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What's the Appraisal Got to Do With It Anyways?

The appraisal is a critical component in the overall sale of a home, and many people overlook just how significant this piece of the puzzle really is. An appraisal is an informed opinion of a home’s value. This opinion, albeit an expert’s perspective, is subjective, but it is treated as the accurate and credible value of a property. In other words, when an appraiser puts a value on a home, it sticks, and is generally accepted as the actual value of a home. It is important to recognize that while buyers may be willing to pay one price for a home, if the buyers are getting a loan on the home and it doesn’t appraise, then the buyers may or may not be obligated to pay that initial agreed-upon amount. The appraisal contingency is an important layer of protection in the residential purchase contract. Not only does it protect buyers from overpaying for a property, it prevents lenders from betting on a property that may or may not be worth the contract price. It also protects housing markets from huge inflationary jumps. Appraisers, who are licensed and governed, must adhere to a strict set of guidelines when valuing a property. In general, they must choose comparable properties that are most “like” the property they are valuing, the goal being to make the fewest price adjustments possible, leaving less room for subjectivity. An example would be comparing a two-story to a two-story home, an exact floor plan match, or exact interior size. Appraisers also look for homes in the area with similar updates or upgrades, similar community features, and homes with similar living space or number of rooms. The types of similar homes appraisers can use to value a property are highly regulated with guidelines on items such as how far away the comparable can be to the subject property, how much larger the comparable can be, how many floors the comparable can be, and so on. Appraisers can often make a case for stepping outside these guidelines if there is a lack of recent sales (recent usually means 6 months, but appraisers can go back 1 year if necessary). Many homeowners often wonder how their “upgrades” will affect the value of their home. It’s important to recognize that appraisers don’t typically place a value on each individual upgrade. If they must make a price adjustment for upgrades, they will usually make an adjustment for the overall condition of the comparable property to the subject property with one all-encompassing number, such as $15,000, which may include flooring, kitchen, and bath upgrades, or whatever general features the appraiser is trying to take into account as a whole. The $750 light fixture in your dining room won’t show up as a $750 price adjustment in an appraisal. It may add value to the overall condition in a price adjustment—if there is one. Appraised value and perceived value are often two different things in a housing market, particularly in fast-climbing markets. While appraisers can definitely make adjustments to market timing and overall market increases since past sales, it’s a smart move to analyze past sales when considering a home’s real value. An astute Realtor with a feel for the market, the area, and comparable properties can help you make a realistic, estimated valuation of a property. To ad context to my explanation, let’s look at Mr. and Mrs. Hypothetical, Mary and Joe, who list their home for $350,000. Similar make and model homes with similar features, upgrades, lot size and location have recently sold in the ballpark of $300,000. Within the first week of listing their home, Mary and Joe can’t believe how many people show interest in it. They have multiple showings and multiple offers. Along come Sue and Bob who just love Mary and Joe’s home. The kitchen remodel is exactly what they’ve been looking for and the fountain in the backyard is a perfect tropical environment for their koi fish. They make an offer to purchase Mary and Joe’s home for $355,000. Mary and Joe accept, and now they are in escrow. Sue and Bob are getting a loan on the home, and the loan requires an appraisal. The appraiser visits the property and reviews many other similar and recent home sales, or what we call comparables or “comps” in industry vernacular. The appraiser notes the kitchen remodel, but also sees that many other homes have similar kitchen remodels with comparable features. She is able to make a slight price adjustment for the fountain in the backyard, but since many of the home’s features are similar to those of nearby homes and are well-suited for the “typical buyer” in that market, she can’t make any significant price adjustments to the home’s value. In the end, the appraiser puts a value of $307,000 to Mary and Joe’s home. Now what? Since there is an appraisal contingency in the residential purchase contract, which Sue and Bob kept in their contract, Sue and Bob are not obligated to pay more than $307,000 for the home. However, that doesn’t mean that they automatically get the home for $307,000. Since they originally agreed to purchase the home for $355,000, if they are not willing to pay $355,000, then Mary and Joe can cancel the contract and sell to someone else. Sue and Bob do, however, have the option to pay $355,000 for the home, but the lender can only base their loan amount off of a value of $307,000. That means that if Sue and Bob planned to put 20% down on their home, then they would put 20% down on $307,000 ($61,400), and then they would borrow the remainder from the mortgager ($245,600). If they choose to go forward with the purchase, then they would also have to pay the difference between the purchase price of $355,000 and $307,000 in cash ($48,000), making their total cash outlay, before closing costs, $109,400. If Sue and Bob don’t have the additional $48,000, or if they don’t want to pay $355,000 after learning of the potential value, then they can either renegotiate the purchase price with Mary and Joe, or cancel the purchase all together. My personal approach to any contract of sale in real estate is to blend reality with the market. In the case of Mary and Joe, their home had no chance of appraising at $355,000 unless there was an overall market jump of around 18% since previous similar sales. Since that is unlikely, their contract was flawed from the start. It’s best to enter into a real estate contract that makes sense to all parties involved from the get-go, making sure that the sale price is in line with what’s realistic in the market. With the right guidance, you can limit and mitigate appraisal snafus for a smooth transaction. P.S. Appraisers are human. That said, they make mistakes, and their opinions can be questioned. I have challenged appraisals before. It’s not an easy task as nobody likes to go on the defensive. Often, appraisers are able to justify their work to the lender, and the lender accepts their defense, and thereby treats the appraisal as gospel. I have had success in challenging an appraisal. The appraiser realized he could have chosen more appropriate “comps,” and ultimately amended his appraisal. This, however, is rare and shouldn’t be counted on as the norm. A good equation is to deal smart with value from the beginning.