Episode #078 - "What the Heck is An Appraisal?" EVERYTHING You Need to Know About Appraisals!

In today's episode, hosts Braden Cheek, Brian Duck and Joel Thompson discuss everything you need to know when going through the appraisal process!

Hey, what's up and welcome back to how to invest in commercial real estate. And today we are taking a deep dive into appraisals. So if you're buying or selling commercial real estate, you're going to be involved in appraisal. And the first question is maybe what the heck is an appraisal? Right? Most people, they think of an appraisal as when they're buying their own home, correct, uh and they pay, you know, 1000 bucks to have somebody to praise the house and typically it comes in and about whatever they've agreed to purchase it, they want it to be as high as possible. So, and is that the same in commercial you want? Is there any reason you don't as possible? Well, I don't think it matters. You don't like money. Yeah, I mean when you, when you're buying, it doesn't really matter. You want the appraisal to come in at uh at the purchase price that you've agreed to pay and somehow magically yeah, always ends up there. Well, okay, but that's that's for a reason the definition of an appraisal is, do we remember that? I don't, okay, I think it's uh you know what a duly motivated buyer and would pay for the property and a duly motivated seller would, would sell the property at in a competitive market or something close to that.

It's used to find market value. Okay, very close. And so, you know the reason most appraisals come back at the contract prices because that contract, if the property has been marketed and there's nothing funny about the property and the seller isn't going through a divorce or probate or something, then this, the contract represents the death definition or you you have you put it out there at all the buyers. This is what a duly motivated buyer that wants to buy a house let's say. And this is what the seller agreed to pay. This is this is a congruence of the price, the value being decided by both of these parties. And so the appraiser that's looking at it doesn't have any reason to come drastically different on the value because these people are telling them this is what the market drove the value to. So let's let's get in first question we found a property we want to buy, we put in an offer, we're under contract and we're talking to the lender right? The lender says, hey we'll get you in the committee in a few weeks, we'll get your final approval you know, in a month from now. But we need to order that appraisal.

So the first step is don't freak out that you don't have a rolodex of appraisals because your lender is going to order, your lender should order it most of the time. Most of the cases you can order it yourself. The lender has to order it so he's ordering or she's ordering at the bank's ordering it lenders ordering and who's paying for it. That's a great question you are you're paying for it whether you buy the property or not the lender's gonna send you a bill if it's if you don't have a reputation of buying property, if you haven't used this lender before, most lenders are going to send you a term sheet, you're gonna sign that they won't order it until you give them the term sheet, maybe a $5000 deposit just so they cover their time and cost ordering that appraisal because ordering it the appraisal until you have a really strong term sheet or commitment from the bank because you don't want them to order the appraisal and then have them come back and tell you, well we're not gonna loan on it, we're not gonna loan those terms and now you're on the hook to pay for that appraisal. So you really want to get a lender that is committed to the terms that you like, that you're willing to close on the deal based on those terms. Then you give them the go ahead.

They'll order the appraisal. Most commercial property appraisals are gonna be anywhere from $3 to $6,000. Okay, quick question. What if you, at that point you change lenders, what happens to the appraisal? That's that's a great question, decent odds are you will change lenders, you'll probably go to the second or third option because the first guy thinks you're not going to get him out but you really are. Um So yeah, you call lender a, you know the first person and say, hey Mr linder, I'm probably going to use this other lender. Um your terms didn't seem to be good enough. I need you to sign the appraisal over to them right? And it's got to be on their their list, their internal list of how they want it appraised. You know, I've never had it happen where they bank came back to me and said, hey that appraisers not on my approved appraiser list, we'll have to order a new one every single time we've been able to get it assigned. But the thing we're paying attention to is the chain of custody right? They just want to make sure you're not tampering with it. That's why the lender has to order it. That's why it has to be assigned from lender to lender. And the lender is not going to do that until you pay for it.

Okay. So you have to, I thought maybe it got settled up in closing but you'll actually, it does because as long as you stay with the same lender. But if you want that lender to assign it to another lender that you're gonna use and he'll want you to pay for it upfront and then going back to your term sheet. Um a lot of people maybe getting bullied on their first deal by the lender and the lender may say, hey, I have to have the appraisal before I can give you a signed commitment letter. But what you need to know is that every commitment letter from every single bank is gonna look different. Even the same bank commitment letter to commitment letter is gonna be different because of the nuances and intricacies of that deal. So just say, hey, give me a commitment letter and then put it out in there for appraised value. As long as it appraises, you'll honor your side if it doesn't give you an out easy fix, right? Yeah. You don't have to have the appraisal done before you get a commitment or term sheet. The commitment can be based on 80 of the appraised value, whatever that is correct. So and so about how long does it take to get an appraisal once it's ordered for commercial, there's some good questions.

