Commercial Real Estate Appraisers Have Had to Adjust Their Measures

COVID-19 and especially higher interest rates have changed the appraisal game — for office buildings in particular


Voltaire once said, “Appreciation is a wonderful thing — it makes what is excellent in others belong to us as well.” Without stepping on an enlightened man’s toes, it does beg the question:

How can you appreciate anything if you don’t know its value?

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In the world of commercial real estate finance, appreciation — either metaphorically or economically through increased building values — has been a rare virtue over the last four years. This is particularly true in the beleaguered office sector, where hybrid work has ravaged traditional cash-flow assumptions, as well as within other asset classes as high interest rates have hindered values since early 2022.

“In this interest rate environment, our valuations have dropped incredibly, and buildings that were trading at $800 to $1,000 per square foot have traded at $300 to $500 per foot,” said Rod Kritsberg, managing partner at KPG Funds, a New York office developer. “There’s few trades and it’s very limited, but values have dropped precipitously — not just in the office sector, but across the market.”

While it might seem easy to blame COVID for everything wrong with CRE these days, the decisions made at the Eccles Building in Washington, D.C., by the Federal Reserve have had a far greater impact on CRE values than anything else, according to several market participants.

“COVID is obviously the change in supply and demand dynamics, but I think what has really created some upheaval in the last 24 months is the Fed moving rates up,” said Ayush Kapahi, principal and co-founder of HKS Capital Partners, a CRE investment firm. “At the end of the day, commercial real estate is a function of debt, what you can borrow, and the cost of capital that flows with it.”

As targeted equity returns are directly correlated with the cost of financing, every interest rate tick upward alters cap rates, impacts demand, freezes lending, and changes the valuation equation for different CRE asset classes and submarkets.

“The interest rate hike has diminished values in a way that I’ve never seen in my 20-year career,” said Kritsberg. “Not even during the Global Financial Crisis have I ever seen a loss of overall values on paper like I’ve seen during this interest rate hike.”

Nowhere has the value declines been more pronounced than in the nation’s office sector, however.

Moody’s Investors Service found that appraised values had declined an average of 35 percent since securitization on 78 office properties, totaling 38 million square feet, currently with defaulted CMBS conduit loans. For the 30 properties within New York and Chicago, value declines were 28.5 percent and 46.5 percent, respectively. Seven office properties in Denver and Houston declined in value by 60.3 percent, while four San Francisco offices declined by a stunning 72.5 percent.

For an asset class that has seen national vacancies rise to 19 percent in the fourth quarter of 2023, conduit default rates double from 2.73 percent in January 2023 to 5.49 percent in January 2024, and transactions essentially grind to a halt, it’s not surprising that question marks have proliferated around market values.

“It’s the transaction volume decrease that makes it tough for people to say they have reference points for cap rates or whatever metric they’re using as valuation benchmarks,” said Darrell Wheeler, Moody’s head of CMBS research, who added the velocity of office transactions now sits at 2013 levels. “There’s a lot of concern about valuations and how they’re done.”

Ah, yes, valuations — how they’re created and what goes into them. In many ways, this element of commercial real estate finance is the secret ingredient baked into all transactions. The opinion of value crafted and then concluded by an appraiser — almost always an independent third party — is often what determines the fortunes of investors, the share of allocated spoils, and the long-term viability of any income-producing property.

“The ding on an appraisal is always that it’s rearward-looking, we take the comp [comparable] that happened yesterday and adjust, and apply it to a transaction today. But when there are no transactions yesterday, that makes it that much harder,” said Robert Skinner, managing principal of Cushman & Wakefield’s New England office

“An appraisal is always a blend between art and science, but it’s not fully scientific,” Skinner continued. “It’s called an ‘opinion of value.’ My opinion of value is different from yours, but we should be within 5 percent if we know what we’re doing.” 

During the first years of the pandemic, a wave of broker opinions of value swept through the industry as soon as the Federal Reserve dropped interest rates, creating one of the frothiest markets in modern times.

Steve Schaller, chief revenue officer at Bowery Valuation, a New York-based appraisal firm, said his business was as busy as it could be when rates were nearly zero in 2020 and 2021. “We couldn’t hire appraisers fast enough and had more demand than we could manage, and that was true for most appraisal firms,” he said.

