Commercial Appraisals: The Purposes, Process and Approaches to Value
It is a common misconception that the only purpose of a commercial appraisal is to assist a property owner in acquiring financing from a lending institution. While this is one of the more common purposes, there are many others. There is quite a wide range of users of our reports who make decisions based on real property values. Whether you are the developer, lender, homeowner, realtor, investor, lawyer, landlord, farmer, government body, bankruptcy trustee, accountant, seller or purchaser – you make decisions based on a property’s value or you make decisions that will have an impact on a property’s value.
Most individuals or organizations with real estate involvement would benefit from an increased understanding of the many circumstances where a professional appraiser’s services would be advantageous. As a decision maker, you understand that quality information is an asset that is essential in determining the ultimate choice of action. Below is a condensed list of areas where a qualified professional appraiser can assist you:
- accounting issues related to property fair market valuations required by the coming International Financial Reporting Standards (IFRS)
- “as complete” valuations for proposed upgrades and renovations
- assessment reviews for tax appeals
- bankruptcy valuations
- blueprint appraisals for proposed structures
- business planning
- condominium reserve fund studies
- current or retrospective (historical) valuations
- divorce settlements
- estate planning and/or settling
- expropriation compensation valuations
- lease analysis & market rent estimates (for landlords and tenants prior to signing leases)
- lender financing
- project feasibility studies
- replacement cost & insurance valuations
- reviewing of appraisal reports completed by other appraisers
- land subdivision development analysis
- tax / capital gains issues
In the process of completing a commercial appraisal, your first step would be to have your specific need identified. During this step, the appraiser should ask you various questions to ensure there is a clear understanding of your situation. With a clear understanding, a knowledgeable and well trained appraiser would then present you with a solution that includes the ideal strategy to complete your valuation request.
At this point, you are ready to choose your preferred appraisal firm. If your aim is to attain the best information, it stands to reason that you should choose the individual or firm with the highest training and expertise. Remember that not all information is valuable, only correct information is. You should know that there is a wide range of real estate appraisal training available in Canada. The most extensive requirements are demanded by the Appraisal Institute of Canada (AIC).
The AIC now requires all members, prior to attaining their designation, to have completed a university degree, additional appraisal courses through the University of British Columbia and a lengthy mentorship experience program. Founded in 1938, the AIC is Canada’s oldest appraisal organization. With membership of over 5,000 members, it is also the largest. Reports completed by AIC members are by far the most accepted by lenders and the courts in Canada.
It is also important that you are aware of the two differing paths of training within the AIC, which lead to either the CRA (Canadian Residential Appraiser) or the AACI (Accredited Appraiser Canadian Institute) designation. Members with the CRA designation are trained in the valuation of single family residential sites and dwellings, containing not more than four family housing units.
For a commercial property valuation, you will require a member with the AACI designation as they are fully accredited, trained and insured to value a wide range of property types including residential, commercial, industrial and agricultural. If you would like additional information concerning the AIC, you can visit their web-site at www.aicanada.ca.
With your appraisal need specified and your appraisal firm hired, the appraiser would then start collecting information about your property and data from the market. This often begins with a physical inspection of your property along with gathering the legal title, real property report, tax assessment and any leases that are in place.
While not all encompassing, some of the data typically gathered from the market includes listings and sales of comparable properties and leases, replacement cost estimates, development and permit information, and other economic indicators and statistics. The key is that this information must be extracted from the market, as market based information is the backbone of a market value estimate.
The Approaches to Value
As mentioned previously, there are many purposes and users of a commercial appraisal. There are also many commercial property types and classes. The length of this article does not allow for a full discussion on all of the processes and approaches to value that are employed by an appraiser. Although there is not any one universal definition of the process of valuing a property, from a broad perspective, it could be described as a systematic set of procedures that gauge the impact of government/legal, economic, social and environmental forces on a property relative to its utility and scarcity in combination with the desire and effective purchasing power of the public.
In order to provide you with a simplified explanation of the most common approaches to value, assumptions will be made to narrow the discussion to the most basic commercial property. The information provided will be based on the following assumptions:
- Your request is for the appraiser to estimate the current market value of your property.
- Your property is one parcel of land improved with one primary building.
- Your property in a commonly traded type of property with a purpose of generating income (e.g. a modestly sized office, general purpose light industrial, or retail property).
- Your property is not a special use property constructed for a specific purpose (e.g. motels, gas stations or car/truck washes).
- Your property does not have any leases in place (fee simple ownership).
Based on these assumptions, a basic improved commercial property can be valued using three common approaches. These are the Direct Comparison, Cost and Income approaches.
