Industry News

Navigating the complexities of national economic trends is critical to understanding their impact on commercial property valuations. These trends can have profound implications on investment decisions, market dynamics, and long-term strategic planning within the commercial real estate sector. At Lowery Property Advisors (LPA), we prioritize providing our clients with comprehensive and insightful analyses that reflect these economic influences. Our expertise in commercial real estate appraisals, enriched by our extensive presence across the Southwest, positions us to offer nuanced and actionable guidance in this ever-changing market landscape.

In this article, we’ll explore the key economic trends that are currently shaping commercial property valuations. From the impacts of fluctuating interest rates to the evolving landscape of technology in real estate, we’ll provide you with the essential knowledge needed to traverse these complex economic waters.

Current Economic Trends and Their Direct Impact on CRE Valuations in 2023

The landscape of commercial real estate is invariably shaped by the ebb and flow of the broader economy. In 2023, we are witnessing a unique confluence of economic factors that directly influence commercial property valuations. From the anticipation of a moderate recession to the impact of the Federal Reserve’s rate hikes, each element plays a crucial role in determining the market’s trajectory. Additionally, sector-specific trends in industrial leasing, the multifamily market, and office space dynamics are redefining investment and valuation strategies. Understanding these trends is not just about responding to current market conditions; it’s about strategically preparing for the future in an industry where change is the only constant.

Recession and GDP Growth

CBRE’s midyear review in 2023 predicts a moderate recession extending into early 2024, revising the GDP growth forecast to 2.0% for 2023 and a downward adjustment to 0.7% for 2024. These changes reflect a resilient yet slowing economy, impacting CRE investment decisions. The anticipated recession, marked by this slowed economic growth, is expected to create a cautious environment among investors and developers in the CRE sector. This caution is likely to lead to more conservative investment strategies, prioritizing stability and long-term growth potential in commercial properties. Additionally, the revised GDP forecasts suggest a shift in market dynamics, possibly affecting the demand and valuation of certain property types more significantly than others.

Interest Rates

The Federal Reserve’s rate hikes, peaking between 5.25% to 5.5%, are intended to curb high inflation. This steep rate-hiking cycle influences borrowing costs and investment dynamics in CRE, with expectations of rate decreases starting in 2024. The higher interest rates result in increased financing costs for property acquisitions and developments, potentially leading to a slowdown in new CRE projects and transactions. These higher costs might also prompt investors to reassess yield expectations and risk assessments, possibly shifting interest towards properties with more stable income streams. However, the anticipated decrease in rates in 2024 could signal a more favorable borrowing environment ahead, potentially reinvigorating investment activity and development projects in the CRE sector.

Industrial and Logistics Leasing

Surpassing expectations, this sector is on track to reach significant activity levels by year-end. This robust performance is driven by sustained demand for warehousing and distribution spaces, particularly fueled by the continued rise of e-commerce and supply chain realignment. Higher rent growth in emerging markets is a reflection of this strong demand, as businesses scramble to secure strategically located spaces for logistics operations. However, alongside this growth, there’s an observed increase in vacancy rates. This rise in vacancies is primarily due to tenant requirements evolving more slowly than the pace of new construction, resulting in a temporary surplus of available space. As the market adjusts to these changing requirements, we may see a realignment of construction projects to better match the nuanced needs of modern logistics operations, potentially stabilizing vacancy rates in the future.

Multifamily Market

​​The multifamily market has exhibited resilience and growth, with new construction and absorption levels surpassing initial forecasts. This trend indicates a sustained demand for multifamily housing, likely fueled by various factors including demographic shifts, urbanization trends, and affordability challenges in the single-family housing market. However, there’s a noticeable downward revision in annual rent growth, which can be attributed to lower Consumer Price Index (CPI) inflation expectations and changes in the employment outlook. The tempered inflation expectations suggest that the rapid rent increases seen in previous periods might stabilize, bringing some relief to renters. Meanwhile, the employment outlook, which directly influences consumer spending power and housing affordability, plays a crucial role in determining rental demand and pricing. If the job market remains robust, it could support continued demand in the multifamily sector, but any downturn might lead to adjustments in rent growth projections and investment strategies.

Office Market Dynamics

The office sector is currently undergoing significant changes. High availability rates are leading to a noticeable reduction in new space deliveries, as developers respond to the market’s current state with caution. This trend is contributing to an increase in the overall U.S. office vacancy rate, reflecting a period of adjustment as the market grapples with post-pandemic shifts in work patterns, including the rise of remote and hybrid work models. These shifts have led to a reevaluation of office space requirements, with many businesses opting for smaller, more flexible office spaces or even relocating to less traditional office markets.

Despite these challenges, demand for prime office space remains robust in fast-growing markets like Austin, Dallas, and Nashville. These markets are attracting businesses due to their strong economic growth, favorable business climates, and quality of life factors. As a result, prime office spaces in these areas continue to see healthy demand, underlining a trend towards a flight to quality where top-tier office spaces in desirable locations maintain their appeal. This resilience in prime office space demand suggests a bifurcation in the market, where well-located, high-quality office properties perform strongly even as other segments face headwinds.

Real Estate Market Dynamics

The dynamics of the real estate market, particularly in commercial sectors, are deeply influenced by the interplay of supply and demand, demographic shifts, and the cyclical nature of the industry. These elements, often interconnected, create a complex tapestry that dictates property values, investment viability, and market opportunities. Understanding these dynamics is not just crucial for appraisers and investors; it’s fundamental for anyone engaged in the commercial real estate space, as these factors collectively shape the market’s present and future landscape.

Impact of Supply and Demand Fluctuations on CRE Values

Recent trends show a mixed picture in commercial real estate (CRE), partly due to economic uncertainties and changing market dynamics. For instance, while interest rates have risen sharply, inflation has shown signs of declining​​. This has led to a more cautious environment in the CRE sector, impacting loan availability and investment decisions. Specifically, there’s an increase in available CRE spaces across various sectors, including retail, office, multifamily, and industrial, with each sector responding uniquely to these economic shifts​​.

Effects of Urbanization Trends and Demographic Shifts

Urbanization continues to significantly influence the CRE market. The multifamily sector, for example, saw a 27% increase in delivered units over the past year, indicating a strong demand driven by urban migration and demographic changes. This sector is expected to remain robust, buoyed by favorable demographics and a strong job market, despite a slight increase in vacancy rates​​. Additionally, changes in work patterns post-pandemic, such as the rise of remote and hybrid models, have led to a record high office vacancy rate of 13.5%, underscoring the sector’s ongoing adjustment to new realities​​.

The Role of Real Estate Cycles in Valuation

The real estate market’s cyclical nature is evident in the current trends. For instance, the industrial sector, while slowing from its previous highs, has returned to pre-pandemic levels, with rental costs still growing but at a moderated pace​​. The retail sector, on the other hand, has shown remarkable resilience, with vacancy rates remaining stable and consumer spending in physical locations recovering swiftly, indicating a strong post-pandemic rebound​​. The hospitality sector, too, has seen a surge in demand, with revenue per available room now more than 13% higher than its pre-pandemic level, signaling a robust recovery in this space​​.

The Influence of Government Policies and Regulations

The regulatory landscape in commercial real estate is undergoing significant shifts, driven by both evolving market conditions and government initiatives. Understanding the impact of these changes is crucial for stakeholders in the commercial real estate sector.

Zoning Laws and Tax Policies

• ESG Disclosure Requirements: Real estate firms are increasingly focusing on Environmental, Social, and Governance (ESG) compliance, with only a small percentage currently prepared for immediate implementation of new regulatory requirements. This shift toward ESG considerations is influencing investment strategies and property valuations​​.
• Tax Regulation Trends: The real estate industry is closely monitoring global trends in tax regulation, including increased tax rates and changes to transfer pricing/profit-sharing. These trends highlight the need for real estate companies to increase transparency and consider the tax implications of ESG initiatives. For example, tax credits may be available for qualifying activities under new or forthcoming legislation​​.

