How to Determine the Security Value for Your Commercial Loan

Security for a loan is an asset put up to guarantee the loan. If the loan is not repaid, the lender may sell the asset to recover its money. The lender will want to ensure that the asset is at least as valuable as the outstanding loan so that if the borrower defaults, the loan can be repaid. However, the loan security value is often not equivalent to the property’s open market value. The purpose of having a loan valuation completed is to establish whether the amount of the loan can be secured against the property’s value and whether, in the event of default, the lender can realistically recoup the amount.

For commercial property loan applications, the valuation of the property plays a crucial role, as banks usually lend a percentage of the property’s value. This value is determined by the bank’s accredited valuer, not by the market value or the contract price.

There are two common approaches used when valuing your property:

Income Approach

The Income Approach values properties based on the net operating income they generate. There are two techniques within the income approach for commercial property valuation: the discounted cash flow (DCF) method and the income capitalization method.

• Discounted Cash Flow Method (DCF): The DCF method values a commercial property by taking all future projected cash flows of the project and discounting them back to time zero (the date of purchase) using a predetermined discount rate. This rate reflects the required rate of return on the property. The DCF method also requires estimating the residual (resale) value of the property at the end of the last discounting period. In general, the DCF method captures cash flow over a period and provides greater flexibility if short-term net cash flow fluctuations are expected, such as large capital expenditure needs and significant changes in lease terms.

• Income Capitalization Method: The Income Capitalization Method is a simpler way to value a commercial property. With this method, the property’s value is determined by capitalizing the current yearly income by the capitalization rate (the expected rate of return for this type of property).

Property Asset Value = Net Annual Rental Income/Capitalization Rate

For example, if a property rents for $80,000 per annum and the rate of return for that type of property is 6.5%, the property value is calculated as follows:

$80,000÷6.5% = $1,230,769

The capitalization method only considers one year’s income, making it ideal for determining the value of stabilized properties, as most commercial properties come with longer lease terms and contracted annual rental reviews.

Direct Comparison Approach

The Direct Comparison Approach is the most straightforward valuation approach. It’s very useful as an error-checking method against other valuation methodologies. This approach analyzes recent sales of comparable properties to determine the value of your property. It considers past sales evidence, including the size, location, zoning, distance to amenities, age, and condition.

This method provides a good idea of what the commercial property is worth, but it isn’t the most reliable because the market is always changing, and every property is unique, with rarely identical conditions.

Value “Subject to Lease” vs. “Vacant Possession Basis”

The valuation of your commercial property would be higher if the existing lease is equivalent to or higher than the “Market Rent” with stable and robust lease terms. If the existing lease is much weaker than the “Market Rent,” it will negatively impact your property valuation. If the property is currently vacant, the valuer may use the “Market Rent” as the benchmark to value your property, with added risk due to tenancy uncertainty.

Determining the value of a security is a complex process that involves multiple methodologies and factors. By understanding and applying these methods, you can make your valuation report more meaningful. Reginsun can assist you in organizing your property valuation for your commercial loan by liaising with accredited valuers to ensure an accurate assessment. Our expertise helps you understand the valuation process. By working closely with you and the valuer, we aim to increase your chances of securing commercial loan approval.

The information provided in this article is factual information only and does not constitute financial advice. Users should seek independent professional advice before making any financial decisions.