If you get a mortgage to purchase a home, one of the steps in the process is to have the home appraised. The appraiser will present a report that gives their opinion of the fair market value of the home. Can you trust this number to be an accurate depiction of the actual market value of a home? Sometimes yes and sometimes no.
What is an appraisal?
An appraisal is an estimate of a home’s value performed by an appraiser. An appraisal can estimate a home’s value in one of three ways. The home is most often compared to nearby similar homes that have recently sold, but also usually includes a rough estimate of reconstruction costs. If the home is a rental property, its value may be estimated by analyzing the rent received versus rents in other nearby rental homes.
An appraisal is done at the request of the lender, not the purchaser. The appraiser is working on behalf of the bank, and it is the appraiser’s job to verify that the lender is not making a loan for more than the home is worth. The appraisal is not done to benefit the buyer, seller or agents involved in the transaction.
Why did the appraisal amount come back exactly at my purchase price? I thought appraisals were independent opinions of value.
Appraisers are an independent party that is hired to offer an opinion of a home’s market value that is free of any undue bias from the parties in the transaction. This means that the loan officer, real estate agents, buyer and seller are not able to influence the appraiser’s analysis. The opinion of market value should come directly from recent comparable sales and market data.
Many borrowers are surprised to have their appraisal value come back exactly at the purchase price. If the process was truly independent, why would the value be exactly the purchase price? When appraising a home purchase, the appraiser is given a copy of the purchase contract. They start the process knowing exactly what the buyer is paying for the home. This seems at odds with the idea that an appraisal is an independent opinion of market value. Yes, this introduces a bias into the valuation process, but it is done this way because the purpose of a bank’s appraisal in a home purchase is to support a particular purchase price and loan amount, not come up with their own purchase price. If the purchase price is supported by market data, the bank is comfortable making a loan.
While having the purchase terms available does influence the appraiser, it can offer data to support a particular price that isn’t necessarily supported by past market sales. This is particularly true in a market with appreciating home values. Let’s say that the appraiser finds 3 similar homes in the neighborhood that sold 3-5 months ago for an average of $500k. If the market was stable, the appraised value would be right around $500k. However, if there were 10 offers on the home that bid the price up to $525k, that is an important data point that shows that the market is changing over time and values have gone up. Since there was an active bidding process between multiple, arms-length bidders on the open market, the fair market value has been determined by what the market was willing to pay. Having the purchase contract available also lets the appraiser account for concessions made by the seller, such as paying for closing costs or including personal property with the purchase.
Is the appraisal the “correct” market value of a home?
Every piece of real estate is unique, with a unique market value that varies over time. An appraisal is not the definitive market value of a home. It is an opinion of value by one appraiser at one point in time, based on their analysis of market data. Valuation of real estate is partially data-driven and partially subjective. If you ordered three appraisals, you would likely receive three different values for a home. The fair market value of a property is the price that a willing and knowledgeable buyer would pay to a willing and knowledgeable seller, when both parties are acting voluntarily and in their best interests.
Appraisals can be very accurate or downright faulty. Large, homogeneous subdivisions or condos with many recent sales can make the process of appraising a home easy, since there are so many similar sales nearby to use for comparison. In an area with few recent sales, or in cases where the home is clearly unique from the surrounding homes, an appraisal requires far more subjective estimation of its value and the appraisal results can be highly variable.
Just like real estate agents, there are good and bad appraisers out there. Sometimes appraisers travel from a surrounding city and are not familiar with the local real estate market. If they bring their bias from the real estate market in their city 20 miles away, you could get a faulty valuation. It is equally possible for an appraiser to pick the wrong comparable properties or omit important comparisons in their analysis.
Dealing with a low appraisal
If your appraisal comes back lower than your purchase price when buying a home, it can be a major downer. The bank will loan you less money, and you will have to bring more money to the table. It can even prevent you from buying the home, if you can’t come up with the extra money. There are a couple of things you can do to deal with a low appraisal.
Home purchase contracts often contain appraisal contingency language that outlines what happens when the home does not appraise for the purchase price. Our local contract allows for an appeal of the value or if that doesn’t work, gives the seller an opportunity to lower the purchase price to the appraised value. The buyer has the option to back out of the deal if the appraisal appeal isn’t successful or if the seller isn’t willing to lower the price.
In a hotly competitive market where bidding wars are common, the appraisal may come back low because of rapidly appreciating prices in the area. If a home receives 10 bids that raise the price $25,000 over what an appraiser thinks the home is worth, clearly the market is valuing the home at a higher price relative to past sales in the area. A buyer must form their own opinion of market value and ask themselves how much they want this particular home, whether they can fund the additional down payment and whether they are really overpaying compared to other homes that they may purchase in the current market environment. Buying the right home for you, despite an appraisal shortfall of $5k-$10k, can be the right decision. Maybe the appraisal was faulty or maybe it simply makes sense to pay a little more to get the house you want. If there are 9 other buyers behind you willing to pay a similar amount, you may have no choice but to pay above your appraisal amount.
Key things to remember about your appraisal
Appraisals during a home purchase can be nerve-wracking. While you could hire an appraiser for your own independent valuation, remember that the regular appraisal is done at the request of your lender to support a particular purchase price and loan amount, not to give a truly independent valuation. The appraiser is not the holder of some magic analysis that gives you the perfect number for market value of a home. Just like you and your agent, they have an opinion of what the home is worth. If you ask five of them, you’d get five different opinions. It pays to look at multiple data points, not just the appraisal, when purchasing a home to determine what you are willing to pay for it.