Government Incentives for Adaptive Reuse

• Adaptive Reuse of Office Properties: There’s a growing focus on converting underutilized office properties into residential buildings, driven by high office vacancy rates and a nationwide housing shortage. This trend is being supported by federal incentives aimed at encouraging adaptive reuse, addressing both the surplus of office space and the need for affordable housing​​.
• Economic Impact of Pandemic and Remote Work: The work-from-home trend, solidified during the pandemic, has led to high office vacancy rates and significant economic implications. This includes a reduction in real estate asset values, affecting state and local government revenues from property taxes​​.
• Environmental Benefits and Regulatory Challenges: While converting commercial buildings to residential use offers environmental benefits, challenges like high conversion costs, zoning restrictions, and building codes have limited its broader implementation. However, several states and cities are enacting policies to reduce these barriers and provide financial incentives. Examples include legislation in California and initiatives in Chicago and New York City aimed at facilitating property conversions and addressing housing shortages.

These regulatory changes and government initiatives are reshaping the commercial real estate landscape. By understanding and adapting to these trends, real estate professionals can better navigate the complexities of the market and capitalize on new opportunities.

Impact of Emerging Technologies on Property Valuations

Technological advancements, particularly in proptech, are not only transforming operations in commercial real estate but also significantly influencing property valuations.

Smart Building Technology and Valuation

The integration of smart building technologies enhances the appeal and functionality of properties, thereby increasing their market value. Smart buildings, equipped with IoT and automation systems, offer enhanced energy efficiency, security, and occupant comfort. These attributes are increasingly valued in the commercial real estate market, leading to higher valuations for properties that boast such advanced features​​.

Efficiency and Cost Reduction through Proptech

Operational efficiencies gained through proptech solutions directly affect the bottom line of property management, making properties more attractive to investors. By automating tasks and improving operational processes, these technologies reduce costs and errors, contributing to better financial performance and, consequently, higher property valuations​​.

Predictive Analysis and AI in Valuation

AI and machine learning play a crucial role in predictive analytics, helping appraisers and investors make more informed decisions about property values. These technologies enable a deeper analysis of market trends, occupancy rates, and rental income potential, providing a more accurate and dynamic approach to property valuation. As highlighted in our recent blog post, AI’s ability to assist in understanding market dynamics, forecasting future trends, and estimating the true value of properties based on a plethora of variables is invaluable for accurate appraisals.

By harnessing these technological advancements, commercial real estate professionals can enhance property valuations, optimize operations, and stay ahead in a rapidly evolving market. The integration of smart technology and AI into real estate not only improves operational efficiency but also contributes to more accurate and dynamic property valuations.

Predicting Future Trends in Commercial Real Estate Valuations

Economic and CRE Market Outlook

The economic outlook for the coming years is shaping the commercial real estate (CRE) landscape. Deloitte’s 2024 commercial real estate outlook highlights several key factors influencing property valuations:

• Expense Mitigation: A significant focus on cost reduction, especially in talent and office space, reflects an environment where revenue expectations are at their lowest since 2018. This trend could influence property valuations, especially in sectors where operational costs are a major consideration​​.
• Cost of Capital and Availability: Approximately 50% of respondents expect cost of capital and capital availability to worsen through 2024, which could impact investment decisions and valuations in CRE​​.
• Cyber Risk: The growing concern about cyber risk, especially as smart technologies become more prevalent in buildings, indicates a shift in factors considered in property valuations​​.

Changing Property Sector Dynamics

• Leasing Fundamentals: There are expectations of worsening leasing fundamentals, including vacancies, leasing activities, and rental growth, which will likely influence property valuations over the next 12 to 18 months​​.
• Shift in Attractive Property Types: Digital economy properties (data centers, cell towers) are now viewed as the most attractive risk-adjusted opportunities. The office sector, both downtown and suburban, has dropped significantly in attractiveness, reflecting the impact of hybrid work models on property valuations​​.
• Remote Work’s Impact on Office Valuations: The remote work trend continues to disrupt office space demand. Despite job additions, the office sector has seen significant space and valuation declines. There is a clear trend towards quality, with newer, high-quality assets outperforming others​​.

Sector-Specific Trends

• Industrial Market Strength: Continued demand for industrial spaces, driven by e-commerce and third-party logistics, suggests sustained competition and rent growth, positively impacting valuations in this sector​​.
• Multifamily Rental Demand: Interest rate hikes have led to a decline in home sales, subsequently increasing the demand for multifamily rental properties. This trend suggests continued rent growth and robust valuations in the multifamily sector​​.

In summary, the future economic projections indicate that commercial real estate valuations will be influenced by a combination of economic factors, including cost mitigation efforts, capital availability, cyber risk considerations, and changing preferences towards property types. The ongoing shift towards digital economy properties, the impact of hybrid work models on office space, and sustained strength in the industrial and multifamily sectors are key trends that CRE professionals should consider in their valuation strategies.

Navigating the Future of Commercial Real Estate Valuations

As we look back on the key points discussed in this article, it’s clear that the commercial real estate (CRE) landscape is undergoing significant transformations driven by a variety of factors, including economic trends, sustainability, and emerging technology.

In conclusion, the need for continuous monitoring of these trends is essential for anyone involved in CRE. Staying informed and engaged with the evolving market dynamics will enable investors, developers, and appraisers to make informed decisions and strategically navigate the complexities of CRE valuation. As we move forward, adapting to these changes and leveraging the insights gained will be key to success in the commercial real estate market.

At LPA, we understand a deep knowledge base steeped in the most accurate market data is critical, and we are committed to providing that level of service for our clients.

To learn more about LPA’s commercial property appraisal services visit www.lowerypa.com.

It’s no secret that Generative AI use has exploded in 2023. Once the stuff of fiction, the technology is now everywhere, with a third of organization leaders saying they now regularly use AI tools, according to a recent survey.

There’s no denying the impact that AI is having on our daily lives. So, how will AI change commercial real estate and commercial appraisal? LPA Senior Associate Researcher Andrew Burns and Research Associate Ashley Travis weigh in on what’s happening and what it means for you.

AI is Already Having a Direct Impact on the Data Center and Industrial Markets

Data centers have been a growing CRE asset class over the past several years as businesses expanded cloud services, consumers embraced streaming content, smartphone use became universal, and social media replaced traditional media as a primary source of information. The switch to remote education and hybrid work during the pandemic further fueled the demand for data processing and storage.

“As AI becomes more popular and more in demand,” says Andrew, “the need for more data centers, and additional industrial warehouses, is going to increase. AI uses up so much more energy and power than normal software that current data centers are running out of power, and room, to keep up with demand. Companies are either going to spend money to build more data centers or lease industrial warehouses, but either way, the data center and industrial markets are going to benefit.”

The computing power needed to meet today’s demands require state-of-the-art facilities with advanced HVAC systems, abundant, reliable power supplies, and strong security. Maintaining and updating an in-house data center can be cost-prohibitive for many businesses, creating a need for data centers to provide space, power, cooling systems, and physical security. This demand has resulted in a strong market for data center real estate with features that vary based on data center type.

The Impact of AI in CRE will be Felt in Both Expected and Unexpected Locations

Data center capacity, measured in megawatts, is not growing fast enough to meet demand, which in turn is pushing up lease costs. CBRE reports that data center customers in Northern Virginia have seen a nearly 8 percent rate increase over the past year, while Silicon Valley rates are up 43 percent over the same period. And demand continues to rise despite the inflated prices, opening new opportunities for CRE investors.

JLL Research estimates that the real estate footprint of AI companies will reach 1.6 million square meters by the end of 2023. Major metro areas with established tech markets are seeing the most data center development, with the most growth occurring in the Washington D.C./Northern Virginia region, Silicon Valley, and Dallas/Fort Worth.

According to Ashley, “It seems as though the cities with the biggest tech imprints are benefiting significantly more than the rest of the cities. This is due to the existing technological infrastructure in place, including established tech companies and research universities. Being able to tap into the research and data that these colleges and companies provide gives certain cities a leg up on the rest.”

