When it comes time to buy a new investment property, the bank’s appraisal can make or break a deal. If the property appraises too low, your financing might fall through. In other cases, the bank might approve the loan but require new contingencies, such as a higher down payment -- putting you on the spot to fill the gap.
Sellers need to be equally concerned about their property’s appraised value. A low appraisal can drastically affect one’s ability to sell the property, particularly to someone who plans on financing the deal instead of paying for it in cash.
Real estate investors tend to pay much attention to what’s happening in the capital markets. Are interest rates rising? Will new construction affecting pricing? All of this matters, sure. However, too often lost in the mix is the importance of a robust appraisal. Here’s what you need to know about appraisals, including how the evaluator determines the property’s value and what you can do to set the stage for getting the best appraisal property.
THE BASICS What is an appraisal?
An appraisal is an act or process of developing an opinion of value. The valuation process is a systematic procedure that an independent appraiser follows to answer a client’s question about real property value (usually, market value). A real estate appraisal is also commonly referred to as a “property valuation.” It is important to note that the appraised value is different from the assessed value. The assessed value is determined by the municipality in which the property is located, and can be drastically lower than the appraised value.
When would you need an appraisal?
A real estate appraisal is needed whenever a person is financing the purchase of a property or when an owner is looking to refinance. Someone might also have an appraisal done before listing their property for sale to help establish the listing price (this is particularly true if the property is unique and no local comps are available).
Who conducts an appraisal?
Most states require appraisers to be licensed or certified. Appraisers have been specially trained to develop independent opinions of value. If an appraisal is required as a condition of your loan (purchase or refinance), the bank will initiate, hire and oversee the appraisal. New regulations prohibit Fannie Mae and Freddie Mac lenders from having direct contact with appraisers, so most banks will launch the appraisal through an appraisal management company that has a pool of appraisers on which to draw.
If you’re getting an appraisal done to establish the property’s value before you sell, you can hire the appraiser directly.
UNDERSTANDING APPRAISALS
There are three different approaches that appraisers use to determine a property’s value:
1. The Sales Comparison Approach: As the name implies, this method compares a property’s characteristics with those of comparable properties that have recently sold in similar transactions. Because no two properties are exactly alike, the valuations of comparable properties are generally averaged to establish a fair market value for the property being appraised. Adjustments can be made as features vary.
2. The Cost Approach: This method begins with an evaluation of the site’s value, as if vacant, and then calculates the replacement cost of any existing building structures, less depreciation.
3. The Income Capitalization Approach: Commonly referred to as the “income approach,” this method is often used when appraising investment property because it values a property based upon its rental history and revenue generating potential.
Most appraisals will use some combination of two or more of these approaches. The values established through each approach are reconciled into one final opinion of market value.
What factors influence a property’s appraised value?
Certain factors influence a property’s appraised value, including local market conditions (basic supply and demand) and macroeconomic trends (e.g., a national recession). The principles of substitution, balance, and externalities can also help explain shifts in value.
What can landlords do to help increase their appraised value?
Appraisers collect a significant amount of data before calculating their opinion of value. To ensure you get the best appraisal possible, make sure you provide the appraiser with any relevant information. Let the appraiser decide whether that information is appropriate or not.
- Give the appraiser information about positive influences in the immediate area. For instance, if you know that a new light rail stop is planned in your neighborhood, be sure the appraiser knows about it.
- If you’ve made any improvements to the property, document those repairs/renovations. Use a spreadsheet to detail the costs, and keep before and after photos that can be shared with the appraiser. Provide copies with receipts, if possible, mainly if the renovation was expensive.
- Turn over copies of bank statements and rent rolls to show the appraiser your actual income and expenses for the property. This will help quell any fears the appraiser may have about the property’s ability to generate a certain level of income.
What if you disagree with the appraisal?
If you feel that the appraisal is unduly low, you are well within your right to challenge the appraiser’s analysis. Grounds for a challenge may include information about the property that is incorrect, or your ability to produce comps from the area that are more recent, closer or more comparable overall than those used in the appraisal report. You might also challenge an appraisal if only one approach was used, and you feel that an alternative approach would have yielded a much different result.
Ultimately, it is up to the bank to determine whether or not your challenge has merit. The bank may entertain a second appraisal, but will usually require you to cover the cost of hiring someone else. Paying the upfront fee may seem unfair, but if it’s going to result in a better appraisal, it may be worth it. If the two appraisals turn out to be much different, your lender will likely take the average of the two. In some cases, though it’s uncommon, a bank might suggest getting a third appraisal and will take the middle value of the three.
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In any real estate transaction, the appraisal is one of the most critical components if any party needs to lock in financing. To get the best results, be sure you understand the appraisal process, the data analyzed and the parties involved in the decision making. There are only so many factors you can control, so do your best to manage those. And of course, challenge the appraisal if and when necessary.
To learn more, read this guide by the Appraisal Institute – a global nonprofit association of real estate appraisers.