The Direct Comparison Approach is based on the principle of substitution, which suggests that the value of the property is set by the selling (and listing) prices of similar properties in the marketplace. Comparative analysis between the subject and these comparables focuses on their similarities and differences that affect value.
The Cost Approach is the estimated cost to replace the property, less adjustments for various forms of depreciation. This is completed by adding the depreciated replacement cost of the property’s improvements to the value of the land. While this approach may seem obvious and straight forward, the depreciation forms are often misunderstood. Due to this lack of understanding, many individuals and appraisers produce an incorrectly high value estimate under this approach. Also, particularly with older improvements, the total estimate of depreciation can be difficult to support resulting in some appraisals being completed without this approach.
The Income Approach is the estimated present value of the property’s future income potential. Two common methods involve the use of either gross income multipliers or an overall capitalization rate application. Both applications involve the conversion of a single year’s expected or projected income for the property into a value and both fall under the sub-heading of Direct Capitalization. Each of these methods is discussed below.
- Gross Income Multiplier (GIM) method - The simplest Direct Capitalization method is referred to as the Gross Income Multiplier (GIM) application. This method simply relates the selling price of a property to its annual gross income. A property’s selling price divided by its annual gross income produces a factor or multiplier. For example, a property that sells for $100,000 with an annual gross income of $14,000 would have a GIM of 7.14. Through the examination of several sold properties that are similar to the subject, an appropriate GIM can be applied to the subject’s gross income to arrive at a market value estimate for the subject.
For this example, a GIM of 8.0 will be selected. The appraiser would also estimate the subject’s annual gross income potential – also through market analysis. It will be assumed that a reasonable income for the subject is estimated to be $16,000 per year. These estimates would then be multiplied against each other to produce a value estimate using the formula of GIM X Annual Gross Income = Estimated Market Value. For this example, the value estimate produced is 8.0 X $16,000 = $128,000.
- Overall Capitalization Rate (OCR) method – This method estimates the market value of the property using the formula of Market Value = NOI / Capitalization Rate. While there are several possible methods to estimate the capitalization rate, the preferred method is to extract capitalization rates from the market by analyzing a number of recently sold similar properties. This is completed by dividing each of the comparable properties’ net operating incomes (NOI) by their respective sale prices. A property’s NOI is determined by deducting operating expenses from income. In estimating a property’s income potential, it is critical that it is gauged through an analysis of the market and not simply based on an existing lease (if one is in place). If leases are in place, the appraiser must estimate their impact on the property’s overall value.
The capitalization rates produced by the comparable sales are communicated in a percentage form. For example purposes, it will be assumed that a reasonable capitalization rate to apply, as taken from the comparable sales, is 10%. The next step is to estimate or calculate the subject property’s NOI to produce a value conclusion for the subject. For this example, the assumption will be made that the subject property’s NOI is $12,000. This produces an estimated market value for the subject property of $12,000 / 10% = $120,000.
Under this type of analysis, it is critical that the cap rate is extracted from market data and not produced with an out-of-date theoretical or built-up method. An example of a built-up method is the Band of Investment (mortgage and equity) technique, where the cap rate is calculated from a blend of current mortgage rates with investor’s expected equity returns. Such methods are only acceptable when sufficient market data is available to extract equity capitalization rates and when equity dividends are the primary investment criteria used by buyers and sellers. Such is definitely not the case in the local market. Furthermore, even if an appraiser has sufficient market data from comparables to support a built-up method, this implies that there is sufficient data for the cap rate to be calculated using a market determined OCR (as discussed in the previous paragraph). In short, a market determined overall cap rate is accepted as the recommended technique by the appraising profession.
While this article should provide you with a basic understanding of a commercial appraisal, there are many complexities that have not been illustrated. The reader is reminded that the approaches to value have been discussed in a very simplified and condensed form with the presentation based on a common commercial property type without any complications.
The authors of this article are Gerry Gehlen and Ken Rutherford of Atlas Appraisal Services. Both of these individuals are members of the Appraisal Institute of Canada. Gerry is the owner of Atlas Appraisal Services and is the only AACI designated appraiser in this trading area. Ken Rutherford, a University of Alberta Commerce graduate, is in the final portion of training for the AACI designation.
Atlas provides a wide range of appraisal services for residential, commercial and agricultural properties. If you have any questions concerning this article or any general real estate valuation questions, please feel free to call Atlas Appraisal Services or stop in for a coffee.
Our contact information:
Atlas Appraisal Services Inc.
Lloydminster, AB T9V 0W7
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