Developers must, however, also consider the cost of land when scouting a site. Tier 1 cities are experiencing a considerable rise in land prices, pushing developers to the suburbs and rural areas. For example, over the next 20 years, Amazon plans to invest $35 billion to expand its data center business in Virginia’s northern suburbs. As Ashley notes, “Areas with large plots of land available have the potential to benefit from the AI boom. Vacant office buildings could also potentially be converted into data centers.”

Greater Demand May Mean Higher Construction Costs and Property Values

While the pandemic-related surge in construction costs has abated, supply chain issues and labor shortages continue to affect building costs. Datacenter structures may resemble ordinary warehouses, but the vast amount of energy they require (nearly 2 percent of the nation’s electricity use, according to the U.S. Department of Energy) demands that centers be equipped with costly energy-efficient hardware and state-of-the-art HVAC systems. Additionally, the growing demand for data processing and storage facilities is inflating land prices in areas best suited for data center development.

AI is also Creating Efficiencies in CRE

Even as prices rise, CRE owners and management companies may be able to tap the power of AI to streamline costs.

“Based on my experience,” says Andrew, “AI has made construction less expensive. This is due to AI being able to optimize the allocation of labor and materials, quality control the work, and overall make things more efficient. AI has become and will continue to be an integral part of the construction as it lowers costs, enhances site safety and maintenance, and increases overall efficiency.”

And as with robotics in the automotive industry and autonomous checkout systems in retail, AI has the potential to reduce labor costs. Technology such as AI can free employees to do the work that only humans can do — innovate, create, and make connections with customers and clients.

“AI can help employees do their job more efficiently and be a great complement to their success,” says Ashley, “or it can potentially make employees obsolete. Overall, it depends on how each company will use AI in the workplace, either to help their employees or work closer to automating their company.”

Andrew sees the potential impact as well. “Companies need to start learning how to best utilize AI or else they risk being left behind by their competitors. AI in the CRE marketplace can be a game changer for certain companies, depending on usage, that would help streamline analytics and increase efficiency. However, clients still want the human touch, so there would need to be a balance of human interaction and AI usage.”

Artificial Intelligence is no longer just an unsettling concept found in science fiction. It has gone mainstream. It isn’t an enemy to be feared, but it is going to have an ever-increasing part in shaping the world of commercial real estate with impacts on commercial appraisals. Those who embrace the changes AI is fostering will find new opportunities open to them as a result.

The team of experts at LPA can help you understand these opportunities and provide the intelligence you need to make informed decisions about your property. Contact us today to learn more about the impact of AI on commercial real estate and for all your commercial real estate valuation needs

After much deliberation and a period of public comment, Gov. Greg Abbott announced last month (August 2023) that the 2024 UTP has been approved. The record infrastructure investment will fund more than 7,000 TxDOT projects and will, over the next decade, create 70,500 new jobs pumping $18.8 billion into the state economy annually. Texas’s largest cities, Dallas-Ft. Worth, Houston, San Antonio, and Austin stand to gain the most from the $100 billion funding, says LPA ROW/ED Practice Leader Mario Caro, although rural communities across the state will benefit as well. What is UTP and why should CRE stakeholders pay attention?

What is the Unified Transportation Program?

With 314,000 miles of public roads, Texas has the longest highway network of any state in the country. The Unified Transportation Program is a 10-year planning document that directs the development of transportation work across Texas and authorizes the distribution of funds. In addition to highway projects, the plan addresses public transportation, aviation, maritime, rail, freight and international trade, and bicycle and pedestrian connectivity. The UTP also features projections about the flow of energy, goods, and people throughout the Lone Star State. As such, it contains key insights about Texas’ economic future.

The UTP process produces a list of projects TxDOT plans to develop or begin construction on within the next ten years. The Governor’s Office explains that “Projects are selected by TxDOT, and local transportation leaders based on effectiveness in addressing criteria such as safety, pavement condition, capacity, and rural connectivity, with opportunities for public input at both the state and local levels.” While the UTP does not guarantee that a project will be built or included in the budget, the document is a valuable tool for long-term planning linking planning of the Statewide Long-Range Transportation Plan, the Metropolitan Transportation Plans, and the Rural Transportation Plan with the Statewide Transportation Improvement Program.

The $100 Billion 2024 UTP represents a $15 billion increase from 2023 funding. “As the state of Texas continues to see exponential population and economic growth, this funding will help meet the needs of all Texans,” says Texas Transportation Commission Chairman J. Bruce Bugg, Jr.

Increased Infrastructure Funding Comes at a Critical Time

Texas has been experiencing exponential growth in population over the past two decades, hitting the 30-million mark in 2022. This growing population is traveling on aging roads and bridges. In its 2021 Infrastructure Report Card, the American Society of Civil Engineers gave Texas a “C” — mediocre, requires attention —on the overall condition of its infrastructure.

The ASCE assessment found that:

• Texas bridges are mostly safe with only 1.4 percent of inventory found structurally deficient, but the state will need to invest billions in bridges and culverts over the next decade to accommodate population growth.
• The state’s airfields are mostly in good condition, but many airports across the state are overcrowded and have outdated terminals and support facilities affecting the ability of airports to operate efficiently during peak travel times.
• 47 percent of roads and highways are in poor condition and cannot adequately handle the increased traffic. “Auto commuters in Austin, DFW, and Houston face significantly more congestion than the national average,” the ASCE reports.

Implications of 2024 UTP Approval for Landowners

The 2024 UTP is an ambitious plan and will guide the Texas DOT’s eminent domain and right-of-way activities for years to come. Caro believes TxDOT may have to condemn more property than ever to make proposed projects a reality, and that will bring more legal challenges to condemnation. Commercial property owners can expect to see property values rise as access to reliable transportation increases. “It’s one of the main drivers of value for commercial and residential properties,” says Caro. “Not only in the traditional sense of when you think of transportation infrastructure, but we’re seeing dramatic increases in property value around our ports, inland and seaports. Trade with our neighboring and foreign countries is booming, and there is a flurry of demand for US companies to be near these ports.”

Key Facts About the 2024 UTP

The 2024 UTP is focused on three strategic goals:

• Promote safety — “Safety is a top priority for TxDOT,” says TxDOT Executive Director Marc Williams, “and these funding levels reflect that.” Annual fatality rates, the ratio of annual fatalities per 100 million vehicle miles traveled, have risen steadily in the state since 2019 from a rate of 1.26 to 1.58 in 2021. The DOT target is to reduce this to .58 by 2033. Included in the 2024 UTP are highway improvement projects designed to increase safety at intersections, reduce lane departures, head-on crashes, run-off-road crashes, collisions with pedestrians and bicyclists, and mitigate roadway obstacles.
• Preserve assets — The DOT annually develops a bridge condition score and measures pavement quality. These numbers have been improving. The 2024 UTP is focused on continuing this trend.
• Optimize system performance —The 2024 UTP seeks to mitigate congestion, enhance connectivity and mobility, improve reliability, and facilitate the movement of freight and international trade.

A Plan to Foster Economic Competitiveness

In a February 2023 press release announcing the plan, Governor Abbot identified a key objective of the UTP, “This 10-year plan will further boost our economy and keep Texas the economic juggernaut of the nation. Together, we are working to ensure that Texas remains the premier destination for people and businesses.” Projects will add capacity, upgrade roads to handle freight, increase road access and safety for the energy industry, connect ports to facilitate trade and upgrade major statewide corridors to achieve Interstate highway classification. Future Interstate highways in Texas include I-14, I-27/Ports-to-Plains, and I-69.

Where is the money coming from?

The $15 billion increase in 2024 from the 2023 funding includes an additional $3.1 billion for rural areas and $2.4 billion for urban areas; more than $2 billion has been added for preventive maintenance and rehabilitation. This funding comes from a mix of state, federal, and in some cases, local sources.

Proposition 1 and Proposition 7 dedicate some of the state’s oil and gas production taxes and sales taxes — revenues that have grown with the population — to the State Highway Fund. These combined revenue sources make up 50 percent of expected funds. Provisions of the federal Infrastructure Investment and Jobs Act and federal motor fuels tax collections are projected to provide 43 percent. Traditional highway funds and other funds make up the balance.