Um this is a great question. 3 - 3 - four weeks. 3 Or four weeks. It could take longer, but I mean three or four weeks, it's pretty standard. And that really is a long lead time when you think about it because you've got, you know, 60 days to close this deal. As soon as you get in, you're not gonna be ordering appraisal, you'll spend the first week or two depending on how judicious you were and sending it out before you got it under contract, just bidding out your lenders. Right. But what we want to encourage or what I want encourage you to do is find a lender who's giving decent terms and have them or have them order the appraisal. You're not at a disadvantage you're gonna pay for it either way at least you're not waiting on it on the back end. Yeah if you can get it ordered and you know you're gonna proceed with the deal on some level. Yeah get it, go ahead and get it ordered. Uh You know let's talk about the timeline of that four weeks. What's gonna happen is it's going to go to an appraisal that bid on it to the bank. It's gonna sit for 3.5 weeks. Then they're going to take a look at a couple nearby properties and there And shove it in with like 200 pages of like standard form documents that tell everybody who they are and why they do what they do and then you're gonna get it about four weeks.

So um like when I get the last one I got on my house do they just go around and they look at other properties that they consider similar and their comps, is that the only method of appraisal that commercial, there's 33 methods of appraisal. Uh you know, any of them? I know comps. Alright comps. So that's typically how people do residential is they'll look in the in the similar neighborhood, similar size, they'll pick two or three comps. And then depending on, well this one has a pool, this one doesn't this one has you know, three car garages has to and so they have the add and subtract value based on that and they'll come up with what they feel is a reasonable value for that home, comparable sales approach. Um, and that, that happens in commercial real estate, but less so well what I found is that they do all three right? And then they pick the best one or they average them out and then kind of have the value from there. Yeah, I don't know if they always do that with residential, but commercial, they're using the three methods which are comp sales and commercial real estate is, is harder to use comp sales because unless you're buying a single tenant, Wendy's, let's say you may have a comp, but even then the market's different.

You don't have a neighborhood of Wendy's where you can compare that are on the same street. Every, every deal is totally different. So different traffic counts, different income. Then you've got the cost approach and, and that's gonna be, hey, if we were to build this today, what does it cost to build, You should be buying properties less than it costs to build them. Just public service announcement. If the cost approach appraisal comes in bad, then you're buying the wrong deal. I mean, you should be buying for, you know, Plaza West. We talked about that deal last week on the podcast to build the plaza. We bought it for like 75, it's 100 and 22,000 ft to build it. Now I'm saying at least double than what we paid for it guaranteed at least double. I wouldn't say it's a hard and fast rule. You can never pay more than replacement value or replacement cost value because there are irreplaceable locations where the strength of the tenant and the income demands higher price.

But it is something to keep in mind is where are you compared to cost? Because if you're in a sub market or a suburb and you're buying a commercial real estate, you know, multi tenant, retail or whatever. But there's a field across the street that somebody can build, they can and they can build it for less than you're paying for. That's where the cost approach comes into play is you want to be less than cost. And then if someone builds next door brand new, it costs them more. So they're gonna have to demand more rent. So they just can't steal all your tenants at the low rent. They've gotta, they gotta get people to pay a higher rent. That's why you want to be lower than cost. Just let's talk about that for a second because we talk about this a lot with our investors and when we put on our investment brochures and we look at deals, we pay attention to that price per square foot number a lot and related to the cost of construction. Now we bought a set in broken arrow, we paid probably 60 or $70 a square foot for it. So the rent we need to make money is significantly lower than the guy right across the street from us who built this brand new retail strip center that looks 100 times better than ours.

It's brand new. But I mean you're at like 350 or $400 a foot. So imagine the rent that that guy has to generate or girl to to pay their mortgage. Right? It's a lot more than you. So you want to, I want to be in a little bit of a lower basis. And that another example right? When we're looking at tenants and we're looking at the rents of the tenants, we bought this deal in stone mountain Georgia and it's got a dollar tree that pays like six or $7 a foot or something. But it's such a dense sub market, there's no, there's no access land for somebody to build and the cost of construction for somebody to go and build a comparable dollar tree, even if there was space to build it would be so much more that they would have to demand $15 a foot more than double. Exactly. So I feel really good about that dollar tree lease because I know they can't get anywhere close for anywhere close to what they're paying. Um So they'll renew. Right? So what is the other, we've talked about comp sales, we've talked about the cost approach. The last method of appraisal is the income approach arguably the most, one of the, I mean for commercial real estate is maybe one of the most important because what it does is it allows the appraisal appraiser to put uh the value of these properties, you know, based on the income they produce.

So kind of levels the playing field. And that's how most people are buying these properties. Like I know we said, we looked at the cost approach, I know we say we look at the comparable approach, but at the end of the day we want to know how much money we're making, Right? And so so does everyone else. So they look at the cap rate on this building versus the cap rate of similar buildings that have sold, correct? And and so then what they do just like with a residential house, doesn't have a pool. Does this have three car garage, whatever they're saying? Okay, is this better located? This, this market? Is is Tulsa that is that is that as good as Oklahoma city? Maybe Oklahoma city slightly better. Maybe Dallas is even better. Maybe in Dallas. This will be a seven cap. Oklahoma city, It's a seven and a quarter cap in Tulsa, it's a 7.5 cap just because of the strength of the market and the comp sales and all that. So that's how they use the income approach to value the property. Talked about these three methods, does one appraisal have all three methods on it or could it have one or more typically they have all 33 and and they'll come to a slightly different value on each and then they'll use their, you know, their professional opinion as to where it ultimately comes out.

