Appraisals and how they impact the home selling process

People have lots of thoughts on appraisals and how they are impacting the market.

First off, let's define an appraisal.

The appraisal is a snapshot of the value of the property at a particular time, the day the appraisal is done.  It does not tell you what the property was worth last year, or will be worth next year.  Just what it is worth today.

The appraisal is done in 3 ways:

Income approach- how much money the property will make the investor based on rents etc

Cost approach- how much it will cost to build the house

Sales Comparison approach- This is the most important and weighted most highly by the banks - you find comparable properties in the immediate area and you base the value on properties that have sold recently.

Who needs the appraisal?

The appraisal is used by the BANK to lend $ on the property.  eg. If you are an FHA buyer, the bank will lend you 96.5% of the appraised value.  If you are a 20-25% down investor, the bank will lend you 75% of the appraised value.

People also need appraisals to refinance their properties. 

Reasons to refinance:

get a better interest rate

reduce the term of their loan

Get rid of PMI (private mtg insurance) because the put down a low down payment, and now have 20% equity in the property

Cash out Refinance (REFI)- they have more than 20% equity in the property so the bank will allow them to take that money out

Here is where appraisals impact the market, and specifically the Multi-Family market.  

Saturday I was out looking at Multis in Worcester and received a call from an appraiser who was inquiring about the sale of a property that I had brokered.  Her concern was that owners were trying to refinance properties they owned and they thought their properties were worth more than she(as an appraiser) thought they were.  

Her concern was that she was seeing buyers were offering more than houses were worth, and people looking to refinance their houses for more than what they were worth.  And there was an uptick of this in Worcester since August.  

The fear is that buyers are paying more for houses than they are worth, by making up the difference when the appraisals come in low.

The appraisal protects the bank in case of the downturn, and the banks want owners to have 20-25% equity in the property, or PMI to make up that difference.

Why the concern on behalf of the appraiser? We will address both Purchase and REFI

Purchase: 

There are a lot of multiple bid situations so Buyers are offering high prices so that they can secure the contract to purchase.  What happens if they offer over the appraised value of the property?  eg. A Buyer offers $525k on a house but it only appraises(is worth) $500k.  The banks don't want to disagree with the buyers on value, but their loan amounts are based on the appraisal value.

What happens when the appraisal comes in short?

there are 4 choices:

Cancel the deal

Seller reduces the price to the purchase price

Buyer and Seller agree to reduce the purchase price by some amount

Buyer makes up the difference

If the buyer is FHA the bank will loan them 96.5% of $500k or $482,500 and the buyer has their normal 3.5% down payment of $17,500.  Now that the seller is expecting $525k for the house the buyer needs to come up with another $25k to make the deal work.  So essentially for the FHA buyer the down payment is more than double at $42,500 + probably another $10 in closing costs.  This is a lot of money for the first time home buyer.

If the buyer is 25% down, the bank loans them 75% or $375k and the buyer puts down 25% or $125k.  In this case the investor comes up with another $25k for a total of $150k + $10k in closing costs.

As you can see here if the seller wanted to bet on which buyer would have another $25k to make up the difference, they would probably bet on the 25% down buyer to have the additional money.

Refi:

Similar to the Purchase the bank loans based on the appraisal.  If the appraisal comes in low, then the deal either goes through, or doesn't

If it doesn't then both the bank (they don't get to sell the loan) and the buyer walks (and they are unable to get rid of PMI, or pull money out of their home) 

How does this effect sellers?

Sellers might get multiple offers for a property, many of which might be above what is the likely appraisal price.

As a seller, you need to make sure there is a provision there if the appraisal comes in below the appraisal price.  Why?  If you accept that offer for $525k and the appraisal comes in at $500k the buyer may walk, and you need to go find another buyer.  Actually any offer above $500k that is subject to the property appraising for purchase price is essentially the same.

A better offer is something that gives the seller downside protection.  eg. and offer for $515k that says they will make up the difference if the property appraises up to $15k under the appraisal price.  Essentially that offer would pay you a max of $515 but would always pay you $15k over the appraised value.

Sellers need to understand that in order to win, Buyers are offering prices they know will not appraise and are hoping that the seller will accept that offer, and end up selling it to them for appraisal price.

I feel for the appraisers, but they are there as a check on the Market.  It is their job to determine the price of the properties and protect the banks, along with PROTECTING THE BUYERS FROM THEMSELVES