Commercial Real Estate Appraisal : A Detailed Guide

December 4, 2022
Contract Management
Lease Management

Valuation of real estate is not just limited to residential properties but also commercial properties. Sometimes referred to as ‘property valuation’ or ‘land valuation,’ real estate appraisals allow both the buyer and seller to calculate the value of any type of real estate effectively.

If it's still unclear, don't worry; we've got you covered. Let's begin with the basics to cover all the doubts and queries you might have.

What is the Difference Between Commercial Real Estate and Residential Real Estate?

As the title of each real estate type suggests, residential real estate is used for the purpose of living, whereas commercial real estate is used to conduct commercial activities.

Bungalows, condos, duplexes, etc., fall under the residential real estate category, whereas offices, factories, hotels, shops, educational institutes, etc., are commercial real estate.

Residential properties and commercial properties are levied with different amounts of taxes and fees because of their usage. For instance, the electricity rate per kWh will be much lower for residential property as compared to commercial property. The price difference can almost be more than double for commercial real estate.

Is Commercial Real Estate Appraisal Different from Residential Real Estate Appraisal?

Given the difference between the usage of both kinds of property, i.e., commercial and residential, the appraisal process also slightly differs.

Typically, residential real estate appraisal is performed by taking into consideration the sales price of similar residential properties and then comparing them. If there are some unique features, the price is increased or decreased accordingly.

However, when it comes to commercial real estate appraisal, it cannot be simply done by taking into consideration similar commercial properties because each commercial real estate is highly unique.

For instance, the chances of two commercial hotels being exactly like each other are very slim. Both the hotels will vary on a variety of factors like the number of rooms, room size, restaurant seating capacity, number of floors, etc.

Given the complexity of commercial real estate appraisal, the process takes much longer compared to residential real estate appraisal. Those appraising might claim that the commercial real estate appraisal process is mostly completed once the property inspection is done; don't fall into that trap.

Various complications and processes might arise later, like a conflict of interest, reporting issues, disagreement between intended use, etc.

What is a Commercial Real Estate Appraisal?

Now that you know the difference between commercial and residential real estate appraisal, let's define what commercial real estate appraisal is for clarity.

A commercial real estate appraisal is the process of getting a commercial property evaluated by a professional appraiser for buying or selling purposes. For instance, if you are buying a commercial property, you can acquire a professionally-made property appraisal document to estimate the right buying price.

Apart from giving out a right estimate of the monetary value of the property, a well-made appraisal document can also provide other relevant information like past ownership records, zoning records, population demographic surrounding the property, etc. These details can help the new owner make the right business-related choices.

For instance, if someone is opening an apparel store in a commercial shopping complex, demographic details will help the business owner recognize who would be the target customer and stock the right kind of brands/clothing in the store.

Benefits of Commercial Real Estate Appraisal

Mentioned above is one example where commercial real estate appraisal can turn out to be extremely useful. Some other pressing reasons for getting a commercial real estate appraisal done are:

  • To support business dissolutions which might happen several years after buying a commercial property
  • To make corporate mergers easier and quicker
  • To assess any damage caused by fire accidents, environmental hazards, extreme weather conditions, or any other unfortunate accident
  • To decide choosing between a capital lease vs. operating lease
  • To support lease negotiations for the sake of both buyer and seller
  • To estimate the viability of future construction and renovation plans
  • To help a business set its objective, goals, year-end goals, investments, etc.
  • To help calculate the investment in terms of taxes and monthly bills
  • To determine the accurate loan amount
  • To deal with deferred rent, revenues, and expenses

How is a Commercial Property Appraised? 

Now that you know what commercial real estate appraisal is, you must also know how it's done. We've described three main approaches:

  • Market Approach
  • Cost Approach
  • Income Capitalization Approach

1. Market Approach

The market approach, also known as the ‘Sales Comparison Approach,’ is most commonly used during residential real estate appraisal. It can be used for commercial real estate appraisal with some tweaks and changes.

This approach relies heavily on determining the selling price by comparing it with other similar or slightly similar properties in the market. A similar property is found keeping in mind factors like similarity in size, preferably in the same area/locality/town, etc.

The only disadvantage of using a market approach for commercial real estate appraisal is the lack of comparable properties. In such cases, the appraiser is then forced to use other approaches like the cost approach or any other seen to be relevant.

2. Cost Approach

The cost approach is widely used for commercial real estate appraisal. This approach is kickstarted by asking a very basic question: how much would it cost the seller to replace this real estate asset?

