How Accurate Are Commercial Appraisals?

It’s an accepted real estate maxim that appraised value lags commercial property sale price. But it’s the size of the gap between appraised and market value that can have a real impact when a seller wants to evaluate an offer or a buyer wants to qualify for a loan. How much variation is there between appraised value and sale price? What should investors keep in mind as they assess appraisals as a way of determining property performance? Research by Susanne Cannon, associate professor of real estate, and Rebel Cole, professor of finance, at DePaul University in Chicago, relies on 27 years of data from the National Council of Real Estate Investment Fiduciaries’ National Property Index.

How much does an appraisal differ on average from a commercial property’s sale price?
Cannon: We found that the median value assigned for individual properties was more than 12 percent above or below sales prices for transactions that took place two quarters after the appraisal. Even for the entire NCREIF portfolio, appraisals were off by an average of 4 to 5 percent. Of course, that’s an average. The variations can range anywhere from almost zero in 1993 to 1995 when the market was down but relatively stable to 15 percent in 2008 when the commercial market suffered a sharp decline. That doesn’t necessarily mean that the appraisal is wrong and the sale price is right. Other factors can also influence how much a buyer is willing to pay. For example, if several buyers get into a bidding war, it might push up a price beyond what the property might be worth based on income or comparable sales.

What accounts for the wide range of variation?
Cole: The greatest deviations take place when markets are changing rapidly. When prices are rising, appraisals tend to underestimate value. When markets are tumbling, appraisals usually overestimate sales price. In our research, we saw the largest deviations between appraisals and sales price during the two biggest peaks and valleys in the real estate cycles. The biggest negative variations were between 1990–1991 and 2008–2009; the greatest positive one was 2004–2006.

Do the differences between sales price and appraisal vary by property type?
Cannon: To some extent, yes. The variation on offices has a mean of 13.5 percent, retail 13.3 percent, industrial 12.1 percent, and apartments 11 percent. The cash flows for apartments and industrial properties are typically more stable than those for office or retail, so we would expect this ordering.

What factors account for the differences between appraisals and sales prices?
Cole: We’ve identified five major determinants that affect the difference: the amount of price appreciation, the number of sales, the change in property income, the change in the cap rate, and the change in construction costs. Together, these variables explain half the difference between appraisals and sales prices.

Cannon: Of the five, by far the most influential is the number of sales, which accounts for more than 37 percent of the variation. When properties are bought and sold more frequently because the market is frothy, the gap between appraisal and sales price widens.

The properties in the NCREIF Index are primarily larger, institutional-grade real estate. Do the same factors that cause a gap between appraisals and sales prices apply to smaller commercial properties bought and sold by individual investors and partnerships?

Cole: I certainly expect so, because these are general macroeconomic factors that influence the value of all properties, large and small. That said, more research is needed on smaller commercial properties, which are much more heterogeneous than institutional investments.