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What is a commercial property appraisal?

A commercial property appraisal is a valuation of a specific commercial property conducted by a professional appraiser.

Commercial property appraisals play a crucial role in the real estate business. They are essential because buyers want an impartial valuation from a trusted appraiser before committing their funds to a deal. Similarly, sellers wish to confirm that they are not getting shortchanged. A fair and unbiased commercial real estate appraisal can provide both parties the assurance they seek.

How does a commercial property appraisal work?

Property buyers and sellers typically request appraisals. However, accurate valuations are essential for several other parties, too. For example, a financial institution providing commercial real estate loans would want to determine the market value of a property proposed by the borrower as collateral.

Mortgage brokers can also depend upon commercial appraisals. If they have a valuation from a licensed commercial property appraiser, they will find it simpler to match buyers with lenders. The list of people interested in knowing the fair market value of a commercial property is extensive.

Appraisers follow a standardized valuation process. They conduct a physical inspection and closely examine various documents and records. Commercial real estate appraisals can also require inquiries about market trends and the property’s income-generating capacity. The person carrying out the appraisal would pay particular attention to many of the following areas:

  • Building plans
  • Site plans
  • Zoning regulations
  • Rental trends in the area
  • Purchase price of similar properties
  • Costs involved in constructing a similar property
  • Vacancies in the area
  • Demographic data
  • Net operating income (NOI) of the property
  • Property inspection report

Types of commercial property appraisals

There are several methods for valuing commercial real estate. This post discusses six. Based on the circumstances and the information available, an appraiser can use any one of them or even a combination to arrive at a property’s fair market value.

Cost approach

The cost approach to commercial real estate valuation asserts that calculating the market value of a property involves adding the cost of the land to the cost of constructing the building and subtracting the accumulated depreciation.

‘Cost approach formula’ image.

This valuation method is suitable for new properties. However, it may be inappropriate if the appraised property is more than several years old, as it can be difficult to accurately calculate the accumulated depreciation figure.

Income approach

The income approach uses a property’s net operating income to determine its market value.

‘Income approach formula’ image.

You need to remember a couple of points about the income approach formula. Firstly, when calculating NOI, deductions are not made for taxes, loan repayments, and capital expenditures.

Understanding the second point will give you an idea of the relationship between cap rates and property values. You would have seen that in the income approach formula, the property’s value is calculated by dividing NOI by the cap rate, while the cap rate is arrived at by dividing the NOI by the property’s value. It follows that the cap rate and the value of a property have an inverse relationship. A lower cap rate will result in a higher property value and vice versa.

The following example will help explain this point:

Formula image explaining the inverse relationship between the value of commercial real estate and its cap rate.

The example shows that an increase in the cap rate from 3% to 6% has decreased property valuation from $2 million to $1 million. Bear in mind that the income approach, also known as the income capitalization method, calculates a property’s value using the income stream it is expected to generate.

Market approach

The market approach to value commercial real estate is simple and easy to use. It is also known as the sales comparison approach, which involves using the sales price of comparable properties to carry out a valuation.

However, this approach has its limitations. Commercial real estate is often unique; getting an accurate “comp” could be difficult. At a time like this, the appraiser would do well to consider one of the other commercial real estate appraisal methods.

Gross rent multiplier approach

The gross rent multiplier approach (GRM) is among the more straightforward commercial real estate valuation methods. The GRM of a property tells you the number of years of gross rent receipts it would take for the property owner to recover the investment made in the property.

Gross rent multiplier approach formula’ image.

To calculate a property’s value using this method, multiply its annual gross rental income by the gross rental multiplier. To arrive at the gross rent multiplier, you need to ascertain the multiplier for similar properties in the area.

The gross rent multiplier approach is similar to the market approach. GRM uses the gross rents for similar properties to arrive at a valuation, while the market approach uses the sales price of similar properties.

Value per door approach

The value per door approach uses the value of a comparable building and divides that sum by the number of units in it to arrive at a per-unit valuation. Appraisers use this method for multi-unit buildings. A multifamily building valued at $10 million with 50 units would have a value per door of $200,000. However, the calculation ignores apartment size, so you must use the value per door approach carefully.

Value per rentable square foot approach

The value per rentable square foot approach is like the value per door approach. However, as the method’s name indicates, it uses the rentable area to arrive at a valuation. In that respect, the value per rentable square foot approach is more accurate than the value per door approach.

