Updated: February 18, 2022, 2:58 p.m.
If you’re selling commercial real estate, chances are you’ll need to undergo a commercial real estate appraisal. With that in mind, you might be wondering how this process works. We’ve covered everything you need to know about completing an appraisal on a commercial property. You will learn what a commercial real estate appraisal is, how the process works and what you can do to increase the value of your property.
What is a commercial real estate appraisal?
Just like in residential real estate, a commercial real estate appraisal is an unbiased opinion of the property’s value. However, rather than looking at the value of single-family residences or individual condos, a commercial real estate appraisal is used to determine the value of properties like multi-family dwellings, office buildings, or commercial spaces.
At their most basic, appraisals are used to determine the selling price of a property in the current market, but they are also important for underwriting. Lenders generally do not lend more than an asset is worth, so an appraisal helps these lenders determine how much financing they can safely provide.
An appraisal is also a useful tool from an investment perspective. Before buying the asset, this can give you an idea of how much you should be willing to pay for the asset in the current market. Additionally, once you have the asset in your portfolio, an appraisal can also help you make decisions about what kind of investments or renovations to add to the property.
How is a CRE appraisal different from a residential appraisal?
Although appraisals are used in both commercial and residential real estate, the two processes are practically very different. Property values are calculated in different ways. In residential real estate, appraisers typically use the sale prices of similar properties (coms) to make their decision. Then they add and subtract value based on the unique features and details the property in question has. In contrast, with commercial appraisals, the focus is more on the amount of income the property is capable of generating.
Generally, commercial appraisals tend to take longer than residential appraisals because they are more complex. In short, many residential properties look alike, making it easy to determine their value on a comparison basis. However, many commercial buildings are unique, which means the commercial appraiser will likely need to spend more time determining how different aspects of the property affect its value.
Finally, because commercial real estate appraisals tend to be much more complex than their residential counterparts, they are also much more expensive. While a residential appraisal will typically cost a few hundred dollars, a commercial appraisal can cost a few thousand.
What are the different CRE valuation methods?
In total, there are four different methods a commercial appraiser can use to determine the value of a property.
Although the cost approach is not used very often these days, it can be useful if a building is particularly unique or brand new. The cost approach determines the value of a property by looking at how much it would cost to rebuild it from scratch. This method looks at land, material, and labor costs to determine how much it would cost to construct the same building in today’s market.
Commercial real estate appraisers always use the same formula to determine the value of a property when using the cost approach. It is as follows:
Land cost + construction cost – accumulated depreciation = property value
This method works on the assumption that you would pay no more for a building than it would cost to build it from scratch. However, this method works better with newer buildings. The older a building gets, the more room there is for price differentials. For example, materials may cost more due to inflation, and it may cost more to bring the building up to current building codes.
The income approach is by far the most popular valuation method in commercial real estate. With this commercial valuation method, the appraiser uses common investment calculations, such as net operating income (NOI) and capitalization rate (cap rate), to determine how much income the property should be able to earn. generate in today’s market.
The formula used for the income approach is as follows:
Net operating income (NOI) / cap rate = property value
This is generally considered the most accurate method of property valuation. That said, keep two things in mind. On the one hand, the net operating income recorded on the property’s pro forma must be precise. If it is inaccurate, the assessment will also be inaccurate.
On the other hand, investors will need to find comparable sales cap rates to find a cap rate for this equation. If there aren’t many comparable sales available, it can be difficult to find a cap rate that makes sense, which can also affect valuation accuracy.
Sales Comparison Approach
The sales comparison method is the method most often used in residential real estate. This method uses comparables, or the sales prices of comparable properties, to determine the valuation of the property in question.
However, as mentioned above, while a residential appraiser will usually have plenty of comparables to choose from, commercial appraisers are generally not so lucky. To find a comparable property, the commercial appraiser may have to look well outside the current market area, which can make the appraisal less reliable.
For this reason, it is more common to see individual investors, not commercial appraisers, using the sales comparison approach to determine how much they should bid for a particular property.
Gross Rent Multiplier Approach
Finally, there is a gross rent multiplier approach. Again, this method is more commonly used by individual investors than by a professional valuation practice. Rather, it is a quick and crude method of business valuation.
With this method, you look at comparables to find the average gross rent multiplier for the area where the property in question is located. You should also consult the pro forma of the building to determine the average gross rental income of the property. Once you have these numbers, you can use the following equation to determine the property’s valuation:
Gross rent multiplier x annual income = property valuation
Again, the values you use for the equation must be exact for the property appraisal to be accurate as well.
How to Increase the Value of a Commercial Real Estate Appraisal
The final piece of this puzzle is figuring out how to increase the value of a commercial real estate appraisal. In truth, ratings are somewhat subjective. Each chartered appraiser will have a different opinion of a property’s appraised value. While you can use these suggestions to give the review the best chance of coming out in your favor, there are no guarantees.
Prepare your documents
Usually, after a commercial appraiser comes to view the property, they will do their due diligence and follow up by researching the property itself. They may ask you to provide copies of several important documents, including building plans and site plans, your current rent lists, and any current leases. You can speed up the process – and hopefully increase your rating – by having this information on hand so it’s ready to use when requested.
Track building maintenance and improvements
In general, properties in better condition tend to be assessed for higher values, so do your best to keep up with regular building maintenance. If your building is older, making occasional upgrades to keep it up to date will also help.
Add ways to generate more revenue
Finally, since commercial appraisers are more likely to use the income approach when appraising your property, add ways to generate more income where possible. For example, the owner of an apartment building can add additional revenue opportunities like laundromat, parking, or vending machines.
The bottom line
If you are in the process of selling your commercial property and have accepted an offer from an investor who needs financing, you will likely face an appraisal requirement. Basically, a commercial appraisal is not too different from a residential appraisal. However, there are some things you need to know about the business appraisal process. With this knowledge, you’ll have a better idea of what to expect when it’s time to have your commercial property appraised.