In case you’ve been hiding under a rock, the real estate market has shot through the roof throughout the country over the past 18 months. The market is hotter than most of us have ever seen. We’ve all started using terms like, appraisal gap, and watched as desperate buyers have started offering to name their next child’s first name after the sellers (it’s a little creepy in my book) as a way to make up that gap in case good old fashioned cash isn’t good enough.
But, what is an appraisal, really? How do they figure out how much my home is worth? Why do I need an appraisal? What happens if my home doesn’t appraise at sales value? And what do my family portraits have to do with it’s value?
Technically, an appraisal is an estimation of value by a third party on a specific date rising from facts about the property (e.g. how many bedrooms, how large/small, size of lot, upgrades, etc.). An appraisal management company (or AMC) is hired by an institutional lender (i.e. bank) to send an individual out to a property to make an assessment.
There are two common types of ways to assess the value of a property in residential real estate: 1. the sales comparison method; and 2. the cost to replace method.
The sales comparison method is similar to how Realtors® come up with a suggested list price, or range for clients – whether buyer or seller. Generally, this is done by reviewing all sales within the last six (6) months of homes of a comparable size within a neighborhood. The appraiser will also take into account homes that are currently on the market and homes that have not yet sold but are in contract. An appraiser is also supposed to take into account current market conditions and whether or not the market is escalating. One thing to note about the sales comparison model: It is almost always, 2-3 months behind the current market trend. Homes that sold today, went on the market 2 or 3 months ago. In a fast market with tight inventory like we’ve had for several years, the market can change dramatically within a couple of weeks, let alone a couple of months.
Cost to Replace
The other method that appraisers frequently us is the cost to replace the property should there be some sort of catastrophic disaster and the owner had to rebuild. The basic formula for cost to replace is this: The cost of material and labor to replace the property using modern materials minus (-) depreciation + estimated land value = estimated property value. It can be a complex method but in a fast market where the cost of materials is skyrocketing (sound familiar???) this might work slightly better than a sales comparison method. Click here for a good primer on the cost-to-replace appraisal method.
Appraisal in the contract…
In section 3.I. of the offer, the contract states that the agreement is contingent on a certified or licensed appraiser finding the the value is at or above the purchase price in the contract. A bank will not lend more money to the buyer than the property is worth. At this point, one of four things will happen: 1. the buyer gives a little and the seller gives a little to make the deal happen and everyone walks away happy; 2. the buyer refused to give up extra cash and the seller decides that it’s in his/her best interest to reduce the sales price and the buyer walks away happy; 3. the seller decides that the purchase price is their minimum number and refused to reduce the price further and the buyer decides that it’s their dream home and that they’re never going to live anywhere else so they come up with some extra cash; and 4. neither the seller nor the buyer are willing to budge and they agree to walk away.
This discrepancy between the purchase price and the appraisal price is what is known as the appraisal gap. This term is coming up more and more as the gap between the appraised price and purchase price is starting to widen and become more frequent.
Waiving the Appraisal Contingency
Generally speaking, this is a fairly bad idea – especially in a fast market where the house might not appraise. I’ve advised clients that if they don’t think that the property will go for more than $XXX, than they shouldn’t write an offer for more than $XXX unless they’re willing to bring cash to the table. In fact, many listing agents are now asking buyers to bring that many to the table because they’re so concerned about a property appraising.
And lest you think that you can write an outrageously stupid offer and then back out when the bank won’t give you a loan because the appraisal came in low…unfortunately that’s not exactly how it works. You owe a duty of honest and fair dealing to the seller (your agent does as well). It won’t be that easy to get out of the contract without losing your deposit. I’m no lawyer, but I’d be willing to be the amount of time and money spent on one to get out of the contract would be less than ponying up the cash to get to the loan.
Actually, the proper terms these days is “appraisal bias.” This means that appraisers (who are largely white and male) undervalue properties owned by people of color at a higher rate than they would white people. I’ll be honest, I feel pretty stupid even writing that sentence. There are several things at play here. First and foremost, there needs to be increased diversity in the appraisal industry. Actually, there really needs to be increased diversity within the world of real estate across the board. I’ve been sitting through quite a few webinars and conferences this fall and that is the one issue that keeps coming up – especially when talking about what can be done within the finance arena…but I’m digressing.
RIS Media had a fantastic article a couple of weeks ago. You can read the whole thing here. But one statistic jumped out at me. As a Black seller, your home is 70% more likely to appraise at a lower value than if you were white. Sadly, this is not a new spin on an old problem. It’s just an old problem that has never been addressed. An article published in the Journal of Housing Research was published in 2014 discussing the problem of appraisal bias. I found a dissertation from a grad student at Georgia State University who was writing about using technology in appraisals from 2011 and he was citing articles from 1986. I’m sure that we can go back far enough to where we bump into Red Lining which is partly where all of this mess started…at least in terms of real estate. The point is that this is a much bigger issue than we are willing to admit.
All of which is to say…we have to do better…again. And still…it is ludicrous to me that one of the best ways to make sure that a house appraises to purchase price is to hide family portraits so that the appraiser doesn’t see who lives there. I mean, if the buyer doesn’t care, why should the appraiser?
The fact is, reading books that stretch our understanding of other people isn’t enough. It’s a step, but only a small step. Only when we – collectively – begin to call out injustices can we take more than baby steps.