2024 UTP Highlights

Energy sector infrastructure

The 2024 UTP boosts energy sector road funding to $1 billion, a move applauded by Permian Strategic Partnership (PSP) Chairman Secretary Don Evans. “Permian Basin energy companies and other energy companies across the state paid 10.8 billion dollars in state severance taxes in FY 2022 alone helping fund infrastructure across Texas,” says Evans. “We are pleased to see additional funds returning to the Basin, helping build and repair infrastructure that will help fuel our local, state, national, and global economy for years to come.” Nearly $285 million will be directed to the North Permian Promise Project, which addresses transportation needs throughout the Permian Basin.

Ports

According to the TxDOT, Texas ports moved more than 607 million tons of cargo in 2020, more than any other state. The port industry supports 128,00 direct jobs and port-dependent economic activity drives another 1.7 million generating a total personal income of $110 billion. The 2024 UTP includes $14 billion for projects that improve economic opportunity, military movement, border and port connectivity, and emergency routes.

Statewide rural and urban connectivity

Nearly $18 billion is dedicated to improving rural and urban connectivity including the SL335 upgrade project, which the Texas Transportation Commission has prioritized recognizing that new freeway connections between I-40, I-27, US 87, and US 287 will allow freight shipments to bypass Downtown and will provide alternate routes for commuters and travelers in Amarillo.

When developing the UTP, district planners sought regional projects that would also address local needs. Upgrading US 59 in the Lufkin District will address local traffic issues and advance a project, the development of I-69, simultaneously. US 59, US 96, and US 69 are major evacuation corridors, which means projects to continue connectivity in the region fall under Category 4-Connectivity Corridors funding.

International Bridge Trade Corridor

The 2024 UTP approves $237 million for Phase I construction of the International Bridge Trade Corridor, a planned 13-mile, four-lane highway that will connect the international bridges between Pharr and Donna in Hidalgo County. When completed, the corridor will give commercial trucks from Mexico direct access to the interstate from several international ports of entry. Billions of dollars of produce and goods are imported through Texas Ports and the steady stream of 18-wheelers creates traffic jams and security risks in border communities. The Corridor will mitigate these problems and facilitate increased international trade.

Following the 2024 Money

The 2024 UTP Report highlights some of the major projects that are planned or under development. A full listing of projects may be found online at TxDot Project Tracker. The following is a regional breakdown of large projects in major metro regions.

Dallas

Some of the largest and most costly projects are in the Dallas District. They include:

• The I-30 Canyon project through Downtown would reconstruct collector-distributor roads and widen the main lanes of I-30 between I-35E and I-45. This $590 million project will alleviate the bottleneck that makes this one of the most congested highways in Texas.
• Two other I-30 projects, the Interchange at Bass Pro Drive and the East Corridor from I-45 to Ferguson Road, have a combined cost of more than $1.1 billion.
• Other major projects are slated for Interstates 35, 20, 820 and 635.

Fort Worth

Metro and urban area corridor projects, statewide connectivity projects, and preventive maintenance and rehab projects in the Fort Worth District have been allocated more than $1 billion each to address urban congestion, mobility, and connectivity between urban and rural counties. These funds are part of the Texas Clear Lanes funding. Much of the funding for the Fort

Worth region is dedicated to improving state and interstate highways that support the freight network in North Texas to reduce travel times and improve safety.

Austin

Caro believes the most important transportation project on tap is in the Austin District. The I-35 Capital Express project is one of the largest in Austin with a $16.5 million price tag. “Broken up into 3 stand-alone projects, it proposes to improve 28 miles of I-35 from SH 45 North and SH 45 Southeast. The project aims to relieve traffic at 4 of the 100 most congested roadway segments in Texas,” Caro notes. In addition to adding lane capacity, the project includes reconstructing ramps, bridges, frontage roads and cross-street bridges, and enhanced pedestrian and bike paths.

Corpus Christi

The Corpus Christi District allocations will help develop interstate highway corridors with US 281, US 77, and US 59 designated as future interstates.

• New overpasses, frontage roads, and relief routes are planned for US 77 and US 281 to prepare for the eventual I-69E and I-69C.
• $60 million in Supplemental Transportation Projects funds are allocated to upgrade infrastructure at the Port Aransas Ferry to meet the demands of a surge in energy industry ship traffic and coastal tourism.

El Paso

• The demands of oil and gas drilling in the El Paso district threaten the integrity of rural roads that were not designed to handle the heavy trucks used in exploration and extraction. The 2024 UTP projects address this with funds to upgrade energy sector corridors.
• Multiple projects aimed to ease traffic congestion in El Paso include widening segments of I-10, US 54, and US 62 and enhancing frontage roads.
• $208.5 million has been allocated to the 178 (Artcraft Road) interchange project at I-10. SH 178 is a major artery supporting international and interstate commercial activity. The area has experienced rapid residential and commercial growth creating congestion and safety issues. The planned improvements include constructing four direct connectors at the interchange of I-10 and Hwy 178 to streamline traffic flow, decrease delays at intersections, enhance connectivity to NM 136 and the Santa Teresa Border Crossing, and facilitate the movement of oversized loads through the interchange.

Houston

• Construction has begun on the project to widen I-45 south of downtown. Multiple improvements are planned for I-45 North, from downtown to Beltway 8, with new express lanes and accommodations for bike and pedestrian traffic. A total of $3.2 billion has been allocated to enhancing this priority corridor.
• Hurricane Harvey drove home the importance of disaster planning in the Houston District. Capacity improvements for SH 146 have been ongoing. The highway is an important hurricane evacuation route and freight corridor.
• SH 99 (Grand Parkway) is a loop around the Greater Houston Region passing through multiple counties. Plans to complete the loop with segments through Fort Bend, Brazoria, and Galveston will cost an estimated $4.2 billion.

San Antonio

• One of the most active oil fields in the U.S., the Eagle Ford Shale, lies under the rural southern counties of the San Antonio District. Planners will utilize funding from the Energy Sector and Preventive Maintenance and Rehabilitation categories to upgrade roads to address the increase in heavy truck traffic and fund safety and maintenance projects in the area.
• $876 million has been authorized for three I-35 Northeast Expansion (NEX) projects.
• $11.9 million has been authorized for the Cibolo Creek bridge replacement project. The new bridge is designed to allow use in heavy rainfall events and will accommodate pedestrians and bicyclists.

This historic level of infrastructure spending will impact CRE values across the state. LPA is committed to ensuring that Texas has enough commercial appraiser capacity to support the 2024 UTP. Our commercial real estate experts are active in the valuation of real estate for right-of-way and eminent domain (ROW/ED) purposes. Their proficiencies span the full range of ROW/ED project types, including:

• Highway and street expansions
• Aviation easements
• Water/sanitary/sewer lines
• Oil and gas pipelines
• Electric transmission lines
• Drainage easements
• Recreational hike and bike trails
• Government buildings
• Ground lease liability
• Surplus right-of-way disposition
• Future utility facilities
• Public parks acquisition

Contact us today to learn more about LPA’s extensive ROW/ED experience and commitment to delivering accurate and comprehensive appraisal collateral on time, every time

Different CRE stakeholders bring different needs to the appraisal process. For investors, identifying properties that have the potential for appreciation is paramount. For developers, the appraisal process can reveal which properties would benefit most from renovation or adaptive reuse. Lenders’ assessments of risk rely on accurate, principle-driven appraisals. Property owners have a whole host of business decisions to make, from determining lease terms to adding amenities to putting their property on the open market.  

One commercial property value metric can help satisfy all these different needs: highest and best use (HBU). As such, HBU plays a significant role in each and every appraisal report, regardless of which valuation methodology the appraiser has applied to the subject property. 

 

What is Highest and Best Use (HBU)?

A highest and best use analysis seeks to measure a given property’s economic potential; specifically, that property’s ability to generate the maximum value under a set of circumstances that are both ideal and real.  

The Appraisal Institute provides a working definition of HBU in The Appraisal of Real Estate. According to the most recent edition (15th, revised in 2020) of this text: 

The highest and best use of property is essentially the reasonably probable use that results in the highest value. … At its core, highest and best use analysis is an examination of alternative uses of a property, each use having its own characteristics related to the value-influencing factors of utility, demand, effective purchasing power, and scarcity. 

