Ask the next ten real estate agents you meet to tell you the biggest reason why a deal falls through. The odds are every single one will say it’s because of financing, usually because of a low appraisal.
But the fact is, a low appraisal can be good (and bad) for a buyer and there are ways to salvage the transaction and get the property you want.
In this article, we’ll explain the biggest reasons for a low appraisal, how to get the appraisal that matches the purchase price, and what to do if your home appraisal comes in low.
What is an Appraisal?
One of the common contingencies in a real estate purchase contract is that the property must appraise for the purchase price. A home appraisal is a report provided by a licensed professional that helps you and the mortgage lender determine the fair market value of the property you’re buying.
Appraisal reports usually run around $300 for a single-family house and a little bit more for a small multifamily property, depending on the market you’re investing in. The lender will order the appraisal, using an independent third-party professional who has no interest in whether or not the transaction goes through.
As the buyer, you’ll pay for the appraisal as part of your closing costs and be liable for the bill even if the deal falls through due to a low appraisal.
How an Appraisal Works
The appraiser will visit the property and walk through the inside and outside, taking measurements, photos, and notes. After the on-site review, the appraiser will pull comparables and write a professional report indicating the appraised value of the property.
Some of the key factors an appraiser looks for include:
- Age of construction
- Construction details such as wood vs. brick
- Date of major updating or remodeling
- Square footage
- Number of bedrooms and bathrooms
- Amenities such as an attached garage, backyard deck, or swimming pool
- Deferred maintenance that reduces current property value
- Lot size and configuration
- Location factors can impact value, such as being next to a greenbelt vs. backing to a busy road
- Neighborhood characteristics such as 2 star vs. 5 star and school district rating
- Trends in the local housing market
- Comparable sales of similar properties within the last few months
Reasons for a Low Appraisal
There are a variety of reasons for an appraisal to come in low. Most of the time you can control whether or not an appraisal can come in low by having your back-up data ready and deciding how and when to buy:1. Market cycle
Researchers at Harvard discovered that as far back as the early 1800s, the real estate market cycle follows a steady 18-year rhythm through four distinct phases:
- Recession sellers are plentiful and homebuyers are scarce
- Recovery as demand for income-producing real estate begins to grow
- Expansion with a balanced blend between supply and demand
- Hyper Supply with more buyers than sellers bidding property prices higher and higher
Historically, each phase of the real estate cycle runs about four or five years on average. Knowing which phase of the real estate cycle you’re currently in – or about to enter - is a good guide of how to invest and what kind of appraisal to expect.
For example, let’s say you’re at that point in time where the real estate market is cycling from recovery to expansion. As an investor, you see that property asking prices are increasing almost daily. But, the only recent comps the appraiser can find are from the recovery phase when demand was low.
Based on the real estate cycle, you know that if you wait to buy home prices will continue to rise, but by the time the appraiser can find the right comps your deal is long gone.
One tactic you can use is to ask the seller or the seller’s real estate agent to show the appraiser all of the offers made on the property. This helps to prove that your offer price is the true fair market value and will help the appraiser to justify the purchase price you’re willing to pay.
2. Hot property
Buyers who allow themselves to get drawn into a bidding way often find themselves offering a price that doesn’t make sense, at least as far as the appraiser is concerned. That’s because appraisers work off of historical sales transactions to pull comps and sometimes that data doesn’t match the price you’ve agreed to pay.
Overbidding can occur in a hot real estate seller’s market where demand exceeds supply, or in a buyer’s market when multiple investors are making offers on the same “once in a lifetime” deal.
When this occurs, you’ll need to bring extra cash to the closing table to compensate for a low appraisal. Just make sure that the property still has positive cash flow with a conservative LTV (loan to value) ratio.
3. Important property details overlooked
A low appraisal can also occur if the appraiser isn’t aware of important upgrades and improvements to the property that the seller recently made. Appraisers are not property inspectors, so they’re not going to do things like climb into the attic or verify the type of electric wiring or plumbing lines.
Features such as a new HVAC, updated electrical and plumbing systems, new appliances, or kitchen and bathroom renovations that affect property value might be easily overlooked by an appraiser who isn’t aware the work was done.
4. Comps are hard to find
The best comparables are properties that are very similar to the one being sold, and that have sold in the last few months. Every now and then, good comps can be hard to find and the appraiser opts for a conservative valuation.
Problems with the comps can occur for a couple of reasons.
First, if your transaction is taking place outside of the normal selling season – such as trying to close on a deal in Fargo, North Dakota in the dead of winter – recent comparables may be impossible to find.
Another reason for having a low appraisal due to poor comps is if the property you’re buying doesn’t fit the median profile of other homes in the neighborhood. For example, if most of the houses in the area are 3-bedroom/2-bathroom and you’re trying to purchase a 5-bedroom house, the odds are the appraisal will come in low because the sales price of the bigger house is larger than the comparable sales of smaller homes.
The farther outside the neighborhood an appraiser has to look for good matching comps, the more conservative the appraiser may be.
5. Seller cash credits
Believe it or not, there are times when too good of a deal can actually backfire on you. A low appraisal can occur when the buyer and seller agree to a higher contract purchase price in exchange for a cash-back credit at closing.
For example, the property might have deferred repairs that need to be done, or maybe the tenant lease is close to expiring and the buyer is worried about negative cash flow until the house can be re-rented.
While getting money back from a higher purchase price might make sense, it also means the property has to appraise higher than the fair market value:
- Fair market value = $100,000
- Credit via higher contract purchase price (for repairs or tenant vacancy) = $3,000
- Agreed-to purchase price (in exchange for cash-back) = $102,500
- Difference between fair market value appraisal and contract price = $2,500
Without the cash-back credit, the net purchase price is $99,500 ($102,500 contract price - $3,000 cash-back credit), a few hundred dollars below the fair market property value. But by agreeing to add the credits into the purchase price, the buyer and seller have created a situation where the appraisal will come in low.
Ways to Deal with a Low Appraisal
When you’re buying real estate, the best thing that can happen when the appraisal is low is for the seller to lower the price. However, sellers and their real estate agents usually have a good idea of what the property is really worth.
So, if the appraisal came in low, you’ll need to have a back-up plan prepared:
- Bring money to closing to make up the difference in cash. If you do this, make sure that the investment still makes good financial sense. Re-analyze key metrics such as cap rate, cash-on-cash, and annual yield to ensure you’re still receiving an acceptable return.
- Ask the seller to carry a second mortgage to make up the difference between the low appraisal and the purchase price. To avoid having to make two mortgage payments that reduce your cash flow, have the seller agree to a balloon payment after the equity in the property increases to the point you can do a cash-out refinance or have set aside enough money from the net cash flow.
- Make the appraiser’s job easier by having a member of your team meet the appraiser on site. Then, provide a list of property updates and payment receipts and any other offers that the seller received to prove you’re offering to pay fair market value.
- Ask the lender to order a second appraisal. The lender may not always agree with this request, but if they do ask the seller to split the cost of the second appraisal or have an independent appraisal ordered and allow the lender to compare the two.
- Compromise on the price or cancel the deal. When you’re buying a property with a low appraisal you have two cards you can play.
The odds are the seller wants to sell as much as you want to buy. Asking the seller to meet you in the middle is fair, especially now that the seller knows what the property is really worth.
If that doesn’t work, exercise the appraisal contingency in your purchase contract, get your earnest money fully refunded, and walk away to find another property.