Some of the factors kept in mind while asking this question are:

  • How much would it cost to replace this real estate in the same location or somewhere nearby?
  • How much would it cost to buy or construct a property of similar size and dimensions?
  • What would be the taxes and monthly investment commitments of the new asset?

Minor adjustments will be made depending on other circumstances like the age of the existing property, depreciation value, accident (if any) in the past, constructional condition, quality of the interiors, etc.

Hence, a seller will simply not consider selling at the price insufficient for buying or constructing a new commercial property of similar characteristics.

3. Income Capitalization Approach

The income capitalization approach depends on determining the amount of money an investor will be able to earn from the property through future transactions like lease agreements, monthly rent, etc.

The projected future income must cover all the investments made while acquiring the property, like purchase price, maintenance costs, taxes paid, and other miscellaneous costs.

Hence, the simple formula used for the income capitalization approach is net operating income (NOI) divided by the capitalization rate.

However, it must be kept in mind that the income capitalization approach is a little more complex than the market and cost approaches. It requires more time and work for proper implementation. Some circumstances which can disturb the income projection process are as follows:

  • Currency exchange rates
  • The life cycle of a firm/asset
  • Unpredictable environmental factors
  • Liquidity risks
  • Unfortunate accidents
  • Political or religious riots or disturbances

Another major disadvantage of the income capitalization approach is that a little discrepancy in projecting or reading the data can greatly affect an asset's value set. It is recommended to hire a trustworthy professional to undertake the income capitalization approach.

Who Conducts a Commercial Real Estate Appraisal?

A commercial real estate appraisal must be conducted by a professional appraiser. Not just commercial real estate appraisal, every real estate appraisal must be done by a professional to get an accurate evaluation.

Each appraiser can come with individual strengths and weaknesses. An appraiser expert in the income capitalization approach might not be as good in the cost approach. Hence, it is important for you to find an appraiser depending on your needs and requirements.

Do proper market research while finding an appraiser, and do not hesitate to ask for help from people in your network. A good appraiser will have good credentials, follow all the codes of ethics and rules, offer you unbiased opinions, and most importantly, get you the best price for your real estate property.

Reviewing the Appraisal Process

For your convenience, we have broken down the commercial real estate appraisal process into a step-by-step method. The steps might slightly differ depending on the individual requirements, but the general steps more or less remain the same.

Additionally, keep in mind that almost the same process applies to residential real estate appraisal.

Step 1 – Identify the commercial real estate which needs to be appraised.

Step 2 – Do a property inspection keeping in mind factors like size, location, past ownership type, zoning records, etc.

Step 3 – Record all the relevant data during the inspection and organize it for future sourcing and referencing.

Step 4 – Verify all the important documents and data recorded by visiting the relevant government offices and services.

Step 5 – Research and determine the right approach to use. The three major approaches which can be used are the market approach, cost approach, and income capitalization approach.

Step 6 – Proceed with the approach and collect all the results and data.

Step 7 – Examine and analyze in reference to the selected approach.

Step 8 – Compile the data and results to make the report and estimate.

Step 9 – Double check the data, report, and estimate for any discrepancies.

Step 10 – Draft the final appraisal report.

Things to Keep in Mind During Commercial Real Estate Appraisal

Here are some additional points you can keep in mind while getting your commercial real estate appraised to make the process as accurate and smooth as possible:

  • Ensure the inspection is done accurately, as it plays a significant part in estimating the evaluation.
  • Do not hide or misinterpret facts with your appraisers. Hiding facts will harm the credibility of the appraisal report.
  • Ensure the appraiser is following a proper protocol and code of conduct.
  • The date of valuation must be clearly and accurately mentioned in the appraisal report.
  • During the appraisal process, ensure the appraiser considers the property's interest and intended use.
  • The client, i.e., the buyer, should be the one ordering the appraisal service. It should never be the other way around.

The Bottom Line

If you are currently in the process of buying or selling commercial real estate, we understand how exhausting the process can be. If you're also caught up amidst the process of buying or selling while dealing with asset management business and commercial real estate, the pressure must double.

This is where Hubler can come in to make it easier for you. As an individual buyer/seller or real estate business holder, Hubler’s asset management software can adapt itself to all your needs.

Features like inventory management, lease management, asset allocation, asset maintenance, custom workflows, in-built depreciation management module, etc., will help you make informed and timely decisions.

The tool is extremely user-friendly and feels highly natural. As you read this, it is being used by more than 100 trustworthy partners.

So check out Hubler and get in touch with our experts to get started. 

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