Appraisals are important for every new home buyer and real estate investor, even for buyers paying all cash, and for sellers to accurately determine a property listing price.
An appraisal also helps the mortgage lender justify the risk of making a loan, and helps an all-cash investor understand how a lender determines property value if the investor decides to do a cash-out refinance at a later date. Knowing what the fair market value of a property is before it goes under contract also helps to reduce the risk of the deal falling through.
How appraisals work
A home appraisal conducted by a licensed, third-party professional provides an unbiased opinion of what a property is worth for all parties involved in a real estate transaction.
With the possible exception of a streamlined no-appraisal refinance loan, nearly every loan application requires an appraisal as part of the underwriting process.
In some cases, the mortgage lender may use an automated valuation model (AVM) to determine a home's market value. AVM appraisals are a type of artificial intelligence (AI) that determine real estate values by analyzing listing and sales activity, along with market trends, then applying that data to determine the value of a specific property.
But, artificial intelligence aside, more often than not an appraisal is still conducted on-site by a licensed human being.
There are three general approaches home appraisers use to determine property value:
1. Sales comparison approach
The sales comparison is the most common appraisal method and is done by comparing properties that have recently sold or are actively listed to the subject property or the property being appraised.
Sources used for the sales comparison appraisal approach include data from the MLS and county assessor records to identify private-party transactions and verify property information such as lot size, square footage, and value adjustments for items such as upgraded finishing or deferred maintenance.
2. Income approach
The income appraisal approach views the property as an income-generating asset, then extrapolates the home value based on financial valuation formulas such as gross rent multiplier or cap rate.
Real estate investors often use the income approach as a preliminary way of determining what a property is worth to them, then verify that valuation by using the sales comparison approach. This mixed methodology is frequently used by single-family rental property investors to help rationalize purchase prices.
For example, even if the cap rate of a rental house suggests the property is worth $150,000, an investor would likely not pay that price if similar houses in the same area are selling for $100,000.
3. Replacement cost approach
The replacement cost appraisal approach estimates the cost of re-building the property with the same materials at today’s costs, then factors in the current age of the property by subtracting depreciation, along with the value of the lot.
Insurance companies and appraisals of property where comparables are hard to find – such as rural properties or special-use properties – frequently is the replacement cost approach. Real estate investors buying property in rural areas can combine the replacement cost approach with the income approach to help determine the true market value of income-producing property.
Other ways to determine property value
There are three other ways real estate investors can determine property value. Although they’re not a substitute for a paid property appraisal by a licensed professional, they are absolutely free and can provide a fairly accurate idea of most property values:
- Comparative market analysis (CMA) using data from the MLS, Zillow, and the Roofstock Investment Property Marketplace
- Broker price opinion (BPO) performed by a licensed real estate broker or agent combining data from the MLS along with the agent’s detailed knowledge of the local real estate market
Why an appraisal can come in low
Appraisal reports can come in lower than the offer price. A low appraisal value can frequently occur during times of economic uncertainty, when sellers haven’t adjusted their asking prices to the realities of a real estate market experiencing a normal downward cycle.
But it’s not just in cold or volatile real estate markets where appraisals can come in low. Appraisals lower than the offer price can occur when the market is neutral, lukewarm, or even red hot.
The reasons for a low appraisal generally fall into one of three categories:
Real estate market
- Property sales prices are trending downward due to a weak economy or overbuilding
- Property prices have begun to recover from the short-term downturn, with market values rising ahead of recent sales comparables
- Short sales, foreclosure, and REOs (real estate owned by the bank or lender) can artificially skew property values downward
Opportunistic seller or inexperienced buyer
- Seller thinks the property is worth more than it is really worth based on current market trends
- Buyer becomes emotionally involved in the property purchase, instead of viewing the property as an asset that generates cash flow
- Seller and buyer work out a “side deal” where the buyer pays above market, then receives a credit back from the seller, which inflates the purchase price above the fair market appraised value
Mistakes by the appraiser or lender
- Inexperienced appraiser overlooks economic factors that influence property values in the local market, such as a new major employer coming into town that will increase the demand for rental housing.
