Education, Finance, Syndication Structure

Understanding the Most Common
Commercial Real Estate Valuation Methods

smartland-understanding-the-most-common-commercial-real-estate-valuation-methods.mp3 A commercial real estate appraisal is an independent, third-party opinion of a property’s value. It is similar to a home appraisal used... Listen to this article

Introduction

Many commercial real estate investors will find the appraisal process to be like a black box—they don’t really understand what goes into the process, how long the process will take, or what the outcome of that process will be.

There’s no reason to fear the CRE appraisal process. Appraisals are a highly effective way of determining a property’s value. They can be used by investors and lenders alike.

What is a Commercial Real Estate Appraisal?

A commercial real estate appraisal is an independent, third-party opinion of a property’s value. It is similar to a home appraisal used when purchasing residential real estate, except that the valuation techniques are slightly different when estimating a commercial property’s value.

CRE appraisals are conducted by highly-trained, licensed professionals. These appraisals tend to be highly nuanced, comprehensive, and both property- and market-data-heavy.

When is a Commercial Real Estate Appraisal Needed?

Commercial real estate appraisals are typically required whenever someone is looking to finance a property using a traditional bank loan. Most banks have a certain loan-to-value threshold they must meet before making a loan commitment. An appraisal helps to determine the asset’s value and from there, the lender can determine how large of a loan they are willing to make relative to that property.

Commercial real estate appraisals are typically required
whenever someone is looking to finance a property
using a traditional bank loan.

In some cases, property owners will also look to conduct an appraisal for their own informational purposes. This is usually the case when an owner is trying to determine whether or not to sell their property and if so, for how much.

The Three Most Common CRE Valuation Methods

Below is an overview of the three most commonly used CRE valuation techniques. Neither technique is better or worse than the others—it simply depends on the circumstances and what data is available (market or property-specific). In practice, most appraisers will try to utilize some combination of the methods below when estimating how much a commercial real estate asset is worth.

The Cost Approach

The cost approach factors in both the land value as well as the replacement costs for any existing building structure. The cost approach is easier to determine when a property is newly constructed. With new construction, an appraiser will calculate the new-build value by adding the total construction costs plus the market land value.

Using the cost approach to value existing real estate is somewhat more complicated.

For existing property, an appraiser will still estimate a building’s replacement value using today’s costs, but will then reduce that cost to account for any accrued depreciation. This depreciation can include discounts for physical deterioration (e.g., costs to cure deferred maintenance), structural or functional obsolescence (e.g., increased energy costs associated with operating an older building), or any external obsolescence from the surrounding area (e.g., population or employment decline) that could impact a property’s net operating income.

The cost approach also factors in the useful economic life of a building and the time that has elapsed since the property was placed into service. The appraiser will then conduct a present value analysis based on anticipated differences in cash flows over time.

Given the complexities associated with the cost approach for existing structures, this valuation technique is mostly used for new construction only.

The Sales Comparison Approach

The sales comparison approach, or “sales comp” approach, uses comparable sale data from recently sold properties as a basis for property valuation. The appraiser will look for comps of relatively similar size, age, location and overall property quality.

Of course, no two properties are exactly alike and therefore, adjustments will be made for differences in sale date, geographic location within the submarket, building age, square footage, and proximity to local amenities or consumer draws (e.g., employment centers, highways or public transit, restaurants and retail, etc.). For example, when using the sales comp approach, a property’s value may be adjusted upwards to account for a superior location, but may be adjusted downwards if the property is older and offers fewer amenities.

The sales comp approach is a particularly effective valuation strategy in areas that have significant transaction volume. Most appraisers will want to use comps that are no less than 12 months old, as market conditions can rapidly change from one year to the next.

The sales comparison approach, or “sales comp” approach,
uses comparable sale data from recently
sold properties as a basis for property valuation.

However, in some cases, there is insufficient activity to warrant using the sales comp approach. For example, if a standalone office complex is one of the only office buildings located in a certain submarket, and no other office buildings have sold in the last 5+ years, the sales comp approach becomes more difficult to use. The sales comp approach requires there to be properties of relatively similar size, age, quality, and location and these properties must trade every so often to provide the sales data needed for comparison’s sake.

The Income Approach

When the cost approach or sales comp approach cannot be used, most appraisers will turn to the income approach. The income approach, sometimes referred to as the “income capitalization” approach, estimates a property’s value based on its in-place rents and/or revenue-generating potential.

There are three main ways of calculating a property’s value using the income approach.

