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How Home Appraisals Work
The appraisal is a necessary part of the homebuying process. It serves to establish the value of a property for the lender. The home must appraise for the amount (at least) that the buyer is borrowing for the contracted price.
The bank that is issuing the loan wants to know that the market value of the property is worth the amount being loaned. If there is ever a situation where the bank has to foreclose, they want to be assured that, given a normal market, the house will be worth what they can sell it for. Banks are not in the business of owning property.
The appraisal involves assessing the value of a home based on various factors such as its location, size, condition, comparable sales in the area, and market trends. Home appraisals work by taking into account the previous 3 to 6 months sales of comparable homes.
The Home Appraisal – The Second Sale
We often refer to the appraisal as the “the second sale”. When the appraisal comes in at the price the buyer offers, everyone breaths a sigh of relief. If the appraisal comes in dramatically under or over, then buyer and seller are back in negotiation over how to handle the valuation. It really is like a second sale.
Appraisals in A Transitioning Market
When the real estate market is in transition, as we find ourselves experiencing today, the appraisals can be a tricky aspect of the transaction.
In the Frederick real estate market, we are continuing to experience a recovery, with values increasing, although not at the rate we saw during the pandemic. We have a healthy demand for housing coupled with a low inventory. These simple market forces result in multiple offers on desirable houses, increasing the contract amounts and values rise. Supply and Demand.
When prices are rising rapidly, the home appraisal can result in a value lower than the price a home sells for. (Think of the squeezing of a Slinky:) When the values an appraiser uses are from three months ago, and multiple offers are driving the prices up at a rapid rate, the appraiser has to do what I call “math magic” and figure a way to account for the acceleration, but realistically. Sometimes the appraisal comes in lower than the offer price.
It can be discouraging for the buyer and seller, and could easily scare a first-time buyer away from going through with the purchase. For a more experienced buyer or seller, it becomes, at a minimum, a kink in the process.
What Can You Do When the Appraisal is Low?
Most banks have a process to dispute an appraisal. This usually requires the buyer, via their agent to supply other comparable sales and explanations as to why they think the appraiser’s value is off. The review takes some time and can go either way. Other options:
- Another option is to reduce the purchase price, if both parties agree.
- One option, depending on the deal, is for the buyer to bring more money to close.
- Both buyer and seller can extend all time frames and the buyer can switch to a new lender.
If all parties can to work together to keep a cool head, and remain flexible, they can most often find a successful maneuver around an appraisal issue, This makes it a hurdle, not a roadblock. In a true sense, the home appraisal is the second sale. Understanding how home appraisals work will help in setting the right expectations.
Some History Regarding Appraisals
The home appraisal industry has undergone a lot of scrutiny since the housing bust of 2008. Some of the blame for the mortgage crisis fell on a handful of appraisers who colluded with some mortgage companies by “puffing up” values in appraisals. There were a small number of guilty parties, compared to the immensity of the crisis, but enough to cause a legislative reaction.
In May 2009, the Home Valuation Code of Conduct (HVCC) was adopted. The HVCC document was created jointly by members of Freddie Mac, the Federal Housing Finance Agency (FHFA), and the New York State Attorney General. One of the results has been the creation of a third party group, Appraisal Management Company (AMC), through which the lender must select the appraiser. The intent was that the lender and the appraiser never have communication and therefore, opportunity for collusion.
Results of HVCC
The other results have been a mixed bag:
- The cost of an appraisal has risen, to fund the third-party AMCs.
- The appraiser makes less, again, to pay for the AMC
- The appraiser is drawn from a pool of appraisers, often the one charging the lowest fee.
- The appraiser is sometimes the least knowledgeable about the area, because of a mandated number in the pool.
- The process is longer, often 2 weeks or more
In 2011, NAR (National Association of Realtors) reported that 24% of home sales that fell apart before settlement, did so because of appraisal problems. Most professionals in the real estate transaction are not satisfied with the results of HVCC and hope for a meaningful change in the process that will meet the needs of consumers as far as protection, but also in regards to making the process efficient.
Recent Changes to Appraisals
The home appraisal industry is going through significant changes. In 2017 Fannie Mae introduced the Property Inspection Waiver (PIW), only available on conventional mortgages. Based on a computer calculation, certain buyers and certain properties are allowed to purchase without an appraisal report. The automated underwriting system (AUS) generates a determination, without human intervention, that a buyer is eligible for a waiver based on things like income, employment history, credit, assets, etc.
This automated underwriting has some pros: it saves the buyer the cost of an appraisal. It also greatly speeds up the process.
AUS also has some cons: You won’t get a third-party opinion of the value of the home. A PIW relies on the data from previous appraisals, which could be in error. It may be also more accurate to get current data on comparable sales. One other benefit of an appraisal is the updated information on the home’s condition, relevant to it’s value.
Fannie Mae is working on “Appraisal Modernization” initiatives, increasing the appraisal options for buyers, driven by technology. While appraisers are still important to the industry, advanced technology and the internet are changing lending appraisal requirements. Fewer traditional home appraisals are being required, and alternative options such as no appraisal, hybrid, or desktop appraisals, are becoming more popular.
If you are purchasing a home, be sure to discuss these issues with your lender. You may have the choice between a traditional appraisal and a PIW, so you want to be fully informed when you choose.
Changing Markets Bring Changes to the Process
In 2020, during the pandemic, we saw a recovery of the housing market, fueled by the Federal Reserve purchasing billions in mortgage-backed securities, combined with historically low interest rates. Appraisal waivers, appraisal gap offers, and cash offers became normal.
In 2023 we are still seeing a woefully low inventory with healthy demand. With multiple offers a normal event, we’re still seeing buyers with cash reserves waiving appraisals, often to a certain amount. Appraisal gap offers are also still common.
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