Will The Appraisal Sink The Deal?
UPDATE: The CFPB in April 2021 rescinded consumer friendly rules put in place for Covid 19 and during a shortage of appraisers. There is a real risk of appraisal delays killing deal financing, delaying deals, or causing thousands in extra costs for borrowers.
In our prior post on FOMO, we covered just what FOMO is and how it might be shaping the market in the short term. It’s also why we have a different forecast than some others as to the window for a good buying opportunity. Today, we want to highlight a few potential effects of FOMO. History frequently repeats itself. With the high current demand for appraisers, there may be a wrench in the purchase and sale of a home. Are appraisers pricing homes appropriately in such a seller’s market, where bidding wars break out more often than not?
One of the most difficult matters buyers and lenders face is a rapidly rising or rapidly falling market. Both of these can lead to difficulty on getting the right mortgage as well as the right purchase price for your home. Of primary importance in a functioning market is the VALUE of the home. Value can be thought of in two ways. First is the price of the home compared to similar homes is a market. This is the basis for appraisals. How much did comparable homes sell for, when did they sell, what differences in the homes need adjustment to get a market value for the subject home, what special terms or circumstances played a role and how are those accounted for?
The second measure of value is the intrinsic value to the buyer (or seller). For the buyer, the intrinsic value revolves around family, location and amenities. In family, does the home check all the right boxes? The number of bedrooms and bathrooms, size, layout, move-in ready or not, upgrades or not, floor plan, condition, and many other factors. For the location, is it in the right school district, right location convenient for work, open spaces/playgrounds, good neighborhood, perhaps similar age children/adults, mature trees or newer built, safety, and other factors.
It is common in a rapidly changing market for the second measure of value to be more important than the first measure of value to the buyer. However, not to the lender.
Lenders are interested in having loans repaid and lessening risks which go into the loan. That is why LTV, DTI, and Credit Score are key drivers in the lending process. In a rapidly changing market, the LTV portion can become difficult to measure. Appraisals are what is termed a lagging indicator. They aren’t predicting the future value, but are taking a snapshot of what happened in the past. In a rapidly rising market, the appraisals tend to come in lower than purchase prices agreed to in a purchase and sale contract. In a rapidly falling market, perhaps when foreclosures are prevalent, the appraisal can be either too high or too low, depending on the comparables. In both cases, appraisals can come in too low.
It’s easy to see in a rising market that the appraisal based on sales six months ago may be lower than one today. In some areas, prices gained 10% or 20% in price in a year. That is the current environment. A shortage of available houses for sale has led buyers to bid up prices as they Fear Missing Out on low interest rates. Note the difference between PRICES and VALUE. The appraiser is not wedded to appraising the home at the buyer’s price, but at the underlying value in comparison. So in the current market where buyers are paying over asking price, that amount over asking price is a Price Adjustment and not necessarily a Value Change! Remember, at some point, a real estate professional likely reviewed the sales and recommended an asking price to the seller. The appraiser is going to see the same numbers in determining the value. Perhaps the target home has had substantial upgrades or changes which need to be factored in against area sales where the homes had no updates. But the real estate sales professional should have taken that into account in the Sale Price recommendation to the seller also! Appraisers can be very cautious not to aggressively value homes and earn a poor reputation among lenders and appraisal management companies. Neither the lender not the buyer can pick the appraisal. By law, a third party, called an appraisal management company, must be retained to pick the appraiser.
As a result, buyers are having to come out of pocket for large sums of cash to meet the gap between the appraised value and the purchase price as the lender will be basing a loan on the appraised value. If a buyer isn’t prepared to do this, it can be a waste of time, money and emotions to chase the home. On a purely financial and non-emotional level, chasing homes with offers well above asking price can be a recipe for regret. Other times, buyers have seen it pay off with additional appreciation after purchase to bring comfort to the buyer that the right decision was made.
When a market is falling, there is a risk that an appraisal also will come in too low. If buying a house in a neighborhood where a number of foreclosures or short sales have occurred, the risk is that those types of distressed sales dominate the market. Appraisers will be wary of valuing a home too high in a difficult market. Here again, there may be a need to have a larger down payment than planned. A contrary outcome is also possible. Since appraisals lag the market, the appraisal may come in high and support a purchase price that is high as the bottom is dropping out of the market.