Commercial Real Estate Appraisal – Everything You Need to Know

This Assets America Guide® provides buyers and sellers of commercial real estate with the ultimate resource on commercial real estate appraisals.  Specifically, we’ll delve into exactly what commercial real estate appraisers do, as well as the cost and accuracy their work.  In addition, we’ll offer useful advice to CRE buyers and sellers, including how to find commercial real estate appraisers.

What Does A Commercial Real Estate Appraiser Do?

If you are new to commercial real estate appraisal services, this section will provide you with a solid introduction.

What is a Commercial Real Estate Appraisal?

A commercial real estate appraisal is an assessment of the value of any type of CRE property.  Importantly, the term “commercial property valuation” refers to the same process.  A commercial real estate appraisal occurs for a variety of reasons:

  • Helping buyers and sellers decide on the prices they will bid or offer.
  • Giving an underwriter the basis for sizing a loan offer.
  • Disputing tax assessments.
  • Supporting lease negotiations.
  • Knowing the value of property that is part of a business dissolution.
  • Updating the fair market value of a property.
  • Supporting the price paid by governments when they seize properties under eminent domain law.
  • Calculating inheritance taxes.
  • Supporting feasibility studies for reconstruction and renovation projects.
  • Estimating value for a foreclosure auction.
  • Helping owners decide whether or not it’s time to sell a property.
  • Helping courts and zoning boards understand the impact of proposed actions.

Video:  Appraisal Best Practices in Commercial Real Estate

The Overall Commercial Real Estate Appraisal Process

Commercial real estate appraisers must be skilled at evaluating a wide variety of property types.  That means, at a high level, the commercial real estate appraiser must:

  1. Understand the property’s intended use, its relevant characteristics and whether it is under assignment to third parties.
  2. Scope out the work, including the type of information and analysis required.
  3. Assess key factors, including utility, desire, scarcity and effective purchasing power. 
  4. Form an opinion about the property’s value.
  5. Write an appraisal report.

This process can last anywhere from a few days to a 8 weeks or longer in some instances.  This is due to the time needed for inspection and follow-up investigation. 

Approaches Used for Commercial Real Estate Appraisal

Commercial real estate appraisers can use any of several approaches to value a property.  Doubtlessly, all use specific data about the property, including its location.  Here are the three main approaches that providers of commercial real estate appraisals services use:

Income Capitalization Approach

This method uses income to deduce value.  Naturally, it’s limited to income-producing properties.  Luckily, you use the property’s cap rate (it’s required return), as suggested by its previous history or from comparative properties.  Thus, the value of the property is set equal to its net operating income (NOI) divided by the cap rate. 

For example, if an office building has a 10% cap rate and earns $1 million NOI per year, its value is $1 million/10% = $10 million.  To their credit, appraisers must take several factors into account when assigning a cap rate.  This includes the property’s age, and the diversity and creditworthiness of its tenants.  Other factors include length of existing tenant leases, payback period, supply/demand fundamentals in the location, and economic factors for the region (population growth, employment growth, etc.).  Commercial real estate appraisers commonly use this approach for office buildings, shopping centers and apartment buildings.  This is because these properties can generate strong earnings.

Cost Approach

In the cost approach, commercial real estate appraisers calculate the cost to construct a building from scratch (aka: ground-up construction).  To clarify, if the building already exists, the appraiser uses the cost of constructing a replica of the building.  To calculate, the market price of the building is set equal to the cost of the land and the cost of construction, minus depreciation.  Happily, this approach is most accurate for new properties.  It assumes that comparable vacant land is available and that similar building materials exist.  Unfortunately, one drawback of using this approach on existing properties is that it’s hard to assume a similar building site. 

Also, it’s questionable whether you can assume equivalent costs when “rebuilding” a replica property.  Not surprisingly, that’s why commercial real estate appraisers limit this approach to new properties and to unique ones lacking comparables.  As you’d expect, appraisers often combine this approach with income capitalization approach when they must adjust the property’s value.  Adjustments arise due to factors concerning the property’s design, construction, grade of materials and functional utility. 