But that changed almost as soon as the Fed began raising interest rates in July 2022.

“It’s definitely significantly slower than it once was,” said Schaller. “And I don’t think we’ve even seen the full distress hit the system yet, in terms of where things are headed.” 

Yet today, without a robust capital markets landscape to interpret, an appraiser’s personal judgment has come to occupy an increasingly important seat at the table as lenders and investors alike consider several key metrics used to determine CRE valuations.

Among the most critical statistics studied in any deal are net operating income (or NOI, also known as revenue), cap rates, vacancy rates, and rental rates, according to Brandon Gollotti, managing director of Bowery Valuation.

“When rental rates fall, that impacts income, and when vacancy increases through excess supply, that has largely negative effects on valuation,” said Gollotti. 

Other key data points appraisers consider are renewal probability, absorption velocity, static vacancy, and net effective rents, as well as expenses, according to David Lyon, executive director at JLL Value and Risk Advisory.

“While ultimately the capitalization rate and discount rates move the needle on valuation, there really is no single metric which I would deem most important,” said Lyon. “A credible expert valuation will consider myriad variables which impact value.”

Fair enough. But what exactly goes into a credible valuation today?

Expert analysis

Despite being an industry of concrete building blocks and impersonal spreadsheets, commercial real estate still depends on human beings to physically enter the equation and craft values based on their own observations.  

Richard J. Sheeler, president of Neglia Appraisals, said that an appraiser has “a fiduciary duty” to dig into the data, visit the buildings and create a comprehensive analysis, rather than simply accept the valuations presented by a building’s ownership group.    

“I can tell you that with appraisers you get what you pay for,” said Sheeler, who added that the numbers presented by ownership are incorrect 90 percent of the time. “I know a lot of appraisers who dig in and do the research, who do it the right way, and others who just take whatever ownership tells them is in the rent roll, not dig in, and say, ‘This is what it is.’ ”

Any appraisal begins with an engagement — either an owner or lender calls the appraiser onto the site to figure out an updated appraisal for either financing a transaction or account for year-end reporting. After reviewing public records and checking the property’s certificate of occupancy, before even entering the building, the appraiser begins the on-site visit with a study of the neighborhood.

“You go out to the property for a physical inspection to figure out what the market is like. Who are the neighbors? How does it fit into the broader market?” explained Cushman’s Skinner. “The classic example is: Is it a church next to a strip club?”

During the physical inspection, the appraisers inspect as many units as possible, including commercial and residential spaces in the case of a mixed-use building, and usually a sampling of residential units within each apartment line. This process usually includes an interview with the building manager or superintendent and takes only a couple of hours.

“The reason why we’re adamant about seeing the commercial space is we want to measure the commercial space, as the rent is done on a per-square-foot basis,” explained Sheeler. “We determine what the space of the commercial real estate unit is to see if rent is in line with the marketplace and to make sure nothing crazy is passed through into the appraisal.” 

Other experienced appraisers believe that only a limited inspection is required to adequately compare the property to the market and determine the revenue it can generate.

“I don’t need to see every single square foot of the building. I need to see a representative sample of what the tenants will see, because what the tenants see determines how much rent they will pay,” said Skinner. “So you make certain assumptions that it’s at a certain market standard and how it is perceived by the market.” 

If there is this critical physical component, then there is also the element of perception.

Generally, appraisers believe their job is to hold a mirror up to the market and reflect the market as accurately as possible to the interested parties. At best, an appraiser keeps their own biases about a building or neighborhood at arm’s length and relies instead on expert opinions to inform their own conclusions.

“It’s not for me to judge the cap rate. All I’m doing is reflecting the market,” Skinner said. “Then you go back to the office and talk to brokers, buyers, sellers, investors about the market, because I can’t reflect the market if I don’t understand the market.”

Three avenues

Even though a physical inspection is required for any legitimate appraisal, there are actually three separate numerical approaches appraisers use to determine values for commercial real estate property: an income approach, a sales comparison approach, and a cost approach.

The cost approach is the least common method because its valuation model usually applies to new construction, where land values, vacant land sales, and depreciation estimates of nearby buildings are used to figure out how much it would cost to construct a replacement property in the same area. If this sounds like reverse engineering to reach an informed value, well, it is.

