Mainly this blog deals with the intricacies of owning and operating single family rent houses in the Dallas, Fort Worth, Denton area. We discuss, buying, rehabbing, marketing, selecting tenants, refinancing and operating an investment property in the DFW metroplex in great detail. We talk about how to find a mentor, agents who are investors themselves, good contractors and professionals to form a team. Mostly our content is practical and non-political. However, once in a while we dive into the broader aspects of investing in real estate including computing market values, addressing myths about tenants etc. This post is one such dive. We are going to talk about “Low Ball Appraisals”.
So, what is a “low ball appraisal”? It is becoming a well known industry term. Owners, sellers, buyers, agents representing sellers, agents representing buyers, investors, landlords, all have an expectation of what their property is worth. When a real estate appraiser, a person who is licensed to appraise a piece of property arrives at a value for that property which is way lower than the expectation of affected parties in that transaction, they tend to display their dissatisfaction at the performance of that appraiser by calling the appraiser’s work product a “low ball appraisal”. So, it is a feeling, not necessarily a fact. However, given that most of home buying is about feelings the topic merits some discussion.
First, we need to understand the stresses in the industry. One could argue that the real estate market is not a free market at all. The basis for this argument stems from the fact that most people don’t use their own money to buy real estate and any time you are using someone else’s money to purchase an item, the cost of that item tends to be higher than it should be. It is essentially the same argument that’s made for rising health care costs or costs of public education. If some one else is paying, things tends to cost more – period.
So, in this “use other people’s money” market, the market is tightly coupled with overall money supply. Prior to the crash of 2008, money was very liberally available. There was so much money, that the entire industry was busy finding people who can use that money! There wasn’t a commensurate increase in consumers, just an increase in how much they consumed. That is to say, there was not a marked increase in population or actual physical individual pieces of real estate. So, most of that excess money supply went towards increasing the “value” of existing real estate and appraisers were under enormous pressure to agree to blown up values. Several did, some did enthusiastically.
The question then becomes, were those houses worth that much? If you looked at it as would someone pay so much of their own money to buy it, then probably not. If you looked at it as given the money supply of the day, would a bank be willing to lend someone that much money to buy it, then probably yes. There lies in the first hiccup of modern real estate appraisals: They tend to treat house values as intrinsic rather than a mere reflection of the availability of money supply.
Let’s look at when one gets an appraisal done. These three scenarios are typical:
- Pre-listing: Before placing a property on the market, the owner may obtain an appraisal. Note that in this case, the owner is hiring and paying for the appraisal. The appraiser is not appraising a collateral for a bank.
- Purchase: If the buyer is obtaining a loan to purchase the property, the lender will require an appraisal. The appraiser has the opportunity to review the sales contract and so knows what the buyer has *already* agreed to pay. If the property has been exposed to the market for a reasonable length of time and the buyer and seller are under no duress, then that contract itself establishes a market value: what the market will bear. However, the lender needs to be assured that another dispassionate buyer will see at least the value this buyer sees and therein comes the job of the appraiser. Nevertheless, the appraiser in this case has a starting point, a frame of reference which is what the current buyer is willing to pay. The impact of this appraisal is on the buyer who is paying for it, the seller who believes a knowledgeable independent buyer has set the market price and the lender who wants to be protected.
- Refinance: Both in the cash-out and rate-term refinance scenarios, the owner typically has an opinion of value. Their financial plans are constructed based on that opinion. This appraisal scenario is similar to the Pre-listing case, except that the owner is expecting to get a loan on the asset value and this asset needs to be appraised as a collateral for a bank. This appraisal impacts the seller and the bank. There is no independent well advised third party like the buyer to set a market price. It’s solely up to the appraiser to protect the lender.
Now, let’s look at the impact of appraisal faults on the appraiser in the above three cases. In the pre-listing case, the seller is the appraiser’s customer. A high appraisal makes the seller happy even though it may cause the seller to enter the market too high. The seller may have to price-drop multiple times till the house eventually sells for what the market will bear. The seller, upon the joyous occasion of finally selling their home, still believes the buyers got a great deal and is less inclined to fault the appraisal. Even if they do, they often have limited resources for a recourse anyway.
In the purchase scenario, if the appraisal is too low, the buyer may have to put more money down to make the deal work and if that’s not possible may have to walk away after losing some loan fees including cost of appraisal and typically as this process comes after the inspection, the home inspection fees as well. They may also lose option fees and even their earnest money. That total loss triggered by the appraisal is not insignificant. If the appraisal agrees with the buyer’s offer amount, the only reason the value may ever be questioned is if the buyer defaults on the loan somewhere down the road, several months or even years later.
In the refinance scenario as there is no neutral party, the appraiser is solely encumbered with protecting the bank’s interest. Furthermore, this transaction often involves drawing liquid assets from illiquid equity, so there’s a high degree of finality (non reversibility) built-in. If the owner ever defaults, the appraisal is more likely to be questioned given the bank’s ability to do so. The appraiser has little incentive to agree with the high value owners often assess their assets at.
So, in analyzing the three scenarios, it would seem that the refinance transaction is most susceptible to the event and impact of a “low ball appraisal”.
(to be continued….)