Valuing commercial real estate
I would like to purchase commercial property from a business associate that consists of 3 units of leased office space. He had an appraisal of the property done in 2004 after he remodeled the building and the income approach value was 330k and the market value ended up being 380k. Right now NOI is about 22k per year and the building is fully leased. The property owner and I have agreed to buy and sell at whatever the property is worth, for this we agreed the price would be the appraised value. Because of what we know the property appraised for in 2004 we assume the property would be in the $400k range just because of appreciation.

I have been in communication with two banks regarding financing and they only want to lend based on the cash flow of the building, and based on the 400k expected value the 20k NOI is very light to support that.

This brings me to my question, how should we value this property? The property is strategic in our succession planning and we both are looking to make a deal based on what the property is worth. I plan to order an appraisal but these are somewhat expensive and I have to make it so far in the bank process before this can happen.

Thank you for your input and replies.
[{"id": "eut85ae", "text": "Get a new appraisal. A 2004 appraisal is worthless in 2019. \n$20,000 NOI and $400,000 value for an office sounds off to me but it could be fine depending on tenant strength and lease terms.", "replies": [{"id": "euta03l", "text": "From your experience how much does the current NOI factor into the appraisal value? I understand there are different approaches but how they end up meshing together isn\u2019t clear to me.", "replies": [{"id": "eutdd8q", "text": "Do yourself a favor and hire an appraiser, and have the seller get an appraisal. Meet in the middle on price. Fair deal between friends, no worries about skewing anything.", "replies": [], "depth": 3}, {"id": "eutduk2", "text": "I agree a new appraisal would be needed. You can order a private appraisal without going through a bank. We can even complete verbal reports, which saves you money since it saves us time in not completing an actual appraisal report but we still do the analysis and have a workfile.", "replies": [], "depth": 3}, {"id": "eutsm87", "text": "For an appraisal of a leased investment, the Income Approach will be given the most weight. The Sales Comparison Approach will be used to identify a market cap rate that can be used in the Income Approach.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "eutbg47", "text": "$22k NOI on a $400k value is a 5.50% cap rate, which I can tell you right off the bat is way too low, as I assume these are just some local tenants in a small building? I don\u2019t know your location but $22k NOI for 3 tenants is very low, so I assume it\u2019s a small building, local tenants, no long term leases in place? It\u2019s hard to get a feel without knowing the location, size and lease terms. \n\nIf you guys plan on just using an appraised value for the purchase price and negotiations then just do that and let them value it for you since it doesn\u2019t seem like you guys are too sure. An 8% cap rate on $22,000 NOI is $275,000, that might be a good benchmark, but again it\u2019s hard to tell without knowing more. Keep in mind if you plan on financing the purchase you will have to pay for another appraisal as no lender will use a previous appraisal where they aren\u2019t the intended user, and another appraiser will be used.", "replies": [{"id": "eutd652", "text": "This is the right answer.", "replies": [{"id": "eutwpic", "text": "As a former commercial banker, yes. There are some additional details as well, but this post delivers.", "replies": [], "depth": 3}, {"id": "euvfgrx", "text": "Agreed, except we don't know the location or size of the improvements either. Get the appraisal. You may end up paying for it twice (on the front end to agree on the price and again through the lender) but it's a small price to pay to get everyone comfortable and on the same page.", "replies": [], "depth": 3}], "depth": 2}, {"id": "euwxlgg", "text": "Ha you think 5.5% cap is low? I\u2019m in SoCal and been seeing 2-3% caps on retail spaces. Especially retail buildings with A credit tenants. Haha\n\nBut to the OP, this post is the answer!", "replies": [{"id": "euz7tkk", "text": "lol holy shit, that doesn\u2019t even sound real. It\u2019s hard to wrap my head around that.", "replies": [{"id": "ev1ij1y", "text": "Yea it\u2019s nuts! My investors are telling me to look outside California now, but I doubt they\u2019d go into another country!", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "eutd8yg", "text": "Commercial Appraiser here, the $22K NOI will be compared to the market. The appraiser will compare income and expenses to comparables. So it may be too low or high as compared to market and the fee simple (100% leased at market) and leased fee interest (current leases) would be analyzed. \n\nAt $400K and $22K NOI, that would be a 5.5% cap. Is that typical for your area? Also, I'm assuming the NOI indicated does not account for debt payments.", "replies": [], "depth": 1}, {"id": "eutyadq", "text": "A bank is only repaid based on cash flow. They will underwrite to a debt service coverage ratio of at least a 1.25x. That means there needs to be at least $1.25 of NOI to cover every $1.00 of monthly debt payment. $22k annual NOI can only sustain a $17.6k annualized debt payment, which at a 20 yr term is only ~$200k in debt. \n\nA 2004 appraisal is beyond worthless. Call a commercial broker in the area and ask what caps rates are doing for a small office building. My guess is 7-9, unless you\u2019re in a coastal market or your tenants are doctors or national corporations with long term leases.  