What is the Importance of Appraisals in Commercial Real Estate?
If you want to purchase a commercial property, you’ll almost always need an appraisal first. An appraisal is a professional estimation of the market value of a property, which needs to be conducted by a certified appraiser in the area which the property is located. Since commercial real estate lenders they need to determine the value of a property in order to accurately calculate its loan-to-value ratio and other important financial metrics, they usually require an appraisal before they approve a borrower for a loan.
In addition to looking at property’s current use, appraisals must examine at a property’s highest and best use— the most economically productive potential use of the property. As a part of this, appraisals also look at how commercial zoning regulations impact the potential uses of a property, as these can have significant impact on a property’s value.
In general, there are three methods for appraising a property’s value: the sales comparison approach, the income capitalization approach, and the cost approach. To give you a better understanding of each method, below we review all three in order to give you a better understanding of each.
The Sales Comparison Approach
In the sales comparison approach, an appraiser attempts to find similar commercial properties that have sold recently in an attempt to estimate the price of the property in question. In general, the comparison properties should be located in the same area, be of similar size, and have similar features. After finding a similar comparison property, the appraiser then adjusts its sale price based on any features that the appraised property might have that are different than the comparison property. While this is a popular method, it may not always be the most accurate.
The Income Capitalization Approach
Unlike the sales comparison approach, the income capitalization approach focuses on the income that can be generated by a commercial property in order to determine its market value. In general, this is determined by dividing the property’s net operating income (NOI) by its cap rate. In most cases, an appraiser uses the sale price of other similar commercial properties in order to determine the property’s cap rate.
The Cost Approach
The cost approach attempts to estimate the value of a property by determining the cost it would take to replace the property. The cost approach does not incorporate the income that the property produces into the calculation, and also assumes that the property will not sell for higher than its replacement cost. For those reasons, the cost approach is somewhat less popular for commercial real estate appraisals.
In many cases, an appraiser will use some combination of all three methods in order to determine an estimated value for a commercial property. They may also factor in other information, such as market trends, location, risks, and development potential.
Other Uses for Appraisals and Appraisal Alternatives
Appraisals are also used to determine the amount of property taxes a property owner will have to pay. In certain cases, property owners may want an appraisal to the selling price of a commercial property.
While appraisals are a great way to get a handle on how much a property is worth, in many cases, buyers and sellers instead turn to a broker price opinion/broker opinion of value (BPO/BOV). This is faster and less expensive than an appraisal, but is generally considered to be somewhat less precise.