How Does a Commercial Real Estate Appraiser Determine an Accurate Market Value? Key Methods Defined

In commercial real estate, it is common to determine a “price per square foot” when evaluating commercial property, but there is more to the valuation process than a simple formula. Very simply put, the purpose of the commercial real estate appraisal is to determine a property’s market value. This is often for lending purposes – to prove to a lending institution that the value of a property in question is comparable to the amount borrowed. There are three commonly used approaches to determine value – the cost approach, sales comparison approach, and the income approach. This article defines each, hopefully educating those not familiar with how value of commercial real estate is determined.
1. The Cost Approach. This form of methodology calculates the cost of reconstructing the subject property, considering the same improvements and site characteristics, and then subtracts a depreciation value from the determined replacement cost. The replacement cost is calculated by conceiving the ultimate cost of reconstructing the design of the commercial property with today’s equipment, materials, and labor, and the depreciation value is determined by the subject’s age, as well as comparable sales data. It is therefore often necessary to use the following method, the sales comparison approach, at the same time.
2. The Sales Comparison Approach. A professional appraiser knows that properties with similar characteristics will also have similar market values. Buyers in the commercial real estate market are always wondering the prices at which comparable properties have sold in the recent past, since they are not willing to pay more than what the previously sold properties have proven to be worth. Hence, a “market value” is created among properties of similar utility, square footage, location, amenities, and so on. This is a great source of data for an appraiser needing to determine market value, but at times this data is limited.
3. The Income Capitalization Approach. This approach is suitable for commercial real estate appraisals and income-producing properties. Simply put, buyers of income-producing properties must consider the Net Operating Income (NOI), which consists of the Gross Potential Income with all units leased at an anticipated market rate, minus operating costs like taxes and owner expenses. The appraiser divides the annual NOI by the current capitalization rate for an eventual market value.
Many times, commercial real estate appraisers will utilize all three methods in their reports, effectively analyzing all aspects of current market trends in the process.