark, when unique properties such as theme parks, petrol stations, or casinos become available.
How Does The Profit Method Work?
In order to conduct a commercial property valuation, the building in question should include an operational business, such as a hotel or restaurant.
Do keep in mind that, with this kind of valuation it’s not necessary for the entire property to be occupied by commercial businesses and spaces. The profit method looks at the earnings, profits, and expenses of the commercial property.
So, this method helps to estimate the gross and net profit of a particular business. You will need to use these two basic calculations to find the net profit:
Gross Profit = Gross Earnings – Purchases
Net Profit = Gross Profit – Working Expenses
Gross Earning
Gross earnings are the total yearly revenue the business generates (does not include any costs).
Gross Profit
Gross profit is defined as the final financial figure that is generated after deducting the business purchase costs from the gross earnings figure.
For instance, a hotel would need to prepare food and drinks for clients, so they need to make purchases almost on a daily basis.
Working Expenses
Working expenses are the expenses that occur daily and are integral to the running of a business like telephone, water, gas, and electricity and business rates.
Net Profit
Net profit is the amount that after all expenses and daily outgoings have been deducted from the gross earnings.
The final figure is important to investors, as it tells them whether an investment, purchase or development of a particular commercial property is actually worth it.
Additionally, most of the property investors not only use this method to determine the value of the commercial property, but also to calculate the amount of rent they should be asking from businesses.
Essentially, the present day rental value of a commercial property is dependent on both the present and the future trading potential of a particular property.
On the other hand, the present-day value of a property is also dependent on the anticipation of future rental income.
Calculating The Rental Cost Using The Profit Method
In general, the basic method to arrive at the rental price for a commercial property is by dividing the net profit in half in order to provide the tenants of the commercial property in question with an income that will help them to sufficiently cover their operational expenses, while still able to pay a rental amount that fits into the open rental market.
Moreover, some property investors also look at the potential return on investment (ROI), since their main income is generated through the rent of commercial units in the property.
For example:
Cost to purchase the commercial property = RM400,000
Renovation cost = RM100,000
Total cost = RM400,000 + RM100,000 = RM500,000
Rental income = RM8,000 monthly (RM96,000 annually)
Expenses (water, tax, insurance, etc.) = RM2,000 monthly (RM24,000 annually)
Annual return = Rental income – expenses (RM96,000 – RM24,000) = RM72,000
ROI = Annual return ÷ Total cost (RM72,000 ÷ RM500,000) = 0.144 or 14.4%
It is simple, the above amount shows us that the annual ROI for a commercial property that costs around RM500,000 and brings in an annual return of RM72,000 is 14.4%.
But, when you see this figure, do not be too happy too soon, this is a very simple calculation and has not taken any potential loan interests, inflation rates, as well as other economic factors into consideration.
Conclusion, property investors can use these basic calculations to determine the worth of a potential commercial property investment.
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