A real estate appraisal provides an expert opinion on the value of the property. If an expert tells you a property is worth $X, does that mean you can expect to receive exactly $X when it is sold? I had an old boss who once said, "I haven't had one appraiser buy a foreclosed property for what they said it was worth!" This brings up an interesting point to consider, which is, an appraiser can be wrong because it is not him who must buy or sell the property. The reasons the sale price of a property and the appraised value differ have to do with several factors.
Instead of blindly accepting the value of an appraisal, a good lender must understand what an appraisal represents and how it should be used. An appraisal for commercial real estate property will usually include three different methods for evaluating the property-cost approach, sales approach, and income approach. The appraiser will either use one approach and explain why he didn't use the other two; or the appraiser will use multiple approaches and try to reconcile them.
Perhaps the easiest method to understand is the sales approach. In this method, the appraiser finds comparable properties that have recently been sold, and evaluates how those properties are similar and different compared to the property he is appraising. The appraiser attempts to adjust for differing characteristics in the set of comparables and explains whether the subject property's value should be higher or lower based on these differing characteristics. This method works well when there are several similar properties that have recently been sold nearby, because this indicates a market for the property is established. The use of this method becomes less valuable when comparable properties reside outside of the subject market or there are simply no similar properties being sold.
The cost approach is a method often used when it is challenging to find comparable properties. The cost approach generally evaluates the cost of replacing the subject property. This will include the cost of acquiring the land at market value and including materials and contruction costs necessary. You should note this approach has little to do with market value, since the cost of improvements will likely exceed the cost of the land. A value determined by the cost approach is more of less telling you the cost of the project, and not the price of similar projects that are being bought and sold.
The income approach evaluates a commercial property based on how much income it generates. In this method, the appraiser treats the property like an investment that will yield an expected rate of return. The value is usually determined by the way of a "cap rate", which is a relationship described as the property's income divided by its market value. A good appraisal will seek out similar properties and adjust for differing characteristics, much like the sales approach; although the adjustments are made to reflect the expected income stream. Then the appraiser looks at what the local cap rates are, by looking at the relation to income and value for similar properties. With a market cap rate, and market adjusted income stream, solving for value is a simple algebra equation.
Often, I see appraisals that the cap rate is not derived by observing local market conditions; but rather, by looking at national investment trends. Much like the sales approach, I feel considering data outside the local market weakens the appraiser's conclusion, since we expect the buyer is likely local, not a faceless, national investor. It's not that the buyer couldn't come from outside the local market; it just isn't reasonable to assume this will be the most likely case.
I think the key to understanding the resale value of any property is to ask yourself who the potential buyers will be if the property needs to be sold. The buyers will likely be local investors interested in marketable properties. If a property is not readily marketable, i.e., can only be used for a special purpose, then the price will likely need to be discounted to attract potential buyers.
The appraisal is a tool which gives you some basis for understanding the value of the property, but it is still an opinion. It is a mistake to use the appraiser's opined value without understanding the assumptions and methods he used to determine that value. An institution should provide analysis with the appraisal which addresses whether potential buyers exist in the market and what the prevailing market conditions look like. Know that if there are not easily identifiable buyers or an established market, it will likely take large discounts to attract potential buyers, rendering the appraised value moot.--Trevor Plett