The Three Methods Of Appraising Commercial Real Estate.

Posted By CIMLS Staff on Mar. 27 2016 at 10:51 PM EST
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To evaluate and price commercial property, investors and their appraisers use one or more of the following methods: Market, Cost, and Income Valuation.

If you are new to commercial real estate market or an old hat at it, having a good understanding of the valuation techniques is a must. That includes investors, sellers, buyers, lenders, and brokers not just the appraisers. Knowing the basics will provide a deeper understanding of the professional appraisal is required for most commercial transactions especially if a lending institution is involved.

The process is relatively simple but mastering the execution requires much more in depth study and access to comparable data and market data such as is available at CIMLS.com. The core of appraisal process consists of three basic approaches to property appraisal: Market valuation, Income valuation, and Cost valuation.

The market valuation is based on sale prices of comparable properties in similar areas and with comparable construction/utility which have recently sold. This method of valuation provide the most accurate and usable valuation when the subject property (Property being appraised) type is sold/bought frequently since we would access to market sales for a number of comparable properties. This approach is commonly used for valuation of single family, smaller multifamily, retail/office, multifamily properties, and land. Condition, size and location of property is key and need to adjusted to match the subject property as closely as possible, each adjustment will also result in changes in the comparable property sales price to reflect the difference. For example, three very similar multifamily homes have been sold in the same area.

$545,000

$585,000

$565,000

Using a basic variation of the Market valuation, we could find a range, or an average between these. Adding these three sales prices and dividing by the total number of properties sold, three in this case, we see that our range is $565,000.

CIMLS.com offers the best comparables for your properties of interest. Comparables should be as similar as possible to the subject property, and at least three or four should be used in the appraisal process. Important factors to consider when selecting comparables are the size and the location of the subject and the comparable properties. The location of the property is also very to consider important because it can have a large effect on a property's market value.

Because no two properties are exactly alike, adjustments to the comparables' sales prices must be made to account for dissimilar features and other factors that would affect the value These attributes include but are not limited to the following:

Physical features, including lot size, landscaping, type and quality of construction, number and type of rooms, square feet of living space and whether or not a property has amenities such as hardwood floors, a garage, kitchen upgrades, a fireplace, a pool, central air, etc;

Age and condition of buildings;

Date of sale, if economic changes occur between the date of sale of a comparable and the date of the appraisal;

Location, since similar properties might differ in price from neighborhood to neighborhood;

Terms and conditions of sale, such as if a property's seller was under duress or if a property was sold between relatives (at a discounted price).

This adjusted range configured using the adjusted sales prices of the comparables will determine the market value estimate. Because some of the adjustments made will be more subjective than others, consideration is typically given to those comparables with the least amount of adjustment.

The second most commonly used approach is Income valuation. Typically this approach is used to cross check and/or support the conclusion from the market approach. Based on the relationship between the rate of return an investor requires and the net income that a property produces, it is used to estimate the value of income-producing properties such as apartment complexes, office buildings and shopping centers. Appraisals using the income capitalization approach can be fairly straightforward when the subject property is expected to have a future income, and its expenses are predictable and stable. In this method, the appraiser will use the property income over time to evaluate the value of building at present. The ratio of net income over price is referred to as capitalization rate or commonly cap rate. Cap rate is driven by potential growth of income in the future, stock market return, interest rate and risk factors. Income approach is most common with apartment complexes, office buildings, shopping centers and other properties that have an income stream. The income approach estimates a sites potential income and considers vacancy and losses from rent collection. Annual operating expenses are deducted to calculate the annual net operating income and estimate the price investors will pay. Then the capitalization rate is applied to the site’s annual net operating income to determine the property value estimate.

A direct capitalization approach utilizes the following steps:

Estimate the annual potential gross income;

Consider vacancy and rent collection losses to determine the effective gross income;

Deduct annual operating expenses to calculate the annual net operating income;

Estimate the price that a typical investor would pay for the income produced by the particular type and class of property.

Apply the cap rate to the property's annual net operating income to form an estimate of the property's value.

The gross income multiplier method is often used to appraise other properties that are not purchased as income properties but that could be rented, such as one and two-family homes. The GRM method relates the sales price of a property to its expected rental income. For residential properties, the gross monthly income is typically used; for commercial and industrial properties, the gross annual income would be used. The gross income multiplier method can be calculated as follows:

Sales Price / Rental Income = Gross Income Multiplier

Recent sales and rental data from at least three similar properties can be used to establish an accurate GIM. The GIM can then be applied to the estimated fair market rental of the subject property to determine its market value, which can be calculated as follows:

Rental Income X GIM = Estimated Market Value

The third and least commonly use appraisal method is the cost approach. The cost valuation is typically used for properties that are unusual and are designed for a narrow use. By their very nature these types of properties are not sold/bought often which mean there minimal market data available so cannot use Market approach. Also, these type of property do not directly generate income, they may enable a business to generate income but not the property alone. Churches, Factories, Hospitals, schools, government facilities are example of properties that are best valuated based on cost approach. As you can see the common attributes that these commercial properties have value for a very narrow group of users and require significant modification for conversion to other uses.

Real estate valuation is a vital tool for mortgage lenders, investors, insurers and buyers and sellers. While these appraisal methods are generally used by commercial real estate professionals, we here at CIMLS.com believe that anyone involved in a transaction can benefit from gaining a basic understanding of the different methods of real estate valuation.

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