In today’s market, the number of appraisals has increased from its notable decline in 2023. At the midyear mark, the number of appraisals is slowly increasing from its notable decline in late 2022 and 2023. Commercial appraisal volume from lenders increased in Q2 2024 by a modest 2.9% above Q1 as moderate momentum builds in a climate of risk-averse lending. While appraisals are improving from 2023 lows, the slow pace of new commercial real estate (CRE) loan originations is suppressing any meaningful rebound in demand for commercial appraisals as interest rates remain at elevated levels.
This suppressed market creates challenges for property valuations in CRE, particularly when there are fewer comparable transactions to reference. The current market has upended the typical reference points: net operating income (NOI), vacancy rates, cap rates and more, making valuation a challenge for appraisers. The common methods of appraising properties in this market may be faced with challenges that require alternative approaches. LightBox Head of Lender Strategy Candi Coleman weighed in on the common approaches and what the industry is seeing.
- Sales Comparison Approach: The Challenge for Today’s Market
In a functioning market, the Sales Comparison Approach is the most widely used method in real estate appraisals. It involves comparing the property being appraised to similar properties that have recently sold in the same market. Adjustments are made for differences in size, location, condition, and other relevant factors to arrive at valuations as accurate as possible. This method is easy to understand and explain to clients, and when there is a high volume of activity, it is particularly useful.
Coleman offers insight on this approach in today’s environment: “In a slow market, appraisers face significant data challenges. With fewer transactions to compare, it becomes difficult to find clear, current indicators of value. Adjustments to older comparables may be necessary. For any current transactions, appraisers must carefully analyze sale conditions that impact value, such as concessions or owner financing.”
- Income Capitalization Approach: Valuing Income Potential
The Income Capitalization Approach is commonly used for income-producing properties such as office, multifamily, and retail. This method estimates the property’s value based on its income potential, using either the direct capitalization method or the discounted cash flow method. This offers investors a comprehensive view of return on investment as it provides a clear picture of a property’s income-generating ability.
Coleman notes that “In a market with few sales, I often see investors place more weight on the income potential of a property, which remains a critical factor when transaction volumes are low. It provides a clear picture of future returns, helping buyers make informed decisions based on potential income rather than fluctuating market prices.”
Given the increased scrutiny from regulators and federal prosecutors on inflated income statements, accurate income assessments have never been more vital for ensuring trustworthy valuations.
- Cost Approach: Depreciation
The Cost Approach involves estimating the cost to replace the property with a similar one, considering depreciation based on factors such as age, wear and tear, and obsolescence. This method is particularly useful for properties that are newer or have specialized improvements whose value can be reliably estimated through replacement cost or where there are few comparable sales.
“This method helps ensure that properties are not over or undervalued simply because of a lack of recent sales data and provides a clear baseline indicator to investors,” says Coleman.
- Gross Rent Multiplier: A Quick Estimate Tool
The Gross Rent Multiplier is a simplified version of the income approach, often used for quick estimates of value for small residential rental properties. It is calculated by dividing the property’s sale price by its gross rental income.
While the Gross Rent Multiplier provides a simplified valuation based on rental income, Coleman cautions that “It doesn’t consider operating expenses or market fluctuations. So, while it is a useful tool for quick initial assessments, it should be supplemented with more comprehensive methods for final valuations.”
- Discounted Cash Flow: Projecting Future Income
The Discounted Cash Flow (DCF) method is used primarily for commercial properties, involving the estimation of future cash flows and discounting them back to their present value. This approach is more complex but can provide a more accurate estimate for income-producing properties. DCF analysis considers variables such as the property’s initial and annual costs, estimated income, and holding period. This method accounts for time value of money, giving a nuanced view of investment worth, which is beneficial for investors seeking to understand the long-term profitability and financial viability of a property. “In times of market distress, this method gains popularity as it is especially useful for commercial properties where future income fluctuation is a primary concern,” remarks Coleman. The reliance on estimations of future cash flows is one disadvantage of DCF because those could prove inaccurate.
Appraisers: Key to the Path Forward
In a market with suppressed transactions, appraisers must rely on a variety of sources to ascertain property values accurately. Benchmark data becomes essential, allowing appraisers to compare properties against historical and regional standards. Interviews with industry experts, property managers, and even tenants themselves provide valuable insights into the property’s performance and potential. By visiting physical locations, appraisers can assess the condition and unique attributes of the property that might not be evident from data alone. Examining tenant rent rolls and lease stipulations further clarifies the property’s income potential and stability, offering a clearer picture of its current value.
As the market begins to recover and transactions volume picks up, appraisers will have access to fresh market data and a bigger pool of sales comps, enhancing the reliability of their valuations. These additional proof points allow appraisers to refine valuation models and provide assessments as accurate as possible.
In this evolving landscape, the role of the appraiser is more critical than ever, ensuring that valuations reflect true market conditions and guiding stakeholders in making informed decisions.
