About Appraisals
Appraisals are probably the least understood aspect of the home buying process, and can generate great emotion, particularly if you're on the 'losing' side of one.
Appraisals are conducted by appraisers licensed by the State of NY (or PA), and most are conducted under very strict Federal guidelines to ensure consistency and uniformity and maintain the integrity of the mortgage securities markets. (What many people don't know is that when you get a mortgage loan from most sources, whether mortgage brokers or one of the big banks like Wells Fargo or SunTrust, your mortgage loan is almost immediately bundled with hundreds of similar loans and sold in the mortgage-backed securities market. While you may send your monthly payment to Wells Fargo, your loan is actually 'owned' by another investor.)
There are 2 parts to the mortgage application process — a determination of your credit worthiness as a borrower and a determination of the value of the house you're purchasing. The appraisal is key to the latter. Basically, the investor wants to know that if you go belly up and stop paying the mortgage that they can sell the house for at least the appraised value and recoup their investment.
Investors want assurance that there is a market for the property at or above the price you're paying, and appraisers employ a very specific methodology to determine that. They are required to show that there have been at least three sales of a property similar to yours in size, style and price in a recent period specified by the lender. (That window used to be 12 months, but recently that 'comp window' has been tightened by many lenders to 6 months, and if private mortgage insurance applies to the loan, it could be as short a 3 months.) Those are known as 'comps', or comparable sales. An important point to keep in mind is that appraisers can only consider houses that have actually sold, not houses with higher asking prices that are on the market now, but haven't sold. That's a problem when sellers have a highly inflated opinion of their home's value, and recent sales don't support it.
There are components of value that a seller and even a buyer may value highly, but an appraiser doesn't. Say you put $100,000 into renovating a 1,500 sq. ft. farmhouse with 3BR and 1 1/2 baths on 5 acres and now believe your tastefully renovated home is now worth $350,000. Renovation quality isn't a key appraisal factor, however, like square footage, number of bedrooms and acreage are. An appraiser has to compare your house to other similarly sized houses on similar property. In this case, he or she will look for 1,300 to 1,700 sq. ft. houses on 3 to 8 acres that have sold in the past 6 months within X number of miles of your property. If the 3 closest comps sold for $240,000, $260,000 and $270,000 respectively, he or she can't bring in your appraisal at $300,000 to $350,000 even if your house is much 'nicer'.
An appraiser's calculations to arrive at an appaised value are much more complex than simply averaging the 3 comps. There are adjustments for square footage, acreage, amenities like fireplaces and garages. They can even make modest adjustments for condition or setting features like a pond or view. But they can't fabricate an appraisal value out of whole cloth, and even with adjustments they generally can't bring in your house above the highest comparable. (I saw "generally" because there are special appraisal methods for very unique properties that private mortgage equity firms will accept, but these are typically something only a high net worth individual would have available for the purchase of a trophy property. If the term "private banking" isn't in your vocabulary, it probably isn't an option.)
What Happens When an Appraisal Comes up 'Short'?
Don't assume the appraiser did a bad job. If you're a buyer, get a copy of the appraisal and review it with your real estate broker. The appraiser may not have been aware of some comps that would better support the value, and most are willing to consider other comps (if politely presented.) If there are some comps that the appraiser overlooked, ask your real estate broker or mortgage broker to present them. Do not ask to speak directly with the appraiser. An appraisal is not a negotiation, and appraisers are very sensitive to ethical issues.
If an appraisal does, in fact, come up short, the buyer and seller have a few options. Say that a house is selling for $290,000 and the appraisal comes in at $260,000. With a conventional mortgage of 80% (20% down), the lender is essentially saying that they will lend 80% of the appraised value, in this case $208,000 (80% of $260,000, not 80% of the agreed-upon-purchase price of $290,000). The lender may offer the option of changing the loan to 90% of the appraised value (lending, in this case, $234,000) and adding private mortgage insurance (PMI) to the loan. Your down payment would remain the same, but only half would apply to the actual 'down payment' for the purpose of the loan, and the other half would essentially go to the seller to make up the appraisal gap.
In the go-go market, when houses were in short supply and buyers were flush with cash, a buyer might just love the house enough to decide to make up the gap with cash. Today, however, in a slowing market, buyers are less likely to be willing to bridge the entire appraisal gap with cash and there will likely be some renegotiation on price.
If the appraisal gap is relatively small, say less than 5% of the purchase price, the seller may just agree to adjust the price to the appraised price. If the gap is larger, some type of split scenario may be more likely. If the gap is 10%, for example, maybe the seller drops the price 5% and the buyer makes up 5% with additional cash or a small second mortgage.
Of course, both sides may stand firm, in which case the deal dies. The problem for the seller, however, is that they now know that the house won't appraise for what they want, and they're faced with finding an all-cash buyer or a buyer who is willing to bridge the entire gap, which can be difficult.
I'm always amazed when I hear of deals falling apart on appraisal. An apprisal shortfall shouldn't come as a surprise to either buyers or sellers. I've sold a number of properties that have appraised 'light', and in every case I've told my clients of possible appraisal issues before ever entering negotiations. A good agent should be able to tell at a glance if a house may face an appaisal issue. In some cases, it isn't that the house isn't 'worth' the agreed upon price, but rather that the comps aren't there to support the price.
Why didn't the house appraise for more than the purchase price? Everyone says its worth much more and I'm getting a great deal!
This is one of the most misunderstood aspects of the appraisal process. An appraiser's objective (at least when appraising for a new 'purchase money' mortgage) is to demonstrate to the investor that the house is 'worth' the purchase price, to protect the investor. It is not necesarily to determine its "true" value. A mortgage appraisal frequently comes in at or only slightly above the contracted purchase price, even if that price is below 'market value.' Why? There is aboslutely no incentive for an appraiser to bring in a higher value (even though it may make the buyer feel better.) Appraisers strive to be conservative in their appraisals, applying the most conservative criteria — using comparable houses that are closest to the target, in terms of distance, size and style. While they can use comps that sold within the past 6 months, if they can, they prefer to use the 'youngest' comps possible. So, if the purchase price of a house is $250,000, the appraisal may come in at just $255,000. If the purchase price on that same house was $270,000, it could still appraise at $270,000 or $275,000, with an appraiser broadening the appraisal criteria.
Appraisal values may also differ because of the underwriting criteria of specific lenders. Log homes are a good example. One lender may require that the primary comp for a log home loan must be another log home. Another lender may accept a conventional home of similar size adn style as a primary comp. As a result, an appraisal with a 'log home comp' requirement may come in substantially different from an appraisal without that requirement.
The house appraised. Why didn't I get the loan?
The appraiser is not the loan underwriter. The
appraiser submits the appraisal to the lender, which is then
reviewed (scrutinized is a better term) by an underwriter. The
underwriter may challenge one or more of the comps used by the
appraiser, or the appraiser's justification to include or adjust
a comp. This can be an issue in a low density rural area like
Sullivan County if the lender doesn't regularly lend on rural
property. Lenders who typically handle suburban or urban houses
usually want all the comps to be within 1 to 3 miles of the
target property, or in the same school district. Here in Sullivan County an appraiser often
has to expand that circle to 25 miles or more to find appropriate
comps, because we are low density and have a relatively low
number of sales. When an appraiser includes a more distant comp,
they note the reason — but it's up to the underwriter as
to whether they will accept that reason. The same lender may
also apply different underwriting criteria to different loans.
For example, if a buyer has great credit and is making a 20%
down payment, a lender may be more liberal in their underwriting
criteria than for a loan to a buyer with less sterling credit
who is only putting 10% down.