The profits method of property valuation is typically applied to commercial property valuations where the major value component is driven by the profitability of the businesses that occupy the buildings and not simply the land or buildings themselves. Situations where the profits method of valuation would be appropriate include hotels, guest houses, pubs and cinemas.
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.
Before we take a detailed look at the profits method of valuation we’ll quickly review the popular comparable method to see how they compare and where they are applicable.
Comparable Method of Property Valuation
The comparable method of property valuation, put simply is all about comparing and contrasting the values of similar properties in similar locations in an attempt to establish an approximate value for the property under consideration.
The comparable method of commercial property valuation is recognised as being straight forward to apply and easy to understand and more importantly, appears to work well under most situations.
There are of course other factors that must be taken into consideration when using the comparable valuation method, but generally that is how it works.
When is the Comparable Valuation Method not Appropriate?
Before we look at how the profits method of valuation works, it is worth reviewing the circ*mstances under which the comparable method may not be appropriate for commercial property valuation.
The comparable approach to property valuation can really 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.
In some instances, there just isn’t sufficient or good quality comparable evidence available which can cause valuers problems.
A unique one-off property for instance, or a property that has lots of unusual or unique characteristics would make it difficult for a valuation surveyor to use this method as there are unlikely to be any comparable transactions that they can use to compare property values.
If this scenario applies to your commercial property, the profits based valuation method may be more appropriate.
Valuing Commercial Property using the Profits Method
If you cannot generate enough comparable information to reliably determine the value of a commercial property, or it is unsuitable in some way, then valuing the property using the profits method can be used to overcome these limitations.
To be able to use the profits method however, the property itself must have an operational business currently running from within it.
Commercial properties such as hotels, guest houses, pubs and cinemas are typical examples where the profits method of property valuation is suitable.
Even though the profits method is sometimes overshadowed by the comparable method, there are many property investors and valuation surveyors that prefer the profits based approach.
This is primarily because even if properties are very similar in appearance, size, quality of construction, and are in the same locality, there are still many factors that mean they may have differing profit generating characteristics.
How to Calculate Property Values using the Profits Method
In terms of how to calculate commercial property values using the profits method, you need to first establish the key financials derived from the occupying business.
Analysing Financial Accounts for the Occupying Business
The first stage in the profits method valuation process is to obtain the financial accounts for the business for the last 3 to 4 years as a minimum, and these then need to be carefully examined.
These accounts for the business should ideally be accurate and reliable allowing any investor or property valuer to quickly identify the financial stature of the business both currently and historically.
Evidence that a suitably qualified accountant has been engaged to prepare and audit the business accounts is also a very good, reassuring signal.
Calculating Property Values Using the Profits Method
When using the profits method it is always useful to bear in mind the following simple calculations:
Gross Profit = Gross Earnings – Purchases
Net Profit = Gross Profit – Working Expenses
It may sound difficult at first, but this approach is actually pretty straight forward.
However, if you don’t feel confident enough to calculate the figures yourself we certainly recommend you engage the services of a suitably qualified and experienced property valuer or chartered valuation surveyor.
What are Gross Earnings?
We’ll start with gross earnings… gross earnings represents the total yearly revenue the business generates.
This gross earnings figure does not include for any costs however, it is simply the money that the business generates without taking anything else into account.
What is Gross Profit?
Gross profit is often confused with gross earnings as it sounds pretty similar.
Yet gross profit is defined as the final financial figure that is generated after taking away the business purchase costs from the gross earnings figure.
Purchases for those that don’t know are the materials that need to be bought in order for the business to exist and perform its day to day activities.
A pub for instance, would need to make food and drinks purchases almost on daily basis… without them they would have nothing to sell!
Working expenses and net profit are the two final financial factors that you should carefully understand.
What are Working Expenses?
Working expenses are just that… they are the expenses that occur daily and are integral to the running of a business.
Working expenses can include telephone, water, gas, and electricity and business rates for instance.What is Net Profit?
Finally, net profit is the final financial figure, and for many investors it is the most important one to bear in mind.
After all expenses and daily outgoings have been deducted from the gross earnings, the net profit figure will importantly show you what is left… this will reveal how profitable the business really is.
Basically, the net profit figure will give you a good idea of the kind of true profit you can expect to make from the business (hotel, guest house, pub etc.), which coupled with your own judgement, research and investment appraisal should be enough for you to make an accurate investment decision.
Calculating Rents Based on Business Profits
From a property rental perspective, if you want to determine the annual rent that could be achieved, as a very rough guide you would normally divide the net profit in half to establish a near accurate figure.
The net profit has to be divided into half because there are two figures that are important.
The first one is the tenants share figure… this half is for the tenants work and the general running of the business, whereas the other half will then be the annual rent payable.
Example – Calculating Annual Rents
Information collected from audited business financials for the year:
Gross earnings for the business are £475,000
Business purchases are £190,000
Expenses for the business are £120,000
Calculations:
Gross Profit = £475,000 – £190,000 = £285,000
Net Profit = £285,000 – £120,000 = £165,000
Annual Rent = 50% of £165,000 (Net Profit) = £82,500
Always bear in mind however, that when trying to determine the net profit, you should exclude any tenants wages from your valuation.
This figure will be considered at a later stage, and shouldn’t be included at this point.
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