A commercial property appraisal, like a residential appraisal, is used to determine the value of a property. If you're buying or selling a commercial building, you'll need a commercial real estate appraisal. Unlike residential appraisals, the diverse methods for commercial property appraisal can yield different results.
You'll learn how appraisal for commercial property works, different appraisal methods and key factors in determining property value here.
How Does a Commercial Property Appraisal Work?
An appraisal of commercial real estate is an unbiased opinion of the value of the property. This metric involves assessing the property’s value licensed commercial property appraiser. A commercial real estate appraisal is used for properties like multifamily housing units, office buildings, retail spaces or parking lots.
A property appraisal indicates what the property will sell for in the current market. It’s important for underwriters as lenders need to know the property’s value to determine how much financing they can safely provide.
As an investor, an appraisal can give you an idea of the property value and return on investment. It can help you determine the cap rate. It can also help in decisions about what renovations make sense to add to the property to improve investment value.
The three most common methods of property appraisal are the sales comparison approach (comps), the income capitalization approach or the cost approach.
How Much Does it Cost?
Commercial property appraisal cost varies widely by building size, location and additional features. A hotel with a swimming pool or a commercial kitchen will require an additional specialized appraisal that a small retail space won’t need. For that reason, an appraisal for commercial property could cost $2,000 or more than $10,000, with average prices around $4,000. Speak to the appraiser about a ballpark quote for appraisal to understand the costs involved.
How Do Appraisers Determine Property Values?
The three main types of appraising commercial real estate are the cost approach, the comparison approach and the income capitalization approach.
Cost Approach
With the cost approach, you will look at how much it would cost to build the building from scratch. This includes land, material and labor to set an appraised value. A cost approach uses the formula:
Land cost + cost to build new - accumulated depreciation = Property value
While this isn’t the most common approach, it’s especially useful for newer buildings with unique features that increase the value significantly or would cost a lot to rebuild.
Comparison Approach
The comparison approach is used in residential real estate. With this approach, the appraiser will find comps of comparable properties to determine the current market value of the property under appraisal. This method often doesn’t work for commercial properties because of the difficulty in locating comparable properties in the same location. However, it can work well for apartment buildings or small retail spaces in a commercial area.
Income Approach
The income approach, usually the favorite for commercial real estate, uses a simple formula involving the capitalization rate and net operating income. The income approach will only work with accurate information on net operating income.
Net operating income (NOI) / capitalization rate = Property value
With this formula, you’ll need to know the cap rate, which assumes you know the property value or have comps to assess property value.
What is the Most Common Method Used by Appraisers?
The income approach is the most common appraisal method for commercial real estate.
What is the Highest and Best Valuation?
The highest and best appraisal, according to the Appraisal Institute, is the appraisal that results in the highest value, assuming a reasonably probable and legal use of a property. This accounts for a possibility that is financially feasible and appropriately supported. In simple terms, this is the highest realistic value of a property in current market conditions. Appraisers will apply four tests to determine the highest and best appraisal value.
Example of a Valuation Formula
Suppose you have a commercial building with retail space with a 7% cap rate and net operating income of $1 million a year. According to the income approach, the appraisal for this commercial property would be:
Net operating income (NOI) / capitalization rate = Property value
Applying this formula with the current numbers =
$1,000,000/7% = $14,285,714
In this example, the appraised value of the commercial retail space would be just over $14 million. Although there isn’t a commercial property appraisal calculator, you can use Benzinga’s cap rate calculator here.
Key Factors Commercial Appraisers Look For
When assessing property value, several key factors come into play for commercial appraisers, including location, condition, age and type of property. Here’s how each of these factors can affect the final appraised value.
Property’s Location
In real estate, the primary consideration remains location. As they say, “location, location, location.” You could have a 5-star hotel in perfect condition in a bad part of town, and the appraised value would be lower. Likewise, a run-down shop in a central commercial district would have a higher value. Independently of any other factor, location will weigh heavily into the property’s value.