“It’s hard to determine the depreciation structure for a building that’s 100 years old, so a lot of times you won’t see that come into play,” said Sheeler. “Lenders usually ask for this [method] to estimate the replacement cost of a new structure to determine what they can insure it for.” 

Then there’s the sales comparison approach. This method is exactly as it sounds: an analysis of data from recent sales of similar properties that produces an agreement on values, as appraisers assume that no informed buyer will pay that much more than the most recent purchase price of comparable properties.

The problem with this method, as one can imagine, is the difficulties appraisers encounter in determining markets when investment sales freeze and transactions fail to materialize.

“When there aren’t a lot of transactions, you as an appraiser, rather than using comparable sales data, are doing a lot more on the interview side: You’re talking to buyers and sellers, getting their feel for what returns should be,” explained Skinner. “But the short answer is it’s a lot harder.”

Moreover, some appraisers eschew the sales comparison approach because of the unique characteristics among CRE properties, such as neighborhood quality, access, renovations, debt yield, debt service coverage, estimated rents, projected vacancies and NOI, which makes comparing values based on recent sales a fool’s errand.

“The problem is no two office buildings are the same and there are all these differences without getting into all the nuances,” said one experienced appraiser, who spoke on conditions of anonymity. “When one is looking at the sales comparison approach, it’s very hard and challenging to get real numbers, so I give little weight to it.” 

With that said, like a dependable brand, one appraisal method remains trusted among all others: the cash-flow approach, also called the income approach.

Because commercial real estate properties are income-producing assets, the cash flow coming out of a property can be used to determine its value relative to market comparables. No matter a down market or a hot market, every CRE property is still able to produce a rent roll for analysis and assessment.

“The entire weight is given to the income approach,” said the anonymous appraiser. “When you have an income-producing asset, no one cares about the cost approach or the sales comparison approach.”

Using the income approach, an appraiser sets up a rent roll and studies the leases, before writing an income and expense analysis that helps determine an estimated rent for the space based on comparable market data. The appraiser then considers vacancies and loss rates, and also applies typical expenses like taxes, heat and hot water, electricity, interior maintenance and other building costs to determine the NOI of the building. After choosing a capitalization rate based on market comparables, that cap rate is applied to the NOI to convert this mix of data into an updated building value.

Moreover, some appraisers (and investors) use a discounted cash-flow analysis, which makes assumptions about building metrics during a fixed time period. These metrics might include rental movements, vacancy levels, and where residual cap rates will be upon a future exit date. 

“From my office, and my way of thinking, we put most weight on actual market transaction cap rates than on a theoretical band of investment cap rates,” said Sheeler. “That’s how we get down to value via the income approach.”

However data-intensive the income approach is to determining values, the consequences of this method extend far beyond the offices of an independent appraiser. Because buildings derive their value from cash flow, widespread value declines across the office sector (and other asset classes) have forced lenders and equity partners to become increasingly involved in the valuation process, or at least more than they typically are when interest rates are low, according to multiple appraisers. 

Consider: When vacancies rise and rents fall, how much cash flow is left over after expenses to service a loan? Likely not as much as underwriting once assumed. And, if estimated cash flows can’t service a loan, which lender would ever float millions of dollars in debt to support the capital stack of even the most accurately valued building?

This uncertainty around debt service in CRE is the primary element that’s freezing transaction volumes and confusing values for appraisals  — after all, is not market value determined by both a willing seller and a willing buyer?

“The biggest problem with office valuations now is even if I come up with an opinion of value, it still assumes that a buyer can purchase the asset,” said Skinner. “The lack of financing is having a greater negative impact on valuations [than anything else].” 

If cash flow assumptions weren’t difficult enough, the fears of inflation photobombing the capital markets picture have in turn heightened dreaded expectations that the Fed will raise interest rates even higher to fight it off, while nervous investors in turn will drive the 10-year Treasury past 5 percent for the second time in 12 months.

All told, market participants are preparing to hunker down in an uncomfortable world where interest rates are higher for a long foreseeable future.

“It’s not a good thing for our market, it’s not a good thing for liquidity, it’s not a good thing for transaction volumes, and it will have the impact of chilling investment sales because it will put things back in doubt today,” said Warren de Haan, CEO of Acore Capital

Brian Pascus can be reached at