What is involved in a commercial real estate appraisal?

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Ask a Lender
September 21, 2017


Key Points

The factors that go into a commercial real estate appraisal

  • Appraisals and assessments are different. An appraisal is a more accurate way of establishing the fair market value of a property.
  • Appraisals go much deeper than a simple inspection, and may last several weeks, as the appraiser researches comparable properties and other information.
  • Commercial real estate appraisals often cost between $2,000 and $5,000, but can be more expensive for more complex properties.
  • Appraisers may use different methods to determine property value, including sales-comparison, cost and income-capitalization approaches.

An appraisal is often a helpful tool when buying or selling a home. The same is true if you’re a business owner looking to buy or sell a piece of commercial real estate.

Before getting started with a commercial appraisal, you should understand the difference between appraisals and assessments. Local governments, like cities and counties, use assessments on a regular basis for the purpose of levying taxes on properties within their jurisdiction. Assessors may not be licensed appraisers. They likely haven’t seen most of the properties they’re assigning values to and, consequently, aren’t aware of any recent improvements or needed repairs.

Appraisals can be ordered at any given time to determine the current market value and a fair sales price for a property. Appraisers must be licensed and skilled at evaluating market data, and they typically use comparable-property data that has been compiled within 12 months of the appraisal date of the subject property. They compare data on properties of similar style, size and location to establish the appraised value.

What you should know

Whether your lender requires an appraisal before approving a commercial loan, or you’re initiating the process on your own, there are several key details to keep in mind. First, a property inspection is only a small part of the appraisal process. An inspection may take a few hours, but the entire appraisal could last several days or weeks.

Appraisers must verify information, so don’t attempt to misrepresent facts or withhold information. The appraiser will likely discover the truth during their investigation, and they may even ask you questions they already know the answers to — just to determine your trustworthiness. Appraisers are bound to a strict code of ethics that helps them develop unbiased reports.

Also, make sure your appraiser knows which type of report they should prepare. Restricted-use reports are solely for a client’s use and can be compiled quickly. Summary reports include more detailed findings and are useful for other parties, such as a seller or lender. Self-contained reports fully describe the data, reasoning and conclusions that an appraiser reached. Generally, the more detailed the report, the more expensive the appraisal will be. Costs are generally between $2,000 and $5,000, but can go up to $10,000 or more on larger properties.

During the process, an appraiser might ask you to present a variety of legal documents related to the commercial property. These can include leases and rent rolls, income and operating statements, property-tax bills, title reports, and diagrams and original drawings of the building.

Appraisals can be used for a variety of purposes. They can help two parties determine an acceptable sales price or support lease negotiations, support mortgage underwriting tasks, assess the value of construction and renovation projects, and even inform zoning boards or courts about the effects of a commercial project.

How appraisals work

Commercial real estate appraisals are conducted on a variety of property types, which may include apartment buildings, hotels and resorts, office buildings, raw land, restaurants, shopping centers and more. There are three accepted approaches to the appraisal process:

Sales-comparison approach

Also known as the market-data approach, the sales-comparison approach is commonly used in tandem with single-family homes and land. The value of the subject property is derived through the use of “comparables,” or recently sold properties in the same area. In order to be valid, the comparables should be as similar as possible to the subject property.

According to the Appraisal Institute, a property should be evaluated with its “highest and best use” in mind. This is applicable whether the property is vacant or improved. Sometimes, the most valuable use for a property is different from the existing use.

To implement the sales-comparison approach, an appraiser must describe the attributes that are relevant toward calculating value. With income-producing properties like commercial buildings, appraisals should be calculated using square-foot formulas that take gross-rental income and vacancy rates into consideration. But appraisers should use their judgment, since no two properties are identical and some comparables will carry more weight when measured against the subject property.

Cost approach

This approach is used infrequently, but is useful in estimating the value of properties that have been improved by one or more buildings. Each building and the land itself receives a separate estimate, with depreciation taken into account, and those estimates are then added together to determine the total property value.

The cost approach assumes that a reasonable buyer would not pay more for an existing improved property than they would to buy a comparable lot and construct a similar building. This method can help appraisers when dealing with properties that may not have comparables or do not produce income, such as churches, government buildings, hospitals and schools.

Depreciation can occur through physical deterioration; functional obsolescence in terms of physical features that are no longer desirable by a property owner; and economic obsolescence caused by location, such as being near an airport or waste site. The reasons for depreciation may or may not be fixable.

Income-capitalization approach

This approach is based on the desired rate of return — how quickly and how much an initial investment earns — and a property’s expected income after expenses. This method is often used to appraise income-producing properties such as multifamily apartment complexes, office buildings and shopping centers. These types of appraisals are efficient when the subject property is expected to generate future income and when its expenses are predictable and steady.

To implement this approach, an appraiser will estimate the property’s potential annual gross income, factoring vacancy and rent-collection losses into the equation; and deduct operating expenses to find net operating income (NOI). Then the appraiser will estimate the property’s rate of return, or capitalization rate, which is an indication of what an investor might pay to acquire the property. The cap rate can then be applied to the NOI to estimate the property’s value.

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