Although this definition is very nearly the final word on HBU, it requires unpacking. To start, HBU is “reasonably probable.” Therefore, a property’s current use (or “utility”) may not be its highest and best use. The overall volatility of the CRE market often means that a property’s highest and best use is different from its current use. 

For example, a property is currently being used as office space. An appraiser determines that, due to a variety of factors, the property’s HBU is multifamily. Therefore, the stated property value will be based on the property’s potential multifamily use, not its current use as office space.  

“Scarcity” meanwhile, pertains both to the subject property’s market area and its overall marketability. Each factor can influence the other. 

Also, as noted, appraisers must analyze any number of alternative uses before they can reach a conclusion about which use qualifies as the HBU. The Appraisal of Real Estate refers to this as a “screening process.” Hypotheticals are inherent in this process, but each one should be grounded in data. 

Finally, those alternative uses entail varying degrees of specificity. Depending upon the appraisal requirements and the appraiser’s findings, HBU can be stated in general or granular terms. An example of the former would be a class of uses, such as industrial. An example of the latter would be a type of industrial property, such as a distribution center. 

 

The Four Tests of Highest and Best Use (HBU) 

Traditionally, commercial appraisers have followed a four-step process to determine a subject property’s HBU. Each of these steps can also be considered a test, and each test can be expressed as a question the appraiser sets out to answer. 

1. What is physically possible? 
2. What is legally permissible? 
3. What is financially feasible? 
4. What is maximally productive? 

For the purposes of this discussion, we will take each question in turn, as they cannot be asked out of order. That is, a proposed use must pass the first two tests before it can be subjected to the latter two tests. Unless a proposed use is physically possible and legal permissible, its financial feasibility and productivity are irrelevant. 

 

Test #1: What Is Physically Possible? 

HBU is contingent on what is “physically possible.” Location, topographic features (e.g., exposure to flood risk), access to infrastructure, and a building’s own condition and dimensions all impose constraints within which the appraiser must operate when assessing what a property’s highest value might be — and how it might realize that value. 

For example, a large, rectangular lot that is located near the interaction of several major highways might be well-suited for a retail development. However, a 30-year-old, 7-story structure located in a central business district served primarily by public transportation is more likely to achieve its HBU by hosting office space. 

The property features that are most relevant to HBU will vary from property type to property type. For example, overall aesthetics and proximity to cultural resources (e.g., movie theaters, museums, public parks, etc.) are likely to exert a stronger influence on the value of a multifamily development than they are an office tower. However, the number of households located within walking distance of a retail center is likely to impact its value.  

 

Test #2: What Is Legally Permissible? 

Appraisers typically research five areas when verifying the legality of a potential property use. Those areas are: 

1. Land use regulations. 
2. Zoning. 
3. Building codes. 
4. Restrictive covenants. 
5. Easements.  

Land use regulations are rules that govern how land can be used, developed, and built upon.  The Environmental Protection Agency (EPA) expands on this definition, noting that land use should not be conflated with those natural features that dictate what is physically possible from a development perspective. “Land use is generally a function of laws, policies, or management decisions that may not always be possible to infer by examining the ground via surveys.” 

Land use regulations are typically enacted by local governments, such as cities and counties. They are primarily designed to promote public health, safety, and welfare. 

Density restrictions, setback requirements, and environmental protections are all examples of land use regulations. Density restrictions limit the number of buildings that can be built on — or people who can be accommodated by — a given piece of land. Setback requirements specify the distance buildings must keep from property lines and roadways in order to preserve open space and create a more aesthetically pleasing environment. Environmental protections seek to mitigate the potentially harmful impacts of development. These protections may restrict the use of certain building materials, require the installation of pollution control equipment, or set aside land for conservation. 

Zoning refers to the process of dividing land into different zones, each with its own permitted uses. For example, a residential zone might only allow single-family homes, a commercial zone might allow businesses, and an industrial zone, while commercial, might be reserved for manufacturing facilities.  

Zoning rules are technically ordinances. As such, they are typically enacted by municipal authorities. However, these ordinances are subject to review and approval by state governments. They can be changed or amended — and entire areas can be rezoned — but this process is typically complex and time-consuming. Nevertheless, in some circumstances, appraisers may have to consider the possibility of rezoning in assigning HBU. A specific lot or parcel of land may be rezoned based on consideration, and a developer or property owner may apply for a zoning exemption, known as a variance. 

Zoning can dramatically impact HBU. For example: 

• A zoning ordinance might prohibit some businesses (e.g., liquor stores) from being located within a certain distance of schools or churches. 
• A zoning ordinance can require that businesses provide parking — for example, one parking space per 100 square feet. 
• A zoning ordinance might require that all new buildings in a particular area adhere to specific architectural requirements. 
• A zoning ordinance might limit the height of buildings to a certain number of stories or require a minimum lot size.  
• A zoning ordinance may specify the size, type, and location of signs that can be displayed in a particular area, thus impacting the visibility a business might achieve. 

Building codes are locally enforced regulations that govern the construction of buildings, from materials used to methods employed. These codes also ensure the integrity of the completed building. Integrity in this context takes several forms. 

• Structural integrity. Building codes require that buildings be structurally sound and able to withstand the forces of nature, such as wind, rain, and natural disasters. 
• Mechanical integrity: Building codes require that buildings have a safe and reliable water supply, sanitation system, and HVAC system. 
• Means of egress: Building codes require that buildings have adequate exits to allow occupants to escape in the event of a fire or other emergency. 
• Fire prevention and control: Building codes require that buildings are equipped with sprinklers, smoke alarms, and other fire safety features. 
• Accessibility: Building codes require that buildings be accessible to people with disabilities. 
• Energy efficiency: Commercial real estate can leave a large carbon footprint. Building codes increasingly include “green” requirements for electrical, lighting, heating, cooling, and other systems that consume energy. These codes are not necessarily limited to new construction. They can also apply to retrofitting, interior design, routine operations, and maintenance. 

Consequently, building codes restrict the types of uses that are permitted on a property. More importantly, they can increase the cost of construction, which can make it less feasible to develop a property for certain uses. 

Restrictive covenants are clauses in a deed, lease, or other contractual document that limit the use of a property. In some cases, restrictive covenants may prohibit specific businesses from operating out of a property. Moreover, if a property is subject to several restrictive covenants, it may be worth less than a similar property that is free from such restrictions. 

Easements are also known as nonpossessory interests in land. In other words, although the easement holder does not own the land, they have the right to use it for a specific purpose. Easements can be created by agreement between the landowner and the easement holder, or they can be created by law. 

Easements may be affirmative or negative. 

• Affirmative easements grant the easement holder the right to do something on the land, such as cross it with a road (also known as an access easement) or connect to water or energy infrastructure (also known as a utility easement). 
• Negative easements grant the easement holder the right to prevent the landowner from doing something on the land, such as building a structure or blocking a view. 

Easements can affect the highest and best use of a property in several ways. Easements can: 

• Make it more difficult to develop the property. If an easement limits the types of uses that are permitted on a property, it may make it more difficult to develop the property for a particular use. For example, a drainage easement may prevent the construction of a building on a property. 
• Reduce the value of the property. If an easement limits the types of uses that are permitted on a property, it may make the property less desirable to prospective buyers. 
• Create a conflict between the easement holder and the landowner. If the easement holder and the landowner have different plans for the property, it may create a conflict between the two parties. 

Easements can also have a positive impact on highest and best use. For example, a utility or access easement may make it possible to develop a property that would otherwise be inaccessible. 

 

Test #3: What Is Financially Feasible? 

Ultimately, a property’s highest and best use must meet two criteria: 

1. It must generate enough revenue to cover the costs of construction and/or property improvements. 
2. It must generate enough revenue to turn a profit. 

The financial feasibility test is primarily concerned with this first question. As such, “financially feasible” is perhaps better understood as “economic feasibility.” This economic feasibility encompasses everything from the local supply of and demand for properties with a similar HBU to capital expenses (such as property improvements), operating expenses (such as continuing maintenance), and the revenue the property can be expected to generate. 