Property’s Condition
After location, the property’s condition will affect the appraised value the most. Does the property need significant repairs or major renovations? Is the foundation solid? How about the roof, electrical and HVAC systems? While a run-down property in an excellent location will still have value, poor condition or the need for major repairs will lower its appraised value.
Design of the Property
The design of the property matters as properties receive higher appraisals if they fit in with other properties in the area. Unique or spectacular design, such as a building designed by highly sought-after architects, might command a higher appraised value. On the other hand, a design that is edgy or controversial may actually lower appraised value, as the property won’t appeal to as many buyers.
Age of the Property
The age of the property matters for the appraisal for commercial property as older buildings will need additional costly repairs with time, from roof replacements to electrical upgrades. In addition, they may need updates to meet current safety codes and regulations. If the building has been well-maintained and regularly updated, the age will not weigh in as significantly but can still be a factor.
Type of Property
Different types of commercial property can have varied appraised values. A warehouse will generally have a lower appraised value than a hotel of the same size. Appraisers will take into account the intended use of the commercial property, and investors should weigh the income-generating potential of the property type.
Property’s Size
A larger property will have a higher appraised value, assuming other factors remain the same. A 3,000-square-foot boutique hotel will have a lower appraised value than the 30,000-square-foot hotel next door unless other factors like condition, design or location detract significantly from the larger property’s value.
Recent Sales of Similar Properties
Previous sales of similar properties impact the appraisal for commercial property as investors and sellers will use these comps to gauge price and market value. If you’re looking to sell a commercial property and similar properties have sold for more than the appraised value of your property, you may be able to get a higher price as well.
Advantages of Property Value Reports
Commercial property appraisals hold significant advantages for everyone involved. The pros of commercial property appraisals include:
- An accurate understanding of current market pricing
- Allows investors to calculate the return on investment (ROI) and income-generating potential
- Helps lenders determine financing amounts
- Can help secure funding
- Can reduce property taxes in case of a lower appraisal
- Can ensure adequate insurance coverage
Disadvantages of Property Valuations
Commercial property appraisals can be costly and time-consuming. The cons for commercial property appraisals include:
- High costs
- Time-consuming
- Not as accurate as residential property appraisals
Comparing Commercial and Residential Appraisals
Commercial property appraisals and residential property appraisals serve the same purpose — to determine the fair market value of a property. Residential property appraisals typically use comps along with an assessment of the condition of the property to accurately determine property value.
In contrast, appraisal for commercial property can use a variety of methods to determine property value. It’s generally more difficult to find accurate comps for commercial properties. However, with various appraisal methods, appraisers can determine a reasonable assessment of a commercial property’s value.
Learn Your Property’s Value Today
Appraisals can be essential tools for understanding a property’s current market value and can provide key insights into investment value, potential repair costs and ROI. For many investors, asking appraisers to apply all three appraisal methods will give the greatest insights into what you can expect regarding the market value and cash flow. If you’re ready to dive into commercial real estate investing, get this ultimate guide or consider commercial real estate exchange-traded funds (ETFs).
Frequently Asked Questions
Why would I need an appraisal for my commercial property?
ou might need an appraisal for your commercial property if you’re planning to sell or refinance it. You might also need an appraisal for property insurance or to request lower property tax rates.
How is a commercial property appraisal conducted?
Commercial property appraisal is conducted through the cost approach, the income approach, or the comparison approach. See more on all three above.
Who pays for commercial property appraisals, and how much do they cost?
In most cases, the buyer will pay for a commercial property appraisal. However, in some cases, the current owner of a commercial property will pay for an appraisal. Commercial property appraisals can cost $2,000 and $10,000 or more.
About Alison Plaut
Alison Kimberly is a freelance content writer with a Sustainable MBA, uniquely qualified to help individuals and businesses achieve the triple bottom line of environmental, social, and financial profitability. She has been writing for various non-profit organizations for 15+ years. When not writing, you will find her promoting education and meditation in the developing world, or hiking and enjoying nature.