The following table summarizes the six different appraisal methods discussed in this section of the post. Remember that these methods can be used for all types of commercial properties:

6 types of commercial real estate appraisal methods

Commercial real estate appraisal method Stand-out features
Cost approach Best used for new properties.
Income approach A popular commercial real estate appraisal method, based on the income the property is expected to generate.
Market approach Based on the sales price of comparable properties.
Gross rent multiplier approach Calculated using the gross rent the property is expected to generate.
Value per door approach A suitable method for multifamily buildings, it has its limitations.
Value per rentable square foot approach Like the value per door approach, but based on rentable square feet instead of units.

Benefits of commercial real estate appraisal

Commercial real estate appraisals play a crucial role in the real estate investment business. Everybody from industry-leading financial intermediaries to mortgage lenders uses appraisals to estimate a property’s fair market value.

The following examples provide instances where appraisals can be of invaluable help:

  • Buyers of commercial properties need them to assure themselves that they are not overpaying.
  • Sellers need to know the market value of their properties.
  • Lenders require valuations to calculate loan-to-value ratios.
  • Valuations are needed for property tax assessments.

Steps that a real estate investor needs to follow

Consider an investor who is planning to buy a new property. The first step would be to identify a lender and review the highlights of the commercial mortgage program. Finding an appraiser and requesting a valuation for the selected property is next. Finally, investors must also check their calculations using a commercial mortgage calculator.

What do appraisers look for in a property?

Experienced appraisers use a wide range of inputs to determine the value of a commercial real estate asset. They look at local market conditions, the price at which similar properties were sold recently, and the condition of the property that is being appraised. An appraiser also studies rental trends in the area. Of course, the rents in the appraised property would also play a key role in its appraisal.

How do you enhance your commercial property’s value?

Property owners must differentiate between factors within their control and those over which they have little influence. You cannot change your property’s location, but you can try to enhance its value. Before the appraisal is done, consider taking some of these steps:

  • If possible, find tenants willing to pay a higher rent.
  • Renovate the property and carry out improvements.
  • Take a close look at operating expenses and economize where you can.
  • Repaint the property and consider improving the lighting fixtures and the HVAC system.

How much does a commercial property appraisal cost?

The cost of a commercial real estate appraisal can vary widely. It depends on several factors, including what the appraisal will be used for, how long the assignment will take, and the property’s features. The cost also depends on the type of report you request. Here are three types of commonly used reports:

  • Restricted use report: These reports contain only basic information. Restricted appraisal reports are generally used by property owners and are not provided to banks or other lending institutions.
  • Summary appraisal report: This contains more information than the restricted use report and typically includes information regarding rentals.
  • Comprehensive appraisal: Financial institutions and law firms require comprehensive commercial appraisals. These can be expensive and contain extensive details about the property.

According to Colliers, a leading provider of commercial real estate services, the cost of an appraisal report could range from $800 to $5,000. However, the best way to estimate the cost is to approach an appraiser and request a quote.

Mistakes to avoid in commercial real estate appraisal

When a property owner is getting an appraisal done, it is essential to provide complete details to the appraiser. Withholding information or furnishing incomplete data is not only wrong, it can also be counterproductive.

The experience of a dentist friend with an extensive real estate portfolio will prove this point. He was acquiring a new real asset and had decided to diversify into the self-storage industry. My friend is a careful investor and knows how to analyze a commercial real estate deal. After extensive market research, he identified a facility and initiated the process of applying for a self-storage acquisition loan. As part of his due diligence, he studied the appraisal report.

That’s when the trouble started.

Upon looking at the report, he saw that the occupancy rates were consistently above 95%. Not convinced with the rates, he asked his brother to visit the facility as a mystery shopper and look around. He found out that many of the storage units were available, and the occupancy rates were definitely not 95%. My friend backed out of the deal immediately.

The self-storage owner lost out because he had provided the appraiser with incorrect information.

Commercial vs residential appraising: Key differences

There are several marked differences between a commercial appraisal and an appraisal of residential property:

Point of difference Key differences between commercial and residential appraisals
Complexity Commercial real estate appraisals are more complex.
Cost Commercial real estate appraisals usually cost more.
Applications Commercial real estate has a wide range of applications, such as office space, industrial, multifamily, retail, etc.
Time The commercial appraisal process typically takes longer than a residential appraisal.

The bottom line

When a prospective investor evaluates a commercial property, the appraisal plays a vital role in the decision-making process. The appraisal can provide information regarding the property’s fair market value, its physical condition, and the income it is expected to generate. It is important to remember that valuations can be arrived at using different techniques, and buyers need to choose an appraisal method that best meets their needs.

Modified Date & Time : 03 Apr 2024, 03:16 pm

Author

Jamie Stadtmauer is the Vice President of Business Development at Agora and has over 20 years of experience in commercial real estate investing.

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