In assessing financial feasibility, appraisers must give appropriate weight to both current and future market conditions. Appraisers typically leverage tools such as comps and data such as occupancy rate, inventory, deliveries, net absorption, time on market, and average price per square foot when gauging current market conditions.  

Because highest and best use analyses span multiple property types, appraisers will also gather data and study trends that point to any convergences or divergences — that is, that reveal how the value of different asset classes may be moving in lockstep or opposite directions. 

Finally, when analyzing a property’s potential development, appraisers must examine both existing properties and vacant land. Renovations, improvements, and other upgrades can increase the value of existing properties. But the development of vacant land may create more value, especially during real estate and construction booms. Under such circumstances, vacant land often demands more of a premium than existing properties. The result could be that the subject property’s HBU requires the demolition of an existing structure. HBU analyses that are not sensitive to possible shifts in the competitive landscape tend to rest on shakier foundations than those that do. 

 

Test #4: What Is Maximally Productive? 

Recall that a property’s highest and best use must meet two criteria: 

1. It must generate enough revenue to cover the costs of construction and/or property improvements. 
2. It must generate enough revenue to turn a profit. 

The final test appraisers apply in establishing HBU pertains to this second question. 

By this stage of the process, the appraiser will have narrowed the field of possible property uses to a handful of top candidates. They then rank these proposed uses and identify which qualifies as the HBU based on its productivity, typically measured in terms of the revenue generated by rent changed to building occupants. 

Establishing productivity requires the use of financial formulas such as net operating income (NOI), capitalization rate, discounted cash flow, and the Capital Asset Pricing Model (CAPM).  

All that being said, HBU cannot be reduced to a number. HBU is both quantitative and qualitative. HBU is dependent upon the stakeholders involved, the actions they take, and the timing of those actions. So, although there is often little overlap between the property buyer and the tenants occupying that property, both parties are major characters in the HBU narrative. 

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Windows of opportunity can open and close unpredictably in today’s commercial real estate market. Whether you’re a buyer, seller, lender, or investor, the most accurate and up-to-date data is more valuable than ever.  

That’s why our valuation experts, including the members of our dedicated research team, always stay proactive, taking extraordinary measures to ensure their reports contain credible — and actionable — business intelligence. 

Contact us today to learn how we use our tech-enabled innovative tools, analytical acumen, and dedication to excellence helps clients make the most informed and timely decisions about their real property assets.  

Price does not equal value. 

It’s a simple principle every commercial appraiser understands. Price is the amount a buyer is willing to pay for an asset. It can change from moment to moment in response to supply and demand. Value is more enduring because it is a measure of worth.  

Consequently, the commercial real estate valuation process attempts to answer questions such as: 

• “What needs does this property meet?”
• “What benefits does this property produce?”
• “What is the future usefulness of this asset?” 

Both value and price are quantitative. However, value is also qualitative and, therefore, somewhat subjective. It is the outcome of what stakeholders in a specific market perceive, the opinions they form based on those perceptions, and the actions they take based on those opinions.  

That said, the most credible opinions are supported by facts and evidence. In this article, we’ll explain the specific approaches or valuation methodologies commercial real estate appraisers use to assure their clients of the quality and dependability of their valuations.  

The Origins of Valuation Methodologies 

Construction boomed across the United States during the Roaring Twenties. But that decade was also a time of rampant real estate speculation. The Great Depression of the 1930s starkly and painfully revealed the consequences of buying and selling commercial properties in the absence of widely applied valuation standards and best practices.  

Ever since, the appraisal profession has collaborated with the federal government to develop, review, document, and consistently apply standard property valuation methodologies. Those efforts arguably reached their pinnacle with the appraisal profession’s adoption of the Uniform Standards of Professional Appraisal Practice (USPAP) in 1989.  

Once again, financial turmoil — the savings and loan crisis — exposed a need to render the commercial appraisal process more transparent. That crisis also prompted individual appraisers and appraisal organizations to hold themselves to a higher degree of accountability lest they be held to such standards by an outside party.   

USPAP’s Valuation Method Requirements 

USPAP does not explicitly allow or disallow the use of any specific valuation method. Instead, USPAP requires that appraisers “correctly employ methods and techniques necessary to produce a credible appraisal.” That direction includes “clear and conspicuous” disclosure of the valuation method and techniques upon which the appraiser’s analyses, opinions, and conclusions rely.  

To determine which method and techniques are most appropriate to the assignment at hand, USPAP specifies that the appraiser should follow these six steps. 

1. Identify the appraisal’s intended users, including but not limited to the client. 
2. Identify how that audience will use the appraisal. 
3. Identify the specific purpose or purposes of the appraisal assignment. 
4. Identify the effective date for the stated opinion of value. 
5. Identify the relevant subject property characteristics. 
6. Identify any extraordinary assumptions or hypothetical conditions relevant to the appraisal. 

Only after those assignment parameters have been established does the appraiser determine their scope of work. Two key provisions of the scope of work effectively limit appraisers to using officially recognized valuation methods and techniques.  

First, the scope of work “includes the type and extent of data researched and the type and extent of analyses applied to arrive at opinions and conclusions.” Secondly, a scope of work is deemed acceptable when it “meets or exceeds what an appraiser’s peers’ actions would be in performing the same or a similar assignment.” 

The Three Most Commonly Used Methods for Appraising Commercial Real Estate in 2023 

 Commercial appraisers often begin their valuation investigations by asking one or more of these three questions.  

1. How much have similar properties in the market sold for recently? 
2. What would be the cost of replacing the current structure with new construction? 
3. How much income does the property generate? 

 These questions for the basis of the three most commonly used valuation methods. They are: 

1. The sales comparison approach (also known as market value approach). 
2. The cost approach (also known as the replacement cost approach). 
3. The income capitalization approach (also known as the capitalization rate approach). 

Appraisal best practices begin — but do not end — with the application of these three methodologies. USPAP goes so far as to state that appraisers must take special measures to explain the “exclusion of the sales comparison approach, cost approach, or income approach” from “each written or oral appraisal or appraisal review report.” 

Depending on the subject property, one of these three approaches may be more appropriate than the others. For example, the cost approach may be more applicable to a Class A office tower built within the last five years, while the sales comparison or income capitalization approach may be more applicable to an apartment complex located near a college campus.  

Whatever the case, the appraiser may use any combination of all three approaches to estimate the property’s market value. The final value will be based on the weight of evidence from each approach. 

The Sales Comparison Approach 

The sales comparison approach is the most common method for valuing commercial property. This method involves comparing the subject property to similar, recently sold properties in the same market. 

What makes commercial properties similar? Appraisers examine property size, condition, location, and income potential data to determine comparability. Those data points include, but are not limited to: 

• Gross building area.
• Price per square foot.
• Age.
• Access to infrastructure (transportation, utilities, etc.).
• Vacancy rate.
• Time of sale
• Operating expenses
• Highest and best use
• Ownership interest (e.g., leased fee interest versus simple fee interest). 

One of the challenges of using the sales comparison approach is that no two properties are exactly alike. A property may not even be meaningfully comparable to itself at a different point in its history due to the evolving nature of local and national market conditions.  

The sales comparison approach thus places a high premium on up-to-date data. It also often involves making many adjustments to account for the differences between properties and the terms of the transactions that generated the sales data being analyzed. 

However, adjustments can only accomplish so much. The sales comparison approach ultimately relies upon the existence of comparable properties and the availability of comparable data.  

The good news is that the data, when available, is based on actual market transactions, making it highly reliable. Yet a certain amount of subjectivity is still built into this approach. The appraiser must exercise individual judgment in deeming which properties are comparable enough to inform their opinion of value.   

The Cost Approach  

Unlike the sales comparison approach, the cost approach is not dependent upon an active market. The cost approach estimates the value of the subject property by calculating the cost of building an equivalent structure.  

The logic underpinning the cost approach is the principle of substitution. This principle states that a rational actor will not pay any more for an existing asset than they would for what it might cost to produce a new asset offering the same type and degree of utility. 

