Commercial Real Estate Appraisal: What It Is & How It Works

If you are considering investing in commercial real estate, you will likely need an appraisal done as part of the investment process. Appraisals are essential for determining the value of a property and making an informed decision about your investments. For that reason, it’s important to understand the commercial appraisal process, methods and benefits of appraisals, and how they’re used. 

What Is a Commercial Real Estate Appraisal?

A commercial real estate appraisal is an objective assessment of the value of a property. The process involves collecting and analyzing market data, conducting site inspections to assess the condition of the property, researching comparable sales in similar markets, and ultimately calculating an estimated fair market value (FMV) for a property at the time of the appraisal. The appraiser’s opinion is based on their experience and expertise as well as available market data at the time of their report.

Commercial appraisals are conducted for a number of reasons. If a property is being purchased or refinanced, for example, a lender may require an appraisal in order to determine the value of the property as collateral for a loan. An insurer may also seek an appraisal if it’s unsure of the value of a property at a point in time. Lastly, if one or more properties are being bought or sold as part of a portfolio, appraisals may help investors reasonably estimate the market value of those properties.

How Does a Commercial Real Estate Appraisal Work?

To begin the appraisal process, an appraiser researches the subject property. This research typically includes a physical inspection of the property’s condition, a review of zoning regulations and other legal documents associated with the property, and an inquiry into comparable sales in similar markets. Depending on the type of appraisal, an appraiser may also use land surveys and aerial photographs to assess the property’s features.

Once an appraiser has reviewed the subject property, they review regional and national market data to estimate a fair market value for the subject property. This estimated value is typically expressed as a range that reflects potential future changes in market conditions or the potential for errors due to uncertain variables. After this initial analysis, the appraiser can make adjustments based on factors such as inflation, current economic trends, or other relevant information. The purpose of these adjustments is to arrive at an appropriate FMV for the property.

The appraiser’s final report will include a complete description of the subject property alongside supporting documentation like sales comparables and market data used to form the appraisal. This report can then be used by lenders, buyers, or other parties to a transaction involving the property.

Why Commercial Real Estate Appraisal Is Important

Commercial real estate appraisal is an important step in any commercial property transaction that helps ensure the parties involved have a clear understanding of the market value of a property. It also allows lenders to protect their interests by providing an accurate assessment of the collateral securing a loan. Additionally, buyers can use this information to make informed decisions when making offers on properties or negotiating a purchase price.

Overall, commercial real estate appraisal provides essential data that helps buyers, sellers, lenders, and insurers confidently understand and agree upon the FMV of a property before closing sales or financing transactions.

Commercial Real Estate Appraisal Methods

Commercial real estate appraisals are a vital part of any real estate transaction, as they provide independent and objective estimates of value for the subject property. That said, there are several different methods used to arrive at a commercial real estate appraisal. 

These are the most common commercial real estate appraisal methods:

Market/sales comparison approach

The market approach—also called the sales comparison approach—is based on the assumption that buyers in a given market will pay similar prices for similar properties. The appraiser analyzes recent sales of comparable properties and makes adjustments to account for differences between the subject property and these comparables based on factors such as age, condition, size, and amenities. 

This method can be most effective when there are many active transactions in the same area or type of property, as it provides more reliable data points for comparison.

Income capitalization approach

The income capitalization approach is used when estimating rental income from a given property. This method assesses net operating income to estimate a commercial property’s value. 

Under the income capitalization method, an investor or appraiser looks at the net income projected for a property over a year (revenue minus fixed costs such as insurance, taxes, and utilities). The appraiser then divides that number by prevailing market yields—as a percentage—for similar properties (a “cap rate”). The resulting number is the estimated value of the property at the current time based on projected income.

Cost approach

The cost approach to appraising essentially calculates the total cost that an investor would incur to recreate a property as it sits at the time of appraisal. This method considers the existing land value, the replacement cost of the building and site improvements, and depreciation costs to determine an estimated value for the property. 

It is particularly helpful for insurers, as they are primarily concerned with the costs of repairing or replacing a property in the event of a claim rather than how much a property may sell for in a given market.

Gross rent multiplier approach

Gross rent multiplier is an informal approach to appraising commercial property. This method estimates a property’s value by dividing the total rentable space by the total gross income of the property, providing an estimate of value based on current market rents. While the resulting figure is of little use to lenders or insurers, it can be helpful to investors when comparing the relative investment value of multiple properties in a particular area.

Value-per-door approach

The value-per-door approach estimates the value of multi-family properties or hotels by calculating the price per unit or room. The process is based on the assumption that similar units will sell for similar prices, and it can be used to compare different properties in the same area or type. Like the gross rent multiplier, it is comparatively less helpful for lenders or insurers.

Price-per-rentable-square-foot approach

The price-per-rentable-square-foot approach is similar to the value-per-door approach and can also be used to establish an objective basis for comparing properties. The appraiser estimates a property’s value by dividing the total gross income of the property by the total rentable space. While this method isn’t terribly useful for lenders or insurers, it is good for investors in major markets with active real estate markets and established per-square-foot (PSF) valuations.

The accuracy and reliability of commercial real estate appraisals depend on the appraiser’s experience and expertise in performing these valuation methods. It is important that the appraisal be completed by an experienced professional who understands local market conditions as well as all applicable regulations related to the process.

How to Increase Commercial Real Estate Appraisal Value

Following these tips can help ensure that the commercial real estate appraisal process provides an accurate assessment of the subject property—and also help owners maximize the appraised value of their property. 

  • Make sure the subject property is well-maintained and adequately equipped with modern amenities.
  • Perform any necessary repairs or upgrades to improve the condition of the building and its value.
  • Research recent sales of similar properties in the area to better understand potential values for the subject property. 
  • Utilize data from the local rental market to ensure income generated from the property is consistent with market rates.
  • Stay current on local and regional market trends that may affect the value of the property being appraised.

Residential vs. Commercial Real Estate Appraisals

Although the appraisal processes for residential and commercial properties are similar, there are some key differences. First, commercial real estate appraisals are typically more complex than residential appraisals and require a greater understanding of business operations and local market conditions.

Additionally—and more importantly—the appraisal methods for commercial properties are more numerous. For instance, the cost approach and income capitalization approach are often used in commercial appraisals. In contrast, the sales comparison approach is typically the only appraisal method used for residential property transactions. 

Lastly, commercial appraisals often consider local zoning regulations and other items. While these things are typically unimportant in residential appraisals, they can be significant in determining the value of a commercial property.

Bottom Line

Commercial real estate appraisals play an essential role in any transaction involving commercial properties, providing reliable evidence of fair market value that can be used by lenders, buyers, or other parties involved in a transaction. With accurate data provided through this process, those involved in a transaction can move forward with confidence knowing that they have an accurate understanding of the subject property’s value.

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