They'll come and they'll finally come down and give you 1 1. They'll Give You one No. Yeah it's higher than one or two of them. It's lower than one, you know? So let's say that number comes in and it's less than you have a lot less than what you anticipated. Is there any is there anything you can do? Can you either talk to the appraiser and try to give him or her additional information. Can you go to another appraiser that rarely works? Yeah I would I would think your your recourse to my house and it didn't work. Your recourse on a commercial deal is to negotiate down the purchase prize if with the seller. If the appraisal doesn't come to the come up to the purchase price. Has this ever happened to us before? I don't think so. Not on the buy side. Right. But we we've tried to sell an asset price. Wasn't. So walk us through that guy? I do this. I don't want to give I don't want to give details of that specific sale but it was a property that we had someone who was interested in buying it, we knew that that they had a lot of cash we weren't really that interested in selling and I wanted to get a premium if we're gonna sell. And you told you told him that I'm like, hey, it's going to be a high price.

They agreed to pay it. But when the appraisal came in lower than the agreed upon purchase price that what that did is it lowered the amount of money they can borrow. Now they have to bring more cash, which brings down their return or percentage return they make on that cash. And so I ended up not wanting to do the deal because the appraisal and there wasn't anything I could do, I can't call the appraiser and say, hey, you know, I'll pay you on the side or whatever. There's just none of that going on. So that didn't work, didn't work. Um, So one last distinction before we hop off here, um, let's talk about, you know, the different approaches when, when buying a deal through the lender's perspective. So a lot of the times we're going and we're getting pretty high leverage, but we're getting loan loan to value right? And the values, the appraisal. So with loan to appraisal is what they're comparing it against the other way is L. T. C. Or loan to cost. So you can get a lower L. T. C. But your cost may include expenses that haven't yet happened yet.

So you're going to say, hey, I need to escrow four or $500,000 for these repairs, these renewals, all of my closing costs, whatever. So I'm buying the property for five million. But really my cost is 5.5 million and you can get lenders to lend you loan to cost instead of loan to value and and get a lower percentage but sometimes more money. Right? Yeah. Sometimes you can do that. I would say a lot of times if it's a rehab situation, you're right, the lender will give you so much for the acquisition and will loan you additional dollars for the Capex that you're going to spend and they may escrow that until you've improved the property then they over fund after that. But a lot of times when you're acquiring they're gonna take the lower of 80% of loan to value or loan to cost. The reason they do that is, let's say the appraisal comes in really high. They don't want to be a 90% LTV. Uh, and so they will say the lower of or the lesser of and that that way, regardless of the appraisal comes in high, they're only gonna loan you 80% of what you're paying for the property.

Another super important point is at the beginning of this year. I know we just talked about Plaza West and the amazing success we had with that deal. But in january that appraised for $7.5 million even though the value of it was, was nine, something was over nine because we appraised it last month and it was like 9.5 with the pad sites. So that should tell you it's not an appraisal as if they're just looking in their magic crystal ball and they're saying, hey, this is what this property's worth. Like a broker's opinion of value. They're not, it's, it's really a justification. They're trying as hard as they can to protect the lender and say, hey, um, bank or who lending institute. We will, uh, we will give you comfort that this property is actually worth that. And here's why, so it's, it's nine times out of 10 you're doing it for a lender, whether it's, it's a purchase or refinance or you're selling a little out parcel or whatever it is. The appraisal nine times out of 10 comes back. Good comes back. Good. And let's end on this point, the appraisal is purely, uh, an opinion of one person that you've hired.

It is mainly to protect the bank. Uh, maybe to protect you if you're a complete idiot and you're, you know, to keep you from over paying. Uh, but, but reality is is that the value can be, whatever it is you think it can be Plaza West is an example where we agreed to pay 7.5. And so when we got it appraised, the appraiser used our contract and the price we negotiated and came back about that number. But six months later we get it appraised having them re evaluate those out parcels and it comes back in at 9, 9.5. So I just want people to know, um don't be limited by the appraisal value. Is that use creativity, evaluate the, the property you're looking to buy, looked on how you can improve the income, improve the tenant base and and just be optimistic about, hey, what could the appraisal be given market improvements given some changes in the property because the, the appraisal you get when you buy it is not necessarily what it's gonna be worth even just six months later. Well there you have it guys that is a deep dive into appraisals and and kind of how we use them, how we order them timeline to get back all of the information you need.

If you have any more questions, just comment down below and we will get back to you on the appraisal or shoot us an email. We would be happy to answer your question and talk to you through it. But an appraisal is pretty easy lenders going to do it About a month process and nine times out of 10, like we said, it comes in fine. So not much to worry about their and brian's got to go to an O. S. U. Game. Like right now we gotta end, talk to you guys later. Thanks folks.