By definition appraisals are backwards looking.  The designed purpose of an appraisal during the loan and purchase process, is to demonstrate to the lender that the security (the house) for the note (the loan), is worth the price the borrower is paying for the property.  The way this value is established is by looking at comparable sales (comps) of similar or “like” properties.  The problem however, is that unless the market is in a static or stable state, the comps are going to reflect different market conditions than the one in which the appraiser is hired.

So how is value established?  The appraiser will be looking for comps to “bracket” the value of your home.  Bracketing is where there is a comparable property that recently sold for more than your home and one below and hopefully a bunch in and around your value.  The key is the one above.  It could be a larger home or more upgraded that the appraiser can make “adjustments” in value for, so long as it’s higher.  It might be a little farther away, but finding the top bracketed comp is critical, especially in a changing valuation environment.

Obviously you can see that by using data of homes that closed a while back, maybe 4 or 5 months ago, the market could have changed dramatically.  For example, when properties are declining in value, as was the case from 2007 through 2011, an appraiser would be basing their assessment on a closed sales, whose value has come down since its sale date; that the price it sold for six months ago, was higher than it would sell for today.  In response to this situation, the lenders at that time were knocking 10% off the appraised value because they insisted the blanket of a “declining market value” be ascribed every property.

When a market is appreciating like it is now, the comps tend to be lower than the same homes are selling for today.  One would think therefore, that the lenders would apply the same logic and accept an appraisal that gave value to a property due to the “appreciating market value.”  This however, is not happening.  So scared are the big banks that appreciation is running out of control and that we are in an overheated market, that they are instructing appraisers not to use “appreciating market value” as a data point when determining the value of a given property.  Technically there is not supposed to be any  direct contact between an appraiser and the lender, only through an intermediary called the appraisal management company.  But don’t think for a minute that this conversation isn’t taking place at upper levels, because it is and guess who owns the appraisal management companies, you guessed it, the big banks. This has led many deals to fall apart or caused sellers to accept less for their property or increasingly common made buyers to come up with extra the cash to make up the difference.

Lenders have certain criteria that they use when making a loan.  The most common is a minimum loan to value ratio.  This is the relationship of the loan amount to the value, reflected as percentage to the value of the property. This is where the whole 20% down payment thing comes from. Why 20%?  No reason in particular, it’s just become the benchmark for all home loans.  It’s kind of like asking, why is 87 octane regular gas and not 91, which is premium; there’s no real reason, it just is.  Anyway, so a borrower puts 20% down and the “Loan to value ratio” is 80%; the loan is equal 80% of the value of the property.  The problem arises when the lender’s appraiser brings a value in less than the agreed to purchase price.  So for example, let’s say I offer to purchase a home for $500,000 and put 20% down ($100,000).  My loan would be $400,000 or 80% of the purchase price.  Now let’s say that I offered to pay $500,000 but the bank’s appraiser determined that the value based on older comparable sales was only, $480,000.  Since the bank is only willing to lend up to 80% of the value of $480,000, the loan amount ends up $384,000, not the $400K I need.  But the seller didn’t agree to sell for $484,000 and I only have $100,000 which when added to the new 80% loan amount of $384,000 equals $484,000.  Uh-oh.  Because of the low appraisal, we are short $16,000.  Now what?

If an appraisal comes in low, there are a few obvious scenarios.  First is to appeal the appraisal, but you have as much chance of having an appraiser admit to his employer that he made a mistake, than you do seeing a cow jump over the moon.  You can also go get another loan from another lender, where maybe the appraiser sees things differently.  You, as the buyer, can come up with the difference in cash, provided you have it.  In an appreciating market where the seller can probably sell the home again quickly, this is the most common scenario.  But if you don’t have the extra cash, you’ll have to ask the seller to come down the $16,000; also not super likely in an appreciating market.  Maybe you can negotiate something in the middle or if the seller says come up with the $16K and you simply don’t have it, you cancel.

Yikes!  A low appraisal, as you can see, can easily kill what was, a perfectly happy transaction.  Not to mention how it shakes the confidence of the buyers who until the low appraisal, were sure they were getting a good home at a fair market price.  So how can this situation be avoided?  First and foremost is that the listing agent has to do their job.  They have to meet the appraiser armed with comps.  If you are a seller, you have to ask your agent how they handle these situations because let’s face it, if you sell your home and then it doesn’t “make value” due to a low appraisal, you either have to re-market the property and find another buyer or have one of the a fore mentioned scenarios take place.  You don’t want to lose your buyer but you also don’t want to come down in price either.  If the appraiser is from out of the area, the listing agent can request a different appraiser.  This can be found out when the appraisal office calls your agent to schedule the appointment.  When the agent meets the appraiser with his stack of comps, he needs to ask the appraiser about his take on the market and get tough if the appraiser won’t speak with him.  Most appraisers are cool and welcome the agent’s input but every now and then you get a jerk, and the agent has to stand tough if the appraiser is uncooperative.  Another way to avoid this issue is to steer clear of the big lenders, Chase, Citi, B of A or Wells.  They are the worst because they have the most exposure should they lend and then the market drops again and since they own the appraisal management companies, have undue influence.  As a seller, you can’t dictate who a buyer uses, but if the buyer’s preapproval is coming from one of the big boys, you may want to consider a different buyer especially if it is a multiple offer situation.

Let’s face it, appraisals are opinions of value.  They are the opinion of one person at a given space and time.  They may be right, they may be wrong, but there’s no denying they are an important part of the process and one that should not be underestimated or ignored.