The bank will also look at the most applicable appraisal method, which in this case would be income approach. The appraiser will use the NOI and market cap rates to derive a value.\n\nAs others have mentioned we need to know more about the property to help any more. But you can get a really good idea of value based on a quick call to a CRE agent and asking here. Also, if you do order an appraisal do it through your bank.", "replies": [{"id": "euvnogf", "text": "This is the other half of the right answer. Value = NOI/Cap Rate AND max debt= 1.25x DSCR. \n\n&amp;#x200B;\n\nAppraisals are not a great valuation metric, TBH. They only serve to make everyone comfortable that you haven't OVERPAID, and to make your investors feel comfortable that there's been price appreciation during the hold. Unless your market is highly liquid, they're usually not a great estimate of future cash flow or value. My first few years as an analyst, one of my primary jobs was to pull cap rate comps to fight low appraisals. We always got them bumped up, which speaks to why they're not a great valuation metric in the first place.", "replies": [{"id": "euyo7bv", "text": "We use them to do exactly what you said, show investors that the underlying assets have appreciated. They seem to like the reassurance.\n\nAppraisers typically want to come in conservative so they don\u2019t get caught up in something because they overvalued the property.", "replies": [{"id": "ev0vlit", "text": "We're starting to see valuation problems with the appraisers not understanding yieldstar/LRO vs concessions. They're underwriting 12 mo burndowns on 4-8 weeks free, and tacking on \"market rent growth\" to both revenue managed and manually priced units. The math looks like this:\nComplex A charges $2000/mo, but gives 2 months free at move in, prorated. The new tenant rent is $1666/mo\nComplex B uses revenue mgmt and charges $1666/mo, which is market rent.\nUpon valuation, for the forward year the appraiser burns down the entire concession of complex A. Then adds 3% market rent growth to both complex A and B.\nThe New Rent at complex A: $2060/mo\nNew Rent at complex B: $1716/mo\nRent growth at complex A: 23.64%\nRent growth at complex B: 3%\n\nain't nobody getting 24% rent growth next year... but the appraisers don't seem to understand that those prorated concessions are going to end up lingering on the rent roll for years. Hell, I remember underwriting concession burnoffs in 2013, a full 5 years after the financial crisis.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "euyw479", "text": "Im an appraiser. There\u2019s some good info here, so I\u2019ll try not to repeat what\u2019s already been said. You can order a restricted appraisal, which may cost less. These can have less analysis on the area and such, which cuts down on time and cost. \n\nI\u2019d also examine the leases. Are they market oriented or below market?  This can be adjusted with the cap rate. If they aren\u2019t long term leases and market vacancy is low, maybe increase rents to market?  \n\nLook at your expenses, too, and think \u201cwhat would a typical investor do?\u201d Appraisers eliminate unnecessary costs. This gives a more accurate and standard picture of what the property can achieve as an NOI ratio. \n\nI\u2019m curious... where is this property located?", "replies": [{"id": "ev0e7bk", "text": "It is in Westmoreland County, PA. So what I decided to do was move forward with getting appraisal bids through the bank. It sounds like you are saying that you won't factor in his schedule E expenses too much then and will instead come up with a normal or best case scenario from what you determine market rent and expenses to be?\n\nAlso, since I am ordering the appraisal through a bank for the purpose of investment, does that change anything? I assume what the property is currently bringing in has something to do with determining market value and I understand that there is also what the property could be doing, and also the inherent value of the building and land. Unless fair market rent incorporates everything when determining value.\n\nI suppose where I am coming from is, if the property can only generate 20k in NOI at fair market rent, can the value of the property really be much different than NOI divided by a cap rate?", "replies": [{"id": "ev0m7rk", "text": "That\u2019s where the lease terms play a big role. If the leases expire in a typical holding period (5, 7, or 10 years, typically) then they can revert to market rents. If they\u2019re long term, then the building should be appraised at what the rents are, currently. If they expire soon, you\u2019re looking to appraise the fee simple interest. If they are long term, you\u2019re appraising the leases fee interest.", "replies": [{"id": "ev0opqs", "text": "Gotcha. Do you see much disparity between what the income approach says the value is versus what market value ends up determined to be?", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ewshaz6", "text": "Most appraisers go through the motion and the process looks good but the value magically comes out near the selling/asking price.\n\nMy recommendation is that you do the work yourself and see if you can find similar properties that have sold near you property over the past 12 months. Make adjustments for anything special in your or the other property.  You can find a lot of information from commercial listing sites sites such as catylist and [cimls.com](https://cimls.com).\n\nIf you can come up with enough data then you can agree on the best price.", "replies": [], "depth": 1}]