Sale Comparison/Market Approach

This approach emphasizes the price of recently-sold comparable properties.  To that end, it forms the basis of Comparative Market Analysis.  In a CMA, the appraiser looks at both recently-sold and currently listed comparables.  Realistically, commercial real estate appraisers assume that a buyer will not overpay for a property if a comparable one is available for less.  A commercial real estate appraisal accounts for any property differences in size, condition, location and floor plan.  This is done to gauge how closely two properties compare with each other.  To be sure, this approach has the virtue of using current market values of comparable properties.

In reality, commercial real estate appraisers often combine all three approaches when evaluating a property.  However, they may weight their findings utilizing results from the approach that is most appropriate to the specific property type.

How Accurate Are Commercial Real Estate Appraisals?

A study by Cannon and Cole found that commercial real estate appraisals are, on average, greater than 12% above or below the subsequent property sales price.  However, when looking at portfolios of properties, the appraisals showed only a 4% to 5% average discrepancy.  This is due to offsetting positive and negative differences.  Furthermore, the authors also found a lag factor.  This lag factor illustrates that appraisals fell below sale prices in hot markets and above sale prices in cold markets.

Video:  Factors that Cause Differing Results in Commercial Real Estate Appraisal

 

Obviously, there are excellent and not so excellent commercial real estate appraisers.  To no one’s surprise, the good ones provide the most accurate appraisals.  This means that their appraisals closely predict a property’s actual sale price.  To that end, here are four factors that you can use to evaluate a commercial real estate appraiser:

Bona Fides

Good appraisers are honest, fully credentialed, and have at least 5 to 10 years of experience in the geographic area of interest.  Moreover, the appraiser should be a Member of the Appraisal Institute (MAI).  This means that they have years of additional education and experience beyond state requirements.  Most high-end, commercial financing above $5 million requires an MAI appraisal.  Naturally, appraisers should avoid bias and must certify that they have no personal interest in the property they evaluate.

Transparency

Appraisal reports should highlight any extraordinary or hypothetical assumptions the appraiser made when valuing a property.  In addition, appraisers should disclose whether they did anything out of the ordinary or that varied from normal practice.

Highest and Best Use

This is a standard that emphasizes the property’s highest return or value.  In that vein, appraisers evaluate the reasonable, legal, financially feasible and physically possible uses of the property.  This is done to find the property’s highest and best use.  Interestingly, the resulting property value can substantially differ from the “as-is” value.

Appropriateness

The appraisal report should support the aims of the requestor, whether it’s the buyer, seller or lender.  Also, appropriateness means that the commercial real estate appraisal reflects just the right level and depth of research and analysis.

Typical Cost of Appraisals

The cost of a commercial real estate appraisal depends on the size, cost and complexity of the subject property.  For example, a $1 million commercial property might require a $4,000 appraisal.  On the other hand, a really large, more complex CRE project might necessitate an appraisal that costs more than $10,000.

How to Find Quality Real Estate Appraisal Companies

A good place to start is to check appraisers who are MAIs by contacting the appropriate Appraisal Institute chapter.  In addition, your loan broker should be able to recommend a high-quality provider of commercial real estate appraisal services.  We at Assets America® will be happy to discuss your requirements in this regard.

Advice for Buyers

It’s important that buyers insist upon commercial real estate appraisers who are very familiar with the property type and the neighborhood.  The reason is that sellers might overprice their properties in the hopes that this will influence the appraiser.  But this is unlikely if the appraiser is competent, unbiased and familiar with the region.  For obvious reasons, we recommend that you do not use an appraiser recommended by the seller.  This of course is due to the potential conflict of interest.  A bank can’t accept appraisals ordered by the borrower or loan broker.  An institutional financing source must order the appraisal directly.  However, commercial loan brokers who work with private lenders have no such restriction.

Advice for Sellers

Sellers should not make assumptions about the appraisal outcome.  Rather, they should wait until the commercial real estate appraiser complete his report.  Unfortunately, you might encounter numbers with which you disagree.  Nonetheless, be prepared to work with those numbers if the appraiser backs them up with sufficient and relevant data.  Of course, all sellers should exhibit patience, because it often takes longer than you ‘d think to sell a property.

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