If you are looking to invest in a commercial property, or if you are looking to sell one, you probably have one number in mind: the value of that property.
So how do we determine the value of a commercial property? You consult an appraiser to do an appraisal. Appraisers will give you a value of the property; but this number isn’t exactly final. Learn more about the commercial property appraisal process, and what buyers and sellers can do to get a satisfactory value that will encourage a sale.
The Commercial Property Appraisal Process
Investors may have to get a commercial property appraisal in order to get a loan for a commercial property. To start the appraisal process, the lender will engage a licensed appraiser. Appraisers are third parties that adhere to a strict code of ethics in order to fairly determine the value of property.
It is important to remember that the lender is the appraiser’s client - not the investor. The client is the person that orders the appraisal. As the investor, you may not have a direct relationship with the appraisal, but you may have to provide them with crucial information about the property and your intended uses.
How does the appraiser determine the value of a property?
The appraiser will need to inspect the property and conduct a fair amount of research in order to determine the value of the commercial property. Appraisers approach this process through three primary methods:
Sales Comparison Approach (Market Data Approach)
The appraiser will research the area and collect information on similar commercial properties. For example, if the appraiser sees that a commercial property across the street sold for $50/square foot and a similar property two streets over sold for $70/square foot, they will take those statistics into consideration. All of these buildings should be similar, but do not have to be identical.
Appraisers will take other factors into consideration, including:
- The age of each building
- Existing tenants and leases
- The condition of the property
- When they were put on the market
- Excess land surrounding the property
- Features (parking, ingress and egress, etc.)
Income Capitalization Approach
The commercial property across the street may have a similar physical structure, but may cater to very different audiences who are willing to pay different prices. This is where the income capitalization approach comes into play.
Appraisers must consider the possible uses of the property and the expected cash flow. If the property is going to be used as office space, how much will the property bring in a year? If the property is going to be used as a shopping center, how much could it bring in?
The income capitalization approach will also take risks and possible costs into consideration, including the credit quality of the tenants and the length of existing leases. Different commercial properties come with different costs depending on the amount of equipment that may need to be installed or the going rate of leased space and occupancy rates in a particular market.
Once the appraiser determines how much the owner could make from the commercial property, they will factor that number into the overall valuation.
The cost approach looks at how much it would cost to build an identical building on an identical lot. Even if the building has been on the lot for a few decades, the cost approach takes into consideration the materials and labor required to replicate the building, as well as the value of the land itself.
Individually, these approaches do not tell the whole story of the building. Together, they offer an insight into the current market, the physical building itself, and its potential to generate cash flow. Appraisers may gather this information through public records, census data, or predictions about the market.
The appraiser will take all of this information into consideration, including information provided by the client, to make a final valuation. Lenders can expect to have an appraisal back within three days, although this may change based on the market and the appraiser’s availability.
The valuation, and the evidence that supports the valuation, is compiled into a thorough report for the client.
What You Can Do to Ensure a Fair Appraisal
Investors may do some preliminary research and have a valuation estimate in their head ahead of time. Unfortunately, the appraiser may see things differently. The best way to prevent a messy or unfavorable appraisal is to do your research ahead of time and provide as much information to the appraiser that you can.
Appraisers will probably ask for a handful of documents beforehand, depending on the client and what their relationship is with the property. Be prepared to present property tax bills and income tax statements if asked. Talk to your lender before you request the appraisal so you can promptly give the appraiser what they need to get started.
Before the appraiser starts their report, you should also confirm the following facts:
- Square footage of the property
- Intended and past uses
- Information on off-market comparable transactions
- A list of building plans (with costs)
- Date of valuation (whether the appraisal is meant to reflect the valuation of the current date, a past date, or looking into the future)
- Intended report readers
The more information you bring forward, the better. Make sure that this information is accurate; appraisers will conduct a lot of information on their own as they create their report. Conflicting information may slow down the appraisal process and will generally not work in the client’s favor.
Preparing accurate information ahead of time, as opposed to waiting to see if report confirms your predicted valuation, saves everyone time and money. Do your part before you order an appraisal.
What happens if the value is too high or low?
Clients may disagree with the appraiser’s report. If you believe that the value of the property you want to invest in might be too high, you have the possibility to “appeal” to the appraiser. But you can’t just call up the appraiser and tell them that they were wrong. Take the following steps within one to two weeks of receiving the report.
Read the appraisal report thoroughly.
The appraiser should include all of the information that factors into the appraisal. Just like the appraiser might miss information about the area or key facts, you might have missed these facts in your research. Do not call up the appraiser until you have read through the report and identified which factors are incorrect or miscalculated.
Bring the facts forward.
Again, telling the appraiser “you’re wrong” is not going to get you the changes you want. As you read the report, make a note of any miscalculations or incorrect facts. Create a list of additional facts that the appraiser may have overlooked or not considered while writing the report. The appraiser may change their mind about the valuation of the property, but only if you show them facts that disprove their original report.
Talk to the bank.
The investor doesn’t usually order the appraisal themselves. Investors typically reach out to a lender, who reaches out to the appraiser. In this case, the lender is the client. Not you. If you have issues with the appraisal, talk to your lender. Let them discuss the facts of the report with the appraisal.
Remember, appraisers must uphold a strict code of ethics in order to hold their position. Unfavorable appraisals are usually the result of missed facts or misunderstandings. The appraisal process is generally painless and agreeable for all parties.
Talk to your lender about whether you need an appraisal to take out a mortgage for your next investment.