The Basics of Commercial Real Estate Appraisal

A commercial real estate (CRE) appraisal may be necessary for financing the purchase of a property, refinancing an existing asset, estate planning or tax appeal purposes. In contrast to residential appraisals (which predominantly rely on the comparison of the subject to recent comparable sales), CRE appraisals may also analyze the income of the property as well as the cost to develop the property. Determination of which approaches to value to include is based on the collection of data about the subject and what is determined to be the property’s Highest and Best Use.According to The Dictionary of Real Estate, 6^th Edition from The Appraisal Institute, Highest and Best Use is defined as:
“The reasonably probable use of property that results in the highest value. The four criteria that the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity.”[1]

An Appraisal is More Than an Inspection

The building inspection is only a small part of an appraisal. In addition, the appraiser must research property records such as previous titles and ownership, zoning history and regulations, tax records, and demographic information. Research from various publications is used to determine historical supply and demand forces, rental and vacancy rates, as well as forecasted conditions in the subject’s competitive market area. An appraiser may speak to city or municipal planners in order to determine what, if any, projects are intended in the market area. Once gathered, this information helps the appraiser determine the Highest and Best Use of the property (either vacant or with an existing improvement).

Types of Appraisal Reports

In 2016, The Appraisal Standards Board of the Appraisal Foundation revised the Uniform Standards of Professional Appraisal Practice (USPAP) to reduce the types of appraisal reporting formats from three to two. Per Standards Rule 2-2, each written report must be prepared as either an Appraisal Report or a Restricted Appraisal Report.

• Appraisal Report. In this format the appraiser, at minimum, summarizes the information sufficient to identify the subject property, the scope of work, the methods and techniques used, along with the data and conclusions. A summary report is the most common appraisal report prepared for commercial real estate transactions.
• Restricted Report. This is a more limited appraisal report with minimal narrative wherein the appraiser, at minimum, states all of the factors listed above and references the work file that contains the data and resources for arriving at the value conclusion. According to USPAP, only an appraiser’s client may use a restricted report. Therefore, these are generally used for internal decision making purposes (i.e. determining a potential sales price, estate planning, etc.).

Three Approaches to Value

1. Sales Comparison. This approach is based on the theory of substitution and utilizes sales data from similar properties or comparables (comps) in the area that sold in recent months. Adjustments are made to the comps for physical characteristics, location, market conditions, financing, and/or property rights conveyed.
2. Income. This approach is used when a property generates income to the owner. In this case, operating expenses and projected vacancy losses are deducted from the income potential of the property (either actual or anticipated), which is then capitalized by a rate of return reflected by other market participants for similar properties. In instances where the property has multiple tenants, a discounted cash flow analysis would be used to analyze the property over a typical holding period and would account for the “rollover” of leases at the end of the tenants’ term as well as the anticipated proceeds upon sale of the property at the end of the designated holding period.
3. Cost. This approach values the cost to construct a property and takes into consideration depreciation (the difference between replacement cost and market value as of the date of the appraisal). There are three types of depreciation: Physical deterioration (curable and incurable); functional obsolescence (curable and incurable); and external obsolescence, which is virtually always incurable.

Selecting a Date of Valuation

USPAP requires that each appraisal report specify a date of valuation. Typically the appraiser will use the date of inspection. However, in some instances (i.e. date of death for estate purposes and January 1^st for a tax appeal) an appraisal date can be retrospective. If a property is proposed, the date of valuation upon completion and upon stabilization may also be used. An appraisal’s date can be significant because changing economic factors affect the value of property.

Property Interest

An appraiser will generally value one of the three property interests. Fee simple interest values the property in absolute ownership unencumbered by any other interest or estate. Leased fee recognizes the addition or deduction in value attributable to contract leases relative to the fee simple value. The leasehold interest indicates the value held by the lessee to use and occupy the property. Some properties are valued as a “going concern” whereby the value to property is allocated between the real estate, the furniture, fixtures and equipment (FF&E) and business value. A primary example is a hotel.

Understanding Client Confidentiality

USPAP holds appraisers to the highest ethical standards, one of which is client confidentiality. Thus, if you are seeking a loan and your lender orders an appraisal, the lender is the client (even though you are likely paying for it). The appraiser cannot discuss the appraisal with any other party without permission from the client. Similarly, if you order an appraisal then you must let your appraiser know who else may access the report.

[1] Appraisal Institute, The Dictionary of Real Estate Appraisal, 6th Ed. (Chicago: Appraisal Institute, 2015), p. 109.

 

The information contained in this article is general in nature and should not be construed as financial, tax or legal advice.  As with any financial or legal matter, consult your tax advisor and legal counsel.