In a commercial real estate purchase/sale transaction, buyers and sellers often have opposing viewpoints on the value of the property. The buyer wants to pay as little as possible and the seller wants the price to be as high as possible. To determine a “fair market value” a third party – the appraiser – is called upon to perform a significant amount of market research and come back with an independent value that can be relied upon by both the buyer and seller (and others) in the transaction. This value is described in a report known as an “appraisal.”
In this article, we are going to describe what an appraisal is and the elements that are evaluated to arrive at a value. By the end, readers will have an advanced knowledge of commercial appraisals and will be able to use it when negotiating an investment, purchase, or sale of a commercial property.
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What is a Commercial Appraisal?
A commercial appraisal is an independent assessment of value for a commercial property. Examples of commercial property types include things like: land, office buildings, multifamily apartment buildings, retail centers, and industrial warehouses.
Commercial appraisals are performed by an “appraiser” who goes through a significant amount of training to learn the rules and practices required to complete an appraisal report.
When Appraisals Necessary for Commercial Real Estate
A commercial appraisal may be commissioned by anyone, but it is typically relied upon by a lender to ensure the property’s value can support a loan and by both a buyer and seller to ensure that a fair price is being paid for a property. If the value does not come back at or near the expected result, it can sink a deal.
A commercial appraisal may also be relied upon by commercial real estate investors to ensure that a property is being correctly being valued before deploying capital into it.
For these reasons, commercial appraisals are a critical part of the purchase, sale, and investment due diligence processes so it is important that individuals understand the key pieces of information that they contain.
How Do Commercial Appraisals Differ From Residential Appraisals?
While the goal of both residential and commercial appraisals is the same – to establish a current market valuation – the method used to establish value is very different.
As a general rule, residential appraisals rely on the sales of comparable properties in the same real estate market to approximate value. For example, if property A sold for $100 PSF, property B sold for $125 PSF, and property C sold for $115 PSF, an appraiser may take a composite average of the three prices and make adjustments for differences between the comparables and the property being appraised. Once complete, they arrive at a value.
Commercial properties are usually valued based on the amount of income they produce. So, instead of looking at comparable sales alone, a commercial property appraiser is likely to look at the amount of income a property produces, the operating expenses needed to keep the property running, and the resulting net operating income. The appraiser applies a “capitalization rate” or “cap rate” to the NOI to arrive at a final valuation.
Commercial Appraisal Methods
The description of a commercial appraisal above is just one of three methods used by commercial appraisers to value a property. Each is described in this section.
Method #1: The Cost Approach
The cost approach assumes that the price a buyer would be willing to pay for a property is equal to the cost it would take to build an equivalent property. So, to arrive at a value, the appraiser takes a detailed look at the methods and materials used to construct an investment property and estimates the cost (using market knowledge and widely available databases) to reproduce it.
The cost approach tends to be most effective for new properties because, theoretically, the reproduction cost should be very similar. It is less effective for older properties, or those that have some unique feature that would be difficult to reproduce because the cost of materials could have risen to a point that it isn’t really economically feasible to build a property. For example, imagine trying to rebuild one of those pre-war apartment buildings in New York, the limestone facades and columns alone would be astronomically expensive in today’s dollars.
Method #2: The Income Approach
The income approach is the one described above. With it, the value of a property is driven by the amount of income that it generates. To estimate this, the appraiser will review things like historical financial statements, current rent rolls, leases, operating expenses (like insurance, depreciation, and property taxes), and market conditions to estimate the amount of cash flow that a property produces. Then, they apply a market cap rate to the NOI to arrive at the property valuation.
For example, suppose that a property produces $250,000 in rental income and has $125,000 in operating expenses. The resulting NOI is $125,000. If the appraiser applies a 7% cap rate to this income, the resulting value is ($125,000/7%) $1.78MM.
The main benefit of the income approach is that it can be used across property types, is relatively simple, and can be done fairly quickly. The downside is that it can be difficult to rely on the accuracy of historical financials, and it may require assumptions about things like rent/expense growth and vacancy rates.
Despite the drawbacks, the income approach tends to be the most widely used and accepted in real estate circles.
Method #3: The Sales Comparison Approach
The logic behind the sales comparison approach is that a real estate property’s value is derived from the sales of comparable properties in the same market.
The benefit of the sales comparison approach is that it is reflective of market conditions. But, the downside is that there are wide variations in commercial properties, which can make it difficult to find one that is truly comparable. Even if two properties were identical, the quality of their tenants, zoning, and the length of their leases could lead to variations in value.
The sales comparison approach tends to me more heavily relied upon in a residential real estate transaction, even if it is still calculated for a commercial real estate investment.
Types of Commercial Appraisal Reports
The result of the appraiser’s valuation analysis is compiled into a report, which is provided to the party who commissions it (usually a lender, but potentially investors, borrowers, buyers, or sellers). There are three types.
Report Type #1: Self-Contained Report
A self-contained commercial appraisal report is one that contains all of the data and analysis used to determine the value of the property. All of the relevant information is contained within the report and there are minimal references to data outside the contents of the report itself.
Report Type #2: The Summary Report
A summary real estate valuation report is exactly what it sounds like. It is a report that summarizes the methods and data used to arrive at a property value. Since it is only a summary, it is likely that the details of the appraiser’s analysis are held in a separate file.
Report Type #3: Restricted Use Report
Again, a restricted use report is exactly what it sounds like. It is the shortest and least expensive type of appraisal report, and its use is restricted to the client who commissioned it. A restricted use report only provides the conclusions of the appraisal and all other data and analysis is contained in a separate file.
Overlooked Aspects of CRE Appraisal Reports
While appraisals are thorough and detailed, it may be common for investors to overlook certain aspects of them. Two of the most common are described below.
The date matters a lot when reviewing a commercial appraisal. It can be easy to assume that any appraisal is as of the date for which it was performed, but this is not always the case. There are three potential dates for which an appraisal could be performed.
- The appraisal could be as of the actual date of the inspection
- It could be as of a past date
- Or, it could be as of a future date. This is most common in construction when a property is valued “as complete”, which could be 12 or more months into the future.
The point is, investors must pay close attention to the date of the appraisal to ensure they fully understand the value.
Perform Your Own Review
A commercial appraiser is a professional with a significant amount of training in their field. But, it can be possible for them to make mistakes. For this reason, investors must not overlook the fact that they should perform their own review of the appraisal once received.
If there is a disagreement over the methodology, approach, or data used, it is possible to register a disagreement with the appraiser who may or may not make an update to the final report. They have the final say.
Summary of Commercial Appraisals
A commercial appraisal is a report, usually commissioned by a property owner, lender, investor, or seller, that uses a defined methodology to provide an independent assessment of value for a commercial property.
As a general rule, commercial appraisals differ from those for residential properties because they rely heavily on the amount of income a property generates versus the comparable sales of similar properties in the neighborhood.
A typical commercial appraisal uses up to three valuation methods. The cost approach arrives at a value based on how much it would cost to build a similar property. The income approach looks at the income stream produced by the property and the sales comparison approach looks at the sales prices of similar properties in the same market.
The results of the appraisal process are described in the appraisal report of which there are three types: (1) a self-contained report; (2) a summary report; and (3) a restricted use report
When reviewing an appraisal for a commercial rental property, investors should pay close attention to the date for which the appraisal is created and to the data used by the appraiser to determine value. If there is a mistake, it should be addressed with the appraiser.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.