Even in a stable real estate market, commercial real estate appraisals can be more of an art than a science. When coupled with an uncertain economy, fluctuating property values may make appraisals all the more challenging for real estate investors to assess.
Unlike appraisals for residential properties, most commercial real estate appraisals consider the income the property may produce. As a result, valuation professionals must conduct significantly more research and analysis to determine the value of a commercial property.
Thus, investors who are concerned about the quality of a commercial real estate appraisal should pay close attention to the qualifications of the appraiser. A valuation may be seriously flawed if the appraiser does not have sufficient experience or judgment to produce an accurate opinion.
Errors, in fact, are not uncommon. One academic study released in the 2010s examined 25 years of commercial property sales data and found that, on average, appraisals were 12 percent above or below subsequent sales prices of similar properties that occurred in the two quarters following the appraisal.
To ensure an appraisal is credible, investors might consider whether an appraiser used accurate data, made viable assumptions, and provided correct conclusions in conformity with industry standards.
Methods for Valuing Real Estate
Investors should first consider the methodology used by the appraiser to value the property. In general, properties are valued in one of three ways: By cost, by income, and by sales. The income methodology is the approach most often used in commercial real estate appraisals.
As the name suggests, the income approach is an estimate of a property’s market value based upon the cash flow an owner might expect to receive. This value may be determined in one of two ways:
1) The direct capitalization method, which estimates the property’s value by using a single year’s forecast of income.
2) The yield capitalization method, which considers potential income over the course of a multi-year investment period.
The direct capitalization method is the less complex of the two methods, and is commonly employed when a property is stable (i.e., the property can demonstrate its reliable income stream and strong leasing history, where solid comparable sales data about similar properties is readily available, etc.).
Yield capitalization, however, requires the appraiser to prepare more meticulous calculations and detailed assumptions over a longer period. This multi-year approach can be helpful in valuing properties that may be unstable or that are facing current market headwinds. For instance, a retail or hospitality property may be suffering low occupancy levels at present, but could be positioned for future growth and, therefore, may be a strong candidate for a yield capitalization approach.
Questioning Appraisal Assumptions
An investor should also understand the assumptions the appraiser prepared in the valuation process. For example, “did the appraiser apply an appropriate balance of cash flow and investment rate to ensure the valuation is not too high or low?”, “were changes in market conditions considered?”, or “were the appraiser’s assumptions based upon outdated data?”
This can be a particularly important issue during times of uncertainty. During the last few years, the COVID-19 pandemic altered the commercial real estate landscape. As a recent article published by GlobeStreet.com noted, many appraisers struggle to assign value to office spaces because it remains unclear what tenants will do once their leases expire. With more employees working from home, tenants may continue to reduce their office footprints and, therefore, cause employers to eliminate the amount of office space needed or an office space in its entirety.
“Appraisers valuing office assets will have to account for these unknown factors and keep market-specific volatility top-of-mind,” the article noted, adding that most appraisers evaluate multi-tenant office assets based on the assumption of a 10-year hold to give an accurate value. “This 10-year holding period accounts for volatility in the market or high tenant turnover that could occur in future years,” the article said. “The net operating income of the 10-cash-flow-years is discounted back to present to conclude the value of the asset. So, the uncertainty of future office usage has disrupted standard assumptions about the asset.”
Commercial real estate appraisers should be well-qualified to conduct the appraisal and adhere to uniform industry standards. Pursuant to said standards, appraisers must furnish unbiased opinions, possess sufficient knowledge to conduct an accurate appraisal and disclose a lack of experience with the type of property subject to an appraisal in addition to other known potential limitations.
Optimally, an appraiser is experienced with both the type of real estate being assessed and local market conditions. To better assess an appraiser’s qualifications, a resume, reference, and a list of commercial real estate sectors where the appraiser’s relative experience lies should be requested by the property owner or investor.
Having experienced counsel assist in the appraisal process can also help commercial real estate investors identify potential appraisal errors and ensure that the values assigned to their properties are as accurate as possible. If you have legal questions about commercial real estate transactions and the appraisal process, contact us for a consultation.