The hypothetical rebuild at the foundation of the cost approach is “from the ground up.” It assumes the land the building occupies is vacant. For that reason, all valuations produced using the cost approach include the value of the land itself in addition to direct costs — materials, labor — and indirect expenses, such as taxes, utilities, and management, maintenance, and insurance fees (TUMMI).  

Appraisers define direct construction costs using one of two rubrics: replacement or reproduction.  

Replacement cost is the cost to build a new building that has the same utility as the existing building. It assumes the replacement structure would be built using current construction materials and methods, and that it would comply with current design principles, standards, and building codes.  

Reproduction cost is the cost to build an exact replica of the existing building, using the same construction materials and methods as the original building. It also assumes the reproduced structure would comply with period-accurate design principles, standards, and building codes.  

The difference between replacement cost and reproduction cost for most newer buildings is negligible, and most appraisers use the former rather than the latter. The same is not true for historic buildings. In those cases, reproduction cost is a more accurate indicator of value. 

The cost approach also assumes that new construction entails certain property improvements. These improvements lose their value or depreciate over time due to physical deterioration as well as the eventual obsolescence of certain features and amenities.  

For example, the COVID-19 pandemic caused many landlords to upgrade their buildings’ HVAC and air filtration systems. Consequently, office buildings featuring outmoded HVAC equipment and offering lower indoor air quality (IAQ) are now less attractive to potential tenants and buyers. Appraisers using the cost approach must calculate the difference between the original installation costs and the value those IAQ solutions currently contribute to the property. 

In summary, the cost approach can be represented using a simple formula. 

Commercial Property Value = Land Value + (Cost of New Construction – Accumulated Depreciation) 

However, each term in this equation must be calculated using one of several valuation techniques. As simple as it may appear to be, the cost approach can be complex and labor-intensive. But it may be the best approach to take when comparable data is in very short supply.  

For that reason, the cost approach is most often used when appraising special purpose properties, such as schools, churches, and sports facilities.  

The Income Capitalization Approach 

Neither the sales comparison nor the cost approach is designed to account for the subject property’s income potential. Income potential is hugely impactful for commercial property types whose value derives (in part) from collections of regular rent payments. Multifamily, office, retail, industrial, and hospitality all fall within this category. Enter the income capitalization approach.  

The income capitalization approach assumes that the value of a property is equal to the present value of its future income stream.  

Using this valuation method, the commercial appraiser first estimates the property’s net operating income (NOI). NOI represents the property’s total income minus its operating expenses. Operating expenses include property taxes and insurance, but they exclude building maintenance, which is treated as a capital expenditure.  

The appraiser then divides the NOI by a capitalization rate (cap rate), which is a measure of the expected return on investment for similar properties. The cap rate is typically expressed as a percentage. 

For example, if a property has an NOI of $320,000 and a cap rate of 7%, then the value of the property would be $4,571,428. 

The income capitalization approach is a popular method of valuing commercial real estate because it is based on the principle of supply and demand. The higher the NOI of a property, the more valuable it will be. Conversely, the higher the cap rate, the less valuable the property will be. Moreover, many potential investors base their acquisition strategies on the cap rate, meaning it is already a factor in how property values are being utilized.   

Nevertheless, the income capitalization approach is not without its limitations. First, it assumes that the property’s future income stream will remain stable relative to its current income stream. This is not always the case, as income streams can fluctuate due to a variety of factors, such as changes in the market or the broader economy. 

Another limitation of the income capitalization approach is that it too often relies on comparable data. The cap rate for a particular property is usually keyed to the cap rates of similar, recently sold properties. If comparable properties do not exist or sales data about them is not widely available, appraisers may find it difficult to estimate the cap rate. 

Additional Valuation Methods and Techniques You May Encounter in an Appraisal Report 

In addition to these three main approaches, appraisers may use several other valuation methods and techniques. Many of these are especially well-suited to special circumstances. They include: 

• Discounted cash flow. 
• Gross rent multiplier (GRM). 
• Value per door. 
• Cost per rentable square foot. 
• The Capital Asset Pricing Model (CAPM). 

The discounted cash flow approach is similar to the income capitalization approach, but it takes into account the time value of money — inflation — and its impact on the property’s future financial performance. It also makes provision for known future changes in revenue, such as an expiring lease that will not be renewed. 

The gross rent multiplier (GRM) approach examines the relationship between the property’s value and its annual income, represented by the combined total of all contractually stipulated rent payments. Appraisers calculate GRM by dividing the property’s value by this gross rent. This technique is particularly useful when attempting to determine whether a property’s asking price is high or low relative to its income potential (as measured in rent collections). 

Value per door is a method for valuing property based on the number of rental units in the property. Value per door is calculated by dividing the property’s value by the number of rental units. This technique is most often applied to multifamily properties.  

The value of a commercial building can also be estimated by calculating the cost per rentable square foot. The term “rentable square foot” refers to the total area of a building that can be rented to tenants, including both individual units and common areas. The average lease cost per square foot is the amount that tenants typically pay in rent for a square foot of space in a particular area. The cost per rentable square foot is well-suited for estimating the value of highly desirable, amenity-rich Class A assets, as it reflects the rent landlords can charge to generate their desired return on investment. 

Appraisers working on large portfolios of commercial real estate assets are increasingly leveraging the Capital Asset Pricing Model (CAPM) to generate insights. This financial model assumes that that the expected return on investment (ROI) is equal to the risk-free rate of return plus a risk premium. The risk premium is a measure of the additional return that an investor expects to receive for taking on additional risk. 

Commercial appraisers can use the CAPM to estimate the subject property’s cap rate. The cap rate, in turn, reflects both the riskiness of the investment and the expected ROI. 

To use the CAPM to estimate the cap rate, the appraiser would need to know the following: 

• The risk-free rate of return. 
• The market risk premium. 
• The subject property’s beta (β). 

The risk-free rate of return is the return that an investor can expect to receive on a risk-free investment, such as a U.S. Treasury bond. The market risk premium is the difference between the expected market return and the risk-free rate of return. The beta of the commercial property is a measure of its volatility relative to the market. 

Once the appraiser has obtained these three pieces of information, they can use the following formula to estimate the cap rate. 

Cap Rate = Risk-Free Rate of Return + Market Risk Premium * Beta 

Use of the CAPM to estimate the value of commercial real estate comes with several caveats. Although the CAPM can be applied to properties and entire property types, it is most applicable to a different asset class altogether: stocks. The CAPM also relies on a linear interpretation of risk versus return which is not always applicable to the commercial real estate market. Finally, appraisers typically need to input a significant amount of historical data to yield robust and truly meaningful CAPM results. In some cases, that data may need to span a full economic cycle or go back decades.  

Ultimately, the CAPM can be a valuable tool for commercial appraisers, but it should be used in conjunction with other valuation methods to arrive at a more accurate estimate of property value. 

Conclusion 

Although the valuation methods discussed in this article are the most commonly used by commercial appraisers and offer a good starting point for understanding how commercial property values are determined, there is no one-size-fits-all solution to estimating the value of any given commercial real estate asset. The best method for valuing a particular property will always depend on its specific circumstances. 

At LPA, we leverage leading technology, including our own proprietary software, to collect the largest possible pool of market data and analyze it using the full range of USPAP-compliant valuation approaches, techniques, and tools. We also prioritize the usability of every property valuation we produce. We combine commercial real estate valuation best practices with a strong design sensibility to generate business intelligence our clients can access immediately, act on swiftly, and leverage successfully.  

Contact us today to learn how you can navigate the complexities of the commercial real estate market with the help of our commitment to unfailing accuracy, best-in-class customer service, and always on-time delivery. 

 

If you’re buying, selling, or investing in a commercial building, having it appraised is an essential step in the process. So essential, in fact, that procuring an appraisal report from a licensed commercial appraiser is often mandatory rather than optional.

What are the different scenarios that make obtaining a commercial real estate appraisal necessary? Who enforces these requirements, and why? And are there scenarios in which obtaining an appraisal, while not necessary, is a wise business decision?

Keep reading to learn everything you need to know about the rules, regulations, obligations, processes, standards, and best practices that will (or can) prompt a search for a commercial appraisal company.

