If you’re buying or selling a commercial building, you will most likely come across or require a commercial real estate appraisal. Like with residential real estate, an appraisal is an impartial, third-party opinion that helps determine the value of a property.
Instead of evaluating the value of a single-family home or condo unit, commercial appraisers provide a calculated valuation of retail spaces, office buildings, hotels or multifamily housing complexes. CRE appraisals are needed for any property that’s being developed, insured, taxed, mortgaged or sold. For a commercial appraisal to be recognized as a legal document, the valuation must be performed by a licensed appraiser.
These reports provide useful information for anyone who owns, manages, sells, lends or invests in commercial buildings. Investors can also benefit from the valuation because it provides a good idea of how much sponsors should pay for the property in the current market, and whether it’s worth renovating.
Here’s how the commercial real estate appraisal process works, and why it’s important.
What Is a Commercial Real Estate Appraisal?
“A CRE appraisal is basically an opinion of value by a person with experience and knowledge of commercial real estate,” explained Stephen Bullock, a commercial real estate appraiser in Windham, New Hampshire.
With commercial real estate appraisals, property values are calculated differently than with residential units, where comparable sale prices and home features are used to determine how much a property is worth. CRE appraisals are more complex because each building is unique, so appraisers need to figure out how much income a property can generate by examining how various aspects affect its value.
Investors sometimes confuse appraisals with inspections, but they’re two completely different procedures, Bullock added.
“An appraiser focuses on the value influencing factors that go into estimating the value of the property, while building inspectors do a much more detailed physical inspection where they’re looking for termites or water mold behind the walls, for example,” he said. “If the appraiser is provided with an inspection report, and it has information that influences value, that’s definitely very useful.”
What Is a Commercial Real Estate Appraisal Used For?
While these valuations are mainly important to determine what a property will likely sell for in today’s market or phase of the real estate cycle, they’re also used by several parties involved in a commercial real estate transaction, Bullock noted.
- By lenders, to establish a value of security for a mortgage, to ensure they make prudent loans and don’t over-lend, or to keep their loan-to-value ratios reasonable.
- By property owners planning to sell in the near future, to get acceptable selling prices.
- By prospective buyers, who want a value estimate before signing a purchase agreement, to make sure they’re not overpaying.
- For property tax assessment purposes, when an owner feels their property has been over-assessed by the municipality and wants to appeal it. An appraisal can be used as leverage to challenge an assessment and get property taxes lowered.
- For legal situations, such as dividing assets in divorce proceedings, partnership dissolution or eminent domain work.
- For governments wanting to acquire private property for public use.
How Is a Commercial Property Appraised? — 3 Methods
Appraisers usually inspect a commercial property to get a good idea of its quality and condition. They use one or more of the following three approaches to then estimate its value. Each method relies on collecting detailed data about a specific property, as well as its location.
1. The Sales Comparison Approach
This method is considered to be the most straightforward type of valuation.
“Here, you identify recent sales of similar properties: Often, you’ll look at them on a price per square foot basis for commercial real estate, so if it’s an apartment building, you’ll look at it on a price per unit basis,” Bullock explained.
Appraisers then compare the property they’re working on to other properties, making adjustments for superior and inferior characteristics such as size, location, floor plan and overall condition.
“Then, you’ll come up with a reconciled value estimate per square foot or per unit,” he added.
Because the sales comparison or market approach relies on available comparable data, it can sometimes be challenging: While residential appraisers usually have plenty of ‘comps’ to look at in any given neighborhood, CRE appraisers often don’t. That limitation means they may need to look far outside the current market area to determine valuation.
2. The Income Approach
For real estate investment properties, appraisers often use the income approach, which is based on the building’s income potential. Investors can then decide whether to purchase a property based on its expected income stream over time.
“You’re trying to estimate the likely income that a property can generate, then estimate and deduct the operating expenses to come up with a net income estimate,” Bullock said. “And that will be capitalized into a value estimate, or what we call a capitalization rate.”
To figure out the net operating income of a property, CRE appraisers review leases that are currently in place, and check rent comparables, historical operating data and other market information. They determine the capitalization rate by dividing the net operating income by the property’s sale price.
This approach is considered to be the most accurate method to determine a property’s value, and is commonly used for large apartment buildings, shopping centers, offices and other properties that have a strong earning potential.
3. The Cost Approach
This method estimates value based on the replacement cost to build a property, and can be useful for newly constructed buildings or ones that are unique on the market.
“First, you estimate the land value, usually with a sales comparison approach,” Bullock said. “We look for other land sales similar to that property, estimate the value of the land, then estimate the replacement cost of the building.”
Assuming a buyer won’t want to pay more for a building than it would cost to rebuild it from scratch, the cost approach also evaluates the costs of the materials and labor when determining how much would need to be spent to construct the same building in the current market. This method is not used as often as the two previous ones, because it’s considered to be the least accurate for any property older than 10 years, since it’s difficult to estimate accumulated depreciation, Bullock added.
“If it’s a 20-year-old building, and you figured the building has a 40-year economic life, you may apply a 50% depreciation charge. There are various methods for estimating depreciation, but they all have weaknesses.”
After collecting data from multiple sources, commercial appraisers then verify and analyze the valuation, taking into account the reliability of their chosen approach and the kind of property being appraised. Then they attempt to form an unbiased opinion of value, and ultimately they create a final appraisal report, which is then provided to the investors and lenders.
Commercial Real Estate Appraisal FAQs
Often, commercial appraisals tend to take longer than residential appraisals because they’re more complex. Timelines can also vary depending on where a building is located and how busy CRE appraisers are in a market. Here are some answers to questions interested parties often ask:
How Long Does a Commercial Appraisal Take?
Factoring in the inspection and investigative work required to gather all necessary data, commercial property appraisals generally take between two to four weeks to complete, says Bullock.
“That turnaround time is largely driven by what the appraiser has as far as other assignments,” he adds.
How Much Does a Commercial Appraisal Cost?
The cost to prepare a CRE appraisal varies depending on the size and type of property and the nature of the appraisal needed.
“Typically, for a full narrative appraisal report, they’re normally in the range of $2,500 to $3,500,” Bullock said. “It’ll be above that for larger, more complex properties, and sometimes below that for a very simple cookie-cutter property. A hotel appraisal, for example, is a much more complex undertaking than a typical apartment building. And a five- or 10-unit apartment complex is generally easier than a 200-unit building.”
Examples of more complicated properties include a strip mall or other multi-tenant retail property with leases in place that need to be analyzed, making it cost more to appraise than a small store.
“And you’ll often have to do a discounted cash flow analysis, so that’s considered a more complex appraisal with a higher fee,” he noted.
Who Conducts the Appraisal?
Professional commercial real estate appraisers will be in charge of the process, doing the detective work to figure out valuation. In smaller firms, Bullock said, one person might do everything, while larger appraisal firms may split up the work with one person assemble information and collect data, while another does the verification and analysis.
Where Can I Find a Commercial Real Estate Appraiser?
Bullock suggested starting your search for a commercial appraiser by consulting The Appraisal Institute.
“If you use an appraiser with the Member Appraisal Institute designation, then you’re pretty much guaranteed to get somebody who’s knowledgeable on your property type,” Bullock said. “We also have state licensing in the U.S., but that’s a much easier and less rigorous qualification, so there’s less of a guarantee that the person will have the expertise you need.”
Appraising the Appraisal Process
Commercial real estate appraisals are similar to residential appraisals, but there are important differences between the two processes. Knowing what to expect, and what to ask, will help prepare you to undergo an appraisal for your commercial property.