The first is the GRM (Gross Rent Multiplier) approach. This involves dividing the sales price of comparable properties by the gross rent that those properties generate on an annual basis. This gives appraisers a number they can apply to the gross rents of the specific property being appraised. The GRM approach is somewhat limited in that most properties have different operating expense ratios.

The second way is called the Direct Capitalization approach. With this method, instead of relying on gross rents, the appraiser will calculate the net operating income (which in turn, accounts for a building’s operating expenses). By using NOI and then applying a market cap rate (based on comparable sale data), the appraiser can then estimate a property’s value.

Property Value = Net Operating Income / Cap Rate

Using the Direct Capitalization approach, the appraiser will then make adjustments upwards or downwards to account for the condition and other specifics of the subject property. For example, if a lesser-quality property recently traded at a 6% cap rate, the appraiser might apply a 5.5% or 5.75% cap rate instead.

The third and final way to value a property using an income-based approach is by conducting a Discounted Cash Flow (DCF) analysis.

The DCF method entails forecasting net cash flows for a predetermined hold period, usually somewhere around 7 to 10 years. The DCF method requires an appraiser to make certain assumptions about future cash flows, projected operating and capital expenses, and the anticipated sales price at the end of the hold period.

Once the appraiser has made these assumptions, they will then apply a discount rate to determine the net present value (NPV) of the property’s cash flows as the basis for the asset’s valuation. In most cases, the discount rate used will be the equivalent to the risk-free rate of return (e.g., the U.S. Treasury rate at the time of appraisal) plus a risk premium to account for the risk the investor is taking on by purchasing the property.

The DCF approach, while complicated, is the most popular commercial real estate valuation technique. This is true among both investors who are analyzing deals as well as appraisers who are trying to determine a property’s value.

Valuing Tenanted vs. Vacant Property

How an appraiser goes about valuing a property will often depend on whether that property is tenanted or vacant. In order for a property to be valued based upon its rents (i.e., the Income Approach), it must be substantially tenanted and generating cash flow. Only then can an appraiser look at it’s income-generating potential and investment yields.

How an appraiser goes about valuing a property will often depend on whether that property is tenanted or vacant.

It becomes more difficult to use the Income Approach when a property is vacant. An appraiser might then need to look at market comps to determine what rents and yields are on a per square foot basis, and then apply that to the subject property before making adjustments upward or downward to account for property condition or other differences.

When valuing a vacant property, an appraiser will also need to factor in some time for property lease-up and stabilization, as well as any marketing or other costs needed to do so. These costs will depend on the market and demand for that specific property type.

Appraisals vs. Brokers’ Opinion of Value (BOV)

As noted above, owners will sometimes hire an appraiser to determine the value of their property. This can cost upwards of $5,000 to $10,000 or more, depending on the size and nature of the subject property.

An alternative way to determine a property’s value is by having a commercial real estate broker put together what’s called a “broker’s opinion of value,” or BOV. Most brokers will do this free of charge, but with the expectation that if an owner decides to sell the property, they will then list it with that broker in turn.

The key difference between an appraisal and BOV is that appraisals are conducted by a licensed and independent third party. CRE appraisals are generally more technical in nature, as well. They can take upwards of 3-4 weeks to complete given how thorough the reports tend to be. Comparatively, a BOV may only be a few pages long and can often be turned around in just a few days.

One benefit to using a BOV, however, is that these analyses tend to be forward-looking in nature. Active brokers know the market inside and out and understand that where something traded 12 months ago may be vastly different than where it would price out today.

Moreover, appraisers tend to be generalists across CRE property types and markets, whereas brokers tend to specialize in certain property types within specific submarkets. This gives brokers keen insight as to how a property should be priced for sale. Indeed, one could argue that nobody knows the market value of an asset better than someone who sells similar properties day in and day out.

Clearly, there are pros and cons to using an appraisal vs. a BOV. There are some instances in which an appraisal will be necessary (e.g., when obtaining a bank loan) and other instances where a BOV will be sufficient.

Conclusion

Given that most commercial real estate deals are financed with some form of debt, most investors will need to go through the appraisal process at some point. Understanding the various methods by which an appraiser may value a property is therefore important for investors to understand.

Those buying property will want to lean on their real estate broker, to the extent one is involved, to help gather information and pertinent data to feed to the appraiser about local comps, etc. This can make the appraiser’s evaluation easier and more streamlined. Those who are investing in a joint venture, syndication or fund can turn this process over to the sponsor who will oversee the appraisal process on the investors’ behalf.

Are you interested in learning more about how to value commercial real estate assets? Contact us today. Our team at Smartland would be happy to discuss how we go about valuing different properties depending on the asset class and market.


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