Commercial Real Estate Appraisal Basics

What are we talking about when we talk about appraisal in the commercial real estate space? In short, we’re talking about a process crucial to ensuring smooth, prompt commercial real estate transactions.

How? An appraisal furnishes decision-makers — primarily buyers, sellers, lenders, and investors — and other stakeholders, such as attorneys, with the information they need to understand any given commercial property’s fair market value.

Commercial appraisers take many factors into account when establishing fair market value, including:

• Market conditions, local, national, and sometimes international.
• The cost of new construction and/or renovation.
• Records of sales of similar properties, also known as comparable sales or comps.
• Tenancy and vacancy rates.
• How much income the property generates (and, in some cases, how much income the business that operates out of that property generates).
• The quality of the building’s exterior, interior, and assorted amenities.

Appraisers are licensed professionals who consult multiple sources and synthesize extensive data into a formal report. Appraisers also present context for their findings. For example, appraisal reports should contain definitions of key concepts as well as disclosures about the assumptions, extraordinary assumptions, hypothetical conditions, and limiting conditions relevant to the valuation methodologies the appraiser has applied.

This context is critical because fair market value is ultimately a matter of opinion. Appraisal reports contain highly informed opinions about fair market value delivered by unbiased experts with broad knowledge of key property types (e.g., apartment complexes, retail centers, hotels, warehouses, etc.), but they are opinions nonetheless. So, beyond presenting the most accurate property valuation the appraiser can present based upon the available data, appraisal reports also contain unique insights and actionable business intelligence.

Now that we’ve covered the basics, we’ll turn our attention to the scenarios that require the procurement of a commercial appraisal.

1. Commercial Real Estate Transactions Involving Properties with a Transaction Value of $500,000 or More

Enacted in 1989 during the savings and loan crisis, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) established appraisal thresholds for residential and commercial real estate transactions. (See Title XI, Sections 1113 and 1114, of Public Law 101-73).

The goal of this legislation was to curb what L. William Seidman, former chair of the Federal Deposit Insurance Corporation (FDIC), called “unsound real estate lending” practices at banking institutions. These practices, coupled with a lack of expert oversight, were a major contributor to the failure of nearly 1,050 American savings and loan associations between 1986 and 1995.

Appraisal thresholds guarantee that real estate transactions over a certain dollar amount, which may expose stakeholders to a higher level of risk, are appraised by licensed professionals who adhere to uniform standards. The Uniform Standards of Professional Appraisal Practice (USPAP) are the most important of these standards. They set forth guidelines for ethical conduct, define key professional competencies, and establish reporting requirements. Appraisers are legally required to comply with USPAP when performing appraisals for federally related transactions.

Although they’re the law of the land for commercial real estate transactions, appraisal thresholds are not set in stone. They’re sensitive to market conditions. Between 1992 and 2017, the appraisal threshold for commercial real estate transactions did not budge from $250,000. In 2018, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and FDIC raised that threshold to $500,000. Why?

The years following the Great Recession saw a boom in property values and a consequent explosion in the number of transactions over $250,000. Simply put, the volume of deals to be closed eclipsed the available supply of licensed appraisers. Lifting the appraisal threshold — so the theory goes — would allow those appraisers to focus on more complex and high-risk transactions, leaving lower-risk transactions to be processed using more turnkey valuation methods, such as Automated Valuation Models (AVMs).

More recently, both the National Credit Union Administration (NCUA) and FDIC have raised the appraisal threshold for residential real estate transactions from $250,000 to $400,000.

To summarize: the greater the value of the commercial property being bought or sold, the higher the likelihood of a mandatory appraisal.

2. Any Real Estate-Related Financial Transaction with a Transaction Value Greater Than $400,000

What distinguishes a real estate transaction from a real estate-related transaction? Let’s turn to the regulatory authorities in our home state of Texas to answer this question.

The Texas Administrative Code (TAC) defines a real estate-related financial transaction as “any transaction involving: the sale, lease, purchase, investment in, or exchange of real property, including an interest in property or the financing of property; the financing of real property or an interest in real property; or the use of real property or an interest in real property as security for a loan or investment including a mortgage-backed security.”

This definition is quite broad and means that a variety of transactions are subject to the appraisal threshold of $400,000. But of particular note is the inclusion of commercial mortgage-backed securities (CMBS).

CMBS are investment products backed by commercial property mortgages. Those mortgages are often mixed and matched, meaning a single CMBS may be secured by loans for different property types — from multi-family to industrial to everything in between — each with its own (generally fixed) terms and value. As a result, appraisals play a crucial role in establishing the value of these complex assets.

3. Qualified Business Loans with a Transaction Value Exceeding $1M

Starting and maintaining a business is costly. Qualified business loans are helpful options for many who do not have sufficient capital to pay these costs out of pocket. While business loans can provide significant funding, sometimes collateral is necessary for a lender to feel confident about extending credit.

Real estate is commonly used as collateral in such instances. This is especially true for long-term business loans, as property assets typically appreciate. Consider, for example, an owner seeking a business loan for $2,000,000 they can put toward the purchase of a rental property. They put up a commercial property they already own as collateral. Even so, the size of the principal to be borrowed would trigger an appraisal. Otherwise, the underwriter may not have the assurance they need that they can recoup any losses in the case of default.

4. Commercial Real Estate Mortgage Refinances

If you want to refinance the loan on a commercial property, a new appraisal is almost always a required step in that process.

Market volatility is a fact of life in the commercial real estate industry. After all, appraisals are snapshots of market conditions at a specific moment in time. A property’s value may have changed significantly since its last appraisal. These conditions place a premium on data that’s as up to date as possible. An opinion of value based on data that’s both current and accurate gives lenders assurances and helps borrowers assess the favorability of the loan’s terms (principal, interest, etc.).

More to the point, most commercial mortgage refinances entail the advancement of new monies, meaning they classify as new commercial real estate transactions. Therefore, the same appraisal threshold ($500,000) that applies in cases of buying and selling applies here — provided the lender is a federally regulated financial institution.

Other Reasons Why You Might Want to Obtain a USPAP-Compliant Commercial Appraisal

Even if you’re engaged in a commercial real estate transaction that does not require an appraisal, it still may be in your best interest to procure one. Consider the following scenarios.

If you’re interested in acquiring a foreclosed or distressed commercial property. An appraisal conducted by a state-licensed professional will contain their analysis of the property’s highest and best use. Just as importantly, the report will explain the reasoning behind the appraiser’s conclusion. This information can help prevent you from paying more than fair market value for the property.

If you’re protesting the taxes assessed on your commercial property. In Texas, you may lodge a formal disagreement with the valuation of your property as determined by your appraisal district. These authorities must reappraise all properties within their jurisdiction at least once every three years. But more current information about the state or value of the property in your possession may have significant tax implications.

If you have property involved in eminent domain or right-of-way proceedings. Suppose you own property whose title is to be transferred to make way for a highway expansion, municipal water line, or electric transmission lines (to name but a few instances in which the government may appropriate private property for public use). In that case, you’ll want to ensure you receive fair market value from the condemning authority. The best way to assess fair market value is with a USPAP-compliant appraisal report produced by a licensed appraiser who has ample experience in this field.

If your commercial property is involved in private litigation. Appraisals may be valuable pieces of evidence to submit in disputes with insurers over property damage, disputes with contractors over the quality of construction, and disputes with tenants over broken leases. Licensed appraisers can also testify as expert witnesses.

If you manage a portfolio of commercial real estate investments. Licensed appraisers with relevant experience can serve as strategic partners to investment advisers, pension funds, REITs, insurance companies, and large independent management companies, providing portfolio and property analyses as well as market research.

Whatever your reason for obtaining a commercial appraisal, you’ll want to work with a qualified appraiser with an outstanding reputation for accuracy, transparent communication, ethical conduct, and 100-percent on-time delivery. LPA’s valuation experts offer all the above in addition to wide-ranging property-type expertise and evaluations, appraisal reports, feasibility analyses, and restricted report appraisals designed for your ease of use.

Contact us today to learn how LPA can help you make highly informed decisions about your commercial real estate assets.