- Underwriter or appraiser made a material error affecting property value, such as not including the value of a recent capital repair or using the wrong square footage.
- Appraiser does not consider pending sales that may be a better indicator of “real time” property values than recent comparable sales.
How a low appraisal affects buyers
As an investor, you can still decide to buy the property even if the appraisal is lower than the purchase price. For example, you may believe the long-term true value of the property is greater than the appraisal due to factors such as a soon-to-be improving economy or strong future population growth.
However, if you’re financing, you may need to put more money down if the appraisal comes in low. That’s because the lender will calculate the loan-to-value (LTV) based on the appraisal value and not the purchase price.
Let’s say you and your lender have agreed to a conservative LTV of 75%, with you making a down payment of 25%. Your purchase price on a single-family house is $100,000 – but the appraisal came in low at only $80,000. If you decide to proceed with the purchase, you’ll need to come up with more money than anticipated:
- Purchase price = $100,000 x 25% down payment = $25,000 total cash down
- Appraised price = $80,000 x 25% down payment = $20,000 + $20,000 difference between purchase and appraised price = $40,000 total cash down
If you don’t want to pay more for the property than the appraised value, there are three approaches you can take as a buyer:
- Negotiate with the seller for a lower offer price.
- Buyer and seller mutually agree to extend the contract appraisal contingency clause to allow time for second appraisal.
- Buyer unilaterally cancels the contract using the appraisal contingency clause, and receives a full refund of the earnest money.
How a low appraisal affects sellers
Sellers have few options if the appraisal is lower than the offer price. How you respond as a seller depends on what part of the real estate cycle you are in.
For example, in a hot market, appraisers often have a hard time keeping up with quickly increasing property values. On the other hand, a cold market may mean that offers from qualified home buyers are few and far between, and that a “bird in the hand is worth two in the bush.”
If you’re selling a property where the appraisal is lower than the offer price, there are three things you can do:
- If you’re in a hot market, refuse to negotiate with the buyer, allow the contract to be canceled, then wait for the comparables to catch up to your original offer price.
- Instead of letting the buyer cancel the deal, persuade the buyer to come up with the difference in cash, using comps created by your real estate agent to convince the buyer the property is really worth the offer price.
- If you’re in a neutral or cold market, lower the offer price to match the appraised value of the property.
Of course, the seller and buyer can also mutually agree to extend the contract appraisal contingency to allow time for a new appraisal. Doing this can create a win-win situation since the buyer will not feel he is overpaying, and also won’t have to come up with the extra money required by the lender to meet the LTV.
Tips to help prevent a low appraisal
No matter what side of the closing table you are sitting on, there are several things a buyer and seller can do to prevent a low home appraisal before it happens:
- Ensure the property is listed at the right price – and that the offer price is at fair market value – by:
- Having your real estate agent pull comps from the local MLS
- Researching recent home sales on Zillow
- Using the Roofstock Cloudhouse Calculator to help determine the property’s true rental potential
- Order a pre-listing appraisal if you’re the seller, then provide the buyer with a copy to give to the lender and appraiser when the property goes under contract.
- Ask your lender to make sure the appraiser has experience working in the part of town your property is in.
- Meet the appraiser on-site to answer questions and point out amenities, and recent repairs and upgrades that can influence property value.
- Appeal or rebut the appraisal, where the buyer’s lender submits a written request for the appraiser to re-examine the property and recalculate the appraised value.
- Find another lender and go through the appraisal process again, with buyer and seller negotiating who pays for the additional appraisal fee and any other extra loan fees.
Final thoughts
Having a real estate transaction fall through because the appraisal is lower than the offer price can be a waste of time and money for both the seller and the buyer.
But the good news is, there are plenty of ways to proactively help prevent a property appraising for less than the contract price such as:
- Ordering a pre-listing appraisal
- Having your real estate agent create a CMA or BPO before listing or making an offer
- Meeting the appraiser at the property
If the appraisal still comes in low despite your best efforts, you can always try to renegotiate the deal. In many real estate markets today, sellers know that qualified buyers can be hard to find. Most sellers will be motivated to keep the deal from falling through than to have a buyer purchase a different turnkey rental property that’s priced right.
