Assessing the value of commercial property is more challenging than residential appraisals. In the end, you should understand which details make a commercial investment unique.
Valuing commercial real estate is more subjective by nature. The valuation incorporates factors like:
- Capitalization rates
- Leased income
- Value of similar commercial properties in the area
In this process, the buyer spends more time working one-on-one with an appraiser. The appraiser is a contracted party that determines the value of the building and land.
All these steps result in a thorough process for determining a commercial property's value.
Three Methods To Value Commercial Property
There are three dependable methods for determining the value of a commercial property:
- Sales or “market” approach,
- Income capitalization method
- Cost approach.
Choosing the correct method depends on the nature of the purchase and property. Appraisers determine the value through at least one of these processes. Sometimes they combine these methods then choose the value that best reflects the property’s worth for a given situation.
Appraisers often determine commercial value based on the balance of rental income and expenses. The value, in this case, is far more important than the underlying asset.
Explore these three approaches in more depth below:
Sales Comparison
Sales comparison is frequently used when the potential investor is seeking financing.
The sales comparison—or marketing approach—likens the given commercial property with similar properties in the area. The appraiser bases the estimation on competitive market analysis. The value of one similar commercial business in the area determines the estimation for your property. An appraiser will then adjust the value depending on comparative strengths or weaknesses. Factors such as property and lot size, floor plan, number of rooms, and age and condition impact the value.
No property is the same, so the comparable property is only a starting point. This method is particularly helpful when renovating—or flipping—a space since it is easier to find a baseline of similar properties.
Income Capitalization
The income capitalization valuing—or the income approach—compares related income levels of commercial properties in the region.
This income-based approach is clearly the most appropriate for commercial businesses. A potential investor determines the net operating income and divides it by the income capitalization to determine the approximate commercial value.
The capitalization rate is lower for more desirable properties, similar to interest rates. Their high rate of return makes them more desirable. Investors are willing to pay much higher rates for their quality and location.
The appraiser then resolves the various values found through this process and uses circumstantial evidence to determine the most appropriate value for the unique property.
Cost Approach
The cost approach is uncommon for determining the value of a commercial property. The cost approach involves calculating the actual value of the materials and construction of the building. Investors should only use this method if they have extensive construction knowledge.
The cost approach is often appropriate for residential real estate. The appraiser adds the amount of land, building material, and the cost to build the same structure today. It can be difficult to understand why this stance would work is for commercial buildings. However, it is helpful for buildings that yield minimal to no profit, such as churches or libraries.
This method is also useful if the specific construction material and design affects the building’s value. Updates to the building are either considered a benefit or hindrance, depending on the new intended use of the upcoming structure.
Some investors use this tactic when replacing or reproducing the building itself. Materials and construction costs help the investor move forward with the new project with a clear idea of its full costs.
Things To Know About Commercial Property Valuation
Understanding the full inspection picture simplifies the process of working with an appraiser. By more understanding their position, it will be easier to gather appropriate information. You are also better able to explain your needs for the appraisal and will know what to expect throughout this final process.
Building The Full Report
The appraiser’s full report encompasses far more than the traditional in-person inspection. The inspection itself, which lasts between an hour to a full afternoon, just kicks off the process. The resulting final report contains far more extensive information. After the inspection, the appraiser collects supporting documents and background information including demographic data, comparable sales in the area, replacement costs, records of zoning and public ownership and past rentals.
Working Honestly With An Appraiser
The appraiser is an objective party hired by the buyer or lender present to uphold complete fairness in the purchasing process. Most importantly, be sure to be as truthful as possible with your appraiser.
Their position requires extreme diligence in the event they are ever brought to court to defend their findings. Distorting the truth will only hinder your working relationship. More than anything, appraisers are trained to be skeptics. This mindset protects against potential issues that could impede a fair investment.
In the same realm, withholding information could also slow down the appraisal process. Appraisers may ask for additional paperwork, such as property schematics, commercial income statements, and property tax bills. These all help the appraiser construct a clear picture, even if all the information does not make it into the final report. To avoid trouble down the line, be sure to provide the most extensive information and documentation possible. You are not allowed to present withheld documents down the line, especially if you end up fighting the appraisal results.
The Appraiser’s Code Of Ethics
Above all, appraisers follow a very strict code of ethics. Understand that they are under very particular instructions to remain neutral and fair. Certain codes of confidentiality bind the appraiser to discretion—protecting both you and the lender. Therefore, if you’ve hired the appraiser for a property tax appeal, there’s no reason they will only release information unless you specifically request it. On the other side, if the client is the lender, the appraiser will not release certain information to you as the investor, so it’s best to be aware of this.
Scope Of Work
An appraiser has many purposes, and it’s important to discuss your project details before the inspection begins. The appraiser can take various angles in their work based on the pertinent information required for the sale or appeal. This also limits who is authorized to read the report, depending on its use. The type of property and sale determines the scope of work, and a varying report is released depending on its purpose.
There are also varying complexities of appraisals. Sellers, initially posting their property, require a relatively simple report. But a potential litigation case is more complex. However, appraisers will gather an expansive amount of information and may not necessarily include it all in the repost—as is the case with a restricted report.
Importance Of Appraisal Date
In the event of a natural disaster, it is important to require the proper date of the appraisal. The community’s view of the building may change, thus decreasing or increasing the value of the property by potential buyers. If something were to change drastically in or around the property itself after the appraisal occurs, this date would signify important factors that determined its value before the extenuating circumstance. Therefore, the role of the appraisal date is just as important as other supportive information.
Communicating Your Intention
Before meeting with the appraiser, determine the best way to communicate your need for the inspection itself. A “fee simple interest” is ideal when you want to shift your company directly into the building and make it your own. The appraisal, therefore, is simply to know the exact value of the building itself. This is the most straightforward report, not taking tenants or landlords’ potential income into account.
The next type of appraisal report is the “leasehold interest” report, ideal for learning the details and worth of a property to a tenant renting the space. This approach is often used by those looking to buy a business, as the value of the building comes into play. Similarly, the worth of the space to a landlord with tenants is the “leased fee interest.” Choosing one of these categories guides the appraiser toward building the best possible report for your needs.
Working through the appraisal process is not necessarily simple or speedy. The reported information is extensive and research-intensive. It’s best to allow enough time for a fair and thorough appraisal.
In the end, an extensive appraisal benefits everyone by providing an impartial report to the lender and to the buyer. It all depends on the intended use of the new commercial property and the future you see for your investment. Honesty, understanding, and patience during the process will go a long way towards ensuring this is the best investment for your long-term goals.
Follow the Trashcans Unlimited blog for more information and insights on developing commercial property. Once you purchase real estate, feel free and reach out for a custom bid on the ideal receptacles for your property.