Lenders almost always require an appraisal before approving a loan, in order to calculate the loan-to-value ratio. The appraisal verifies the value of the real estate is sufficient for what they are lending money on.

There are many ways to value commercial real estate.

Real estate investors usually value real estate based on certain return metrics they can hit.

A commercial property appraiser will use one or a combination of three methods including the cost approach, the income approach, and the sales comparison approach.

Here are the 3 most common valuation methods appraisers will use:

Sales Comparison Approach:

Description: This approach estimates the value of a property by comparing it to similar properties that have recently sold in the same market. This approach is based upon the assumption that an informed buyer would pay no more for a property than he or she would have to pay in order to purchase an equally desirable substitute property having the same or similar utility.

How it works: Real estate appraisers and investors gather data on recently sold properties with similar characteristics (e.g., size, location, type, age) to the subject property. The notable differences in the comparable properties are then adjusted to the subject property to indicate a value range for the property being appraised.

When to use: Most suitable for properties with an active market and a sufficient number of comparable sales. It's commonly used for single-family homes, multifamily properties, and some types of commercial real estate. The validity of the value indication derived by this approach is dependent upon the availability of data pertaining to sales of directly comparable properties.

Income Capitalization Approach:

Description: This approach values a commercial property based on its income potential. It is particularly relevant for income-producing properties such as apartment buildings, office buildings, and retail centers.

How it works: The income approach calculates the property's value by calculating its potential net operating income (NOI). This NOI is then capitalized into an indication of value by using capitalization rates extracted from competitive properties in the market or by using other techniques when applicable. The formula used is Value = NOI / Capitalization Rate.

When to use: The income approach is commonly used for properties that generate rental income, as it focuses on the property's ability to generate cash flow.

Cost Approach:

Description: This approach values a property by estimating the cost to replace it with a similar property, adjusted for depreciation.

How it works: The appraiser must first estimate the value of the subject site by comparing it to similar sites that have recently sold or are currently offered for sale. Appraisers take into consideration many factors such as land value, construction costs, and depreciation. Depreciation can be categorized as physical (wear and tear), functional (outdated design or features), or external (changes in the market or neighborhood).

The depreciated cost of the subject improvements is then added to the estimated site value with the result being the indicated value by the Cost Approach.

When to use: The cost approach is typically used when there are no comparable sales available or when the property's value is primarily derived from its physical structure. It is often employed for special-purpose properties like schools, churches, or government buildings.

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📈 Chart of The Week

Five Largest Apartment Transactions in 2nd Quarter 2023

In the year-ending 2nd quarter 2023, transactions totaled nearly $189 billion with around 7,900 properties trading hands. Looking back over the past few years, sales dipped in calendar 2020 due to the pandemic, when about 7,200 apartment communities were sold for roughly $148 billion.

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