"Why Didn't it Appraise?"

Multiple Choice Quiz

Test your knowledge of today's real estate market, and answer the following question:

Which of the following are to blame when a home does not appraise pursuant to a Purchase Agreement and mortgage application?

(Note: the home being appraised is called the "subject home"; its peers, which establish value, are individually known as "Comp's," or "Comparable Sold Properties").

A. Nearby foreclosures torpedoed the value of the (non-foreclosure) subject home;
B. The appraiser didn't know the area;
C. The appraiser didn't know various negatives associated with one or more Comp's (dated Kitchen, poor condition, bad floor plan, etc.) that depressed their market value.
D. The appraiser was missing the last, fully executed Counter-Offer or Purchase Agreement Addendum -- and therefore was using a too-high price.

Answer: all of the above.

Of the foregoing, the only circumstance that is entirely avoidable is "D."

However, an attentive, hands-on Realtor can also help avert/mitigate "B." and "C." by being proactive.

P.S.: And yes, some homes fail to appraise these days . . . because the purchase price simply isn't supported by valid Comp's.

I'd put that number at 15% or so -- up from 5% a few years ago.

Pre-Approval Letters & Written Statements

What Are They Really Worth?

Put it this way: the picture of toilet paper should give you a hint.

First, some background.

In Minnesota, the first things that typically lead off any offer to purchase residential real estate are the Buyer's earnest money check, and a pre-approval letter from a lender (unless the Buyer is paying cash).

The standard pre-approval letter recites that the lender has initially screened the Buyer's finances and credit scores, and, based on that quick review, says that the Buyer can afford the home.

In practice, a pre-approval letter almost always means . . . nothing.

Most lenders will issue them in less than 10 minutes on the phone with a prospective borrower, after collecting the most basic information.

Meanwhile, their express language explicitly states that nothing in the pre-approval letter obligates the lender issuing it to actually fund the loan.

The Written Statement

Which is where the Written Statement supposedly comes in (think of it as "the Final Approval" Letter).

Once the Buyer and Seller reach agreement on terms, the Purchase Agreement typically includes a Financing Addendum that calls for the Buyer to deliver a Written Statement within 2-3 weeks.

The standard Written Statement recites that an appraisal satisfactory to the lender has been completed; presumes that the lender has finished vetting the Buyer's W-2's, recent tax returns, and any other Buyer financial "bona fides"; and lists any outstanding conditions remaining -- usually pro forma ones, like the Buyer not blowing up their credit or losing their job.

Once the Buyer delivers the Written Statement to the Seller, the Buyer's loan is supposed to be finally underwritten -- and the Buyer's earnest money becomes non-refundable.

O-for-2

Except that in practice, that's not how it works today.

Now, skittish lenders can and do reserve the right to revisit the loan at any time up until closing.

They may request additional Comp's to substantiate the value of the collateral (the home being purchased); ask the Buyer for (still) more financial documentation; or tweak (tighten) their underwriting standards.

Or all of the above.

The result?

What was supposed to be a finally underwritten loan suddenly . . . isn't.

All of the foregoing means two things:

One. Buyers and Sellers today, especially when upper bracket properties are involved, should consider drafting custom language to address the Buyer's financial qualifications, and defining when their earnest money becomes non-refundable; and

Two. Sellers shouldn't load up the moving van until they know, for sure, that the Buyer's financing is good.

Spiking the Ball . . . on the 2 Yard Line

Q: When Doesn't "Sold" Mean "Sold?"

Answer: when it means "Pending" (as, when it's in front of a home that's for sale).

Huh?

At least in Minnesota, once the Buyer's Inspection has been removed, the convention is to switch a home's status from "Active" to "Pending" on MLS, and to put a "Sold" rider on top of the "For Sale" sign in front of the home.

That's the case even though the home hasn't closed yet -- and the Buyer's loan most likely hasn't been finally underwritten (or even successfully appraised!).

Of course, that's in addition to any title work still to be done, as well as any other outstanding conditions that the Buyer and Seller may have contractually agreed -- or be subject -- to (repairs, obtaining a municipal inspection certificate, etc.).

Isn't declaring such a home "Sold" like spiking the ball on the 2 yard line?

Explanation/Rationale

It can be.

However, once any Inspection issues have been resolved, the odds of a deal closing go up dramatically; from experience, I'd peg the odds at anywhere from 80% to 98%.

Why the range?

If it's a cash deal and the Buyer is richer than Croesus . . . it's virtually a done deal.

However, especially if the Comp's are thin and the sales price lacks recent, nearby precedent, the risk of an appraisal issue goes up.

Too, if the Buyer works for a company that's been hit by the recession, or is otherwise vulnerable to layoffs, there's the added risk that the Buyer will lose their job before closing (or otherwise suffer a major hit to their "creditworthiness").

Less likely, but still within the realm of possibility, are such things as Buyer health issues, an unexpected job relocation, major damage to the home (fire or weather-related) -- or even a simple change of heart (and mind).

"Pending" vs. "Closed"

So, to repeat, why not put up a sign that says "Pending" rather than "Closed" -- or remove the "For Sale" sign altogether?

My take is that it's a mix of the following reasons:

--Psychologically, putting up "Sold" helps cement the Buyer's commitment (see, "change of heart").

--"Sold" better tells prospective Buyers that the house is spoken for, and not to bother the homeowner.

--Marketing exigencies. Whereas "Pending" sounds equivocal and gray, "Sold" is strong and declarative.

Too, because there is a risk that the house won't close, it's premature to remove the sign.

However, once the risk of not closing is effectively zero, i.e., the Seller has been paid, title has transferred to the new owner, and the "For Sale" is removed . . . there's nothing to attach "Sold" to.

Appraisal Air Pocket

Housing Market Circular Reasoning

The reason more upper bracket homes aren't selling . . . is because more upper bracket homes aren't selling.

Huh?

Once a deal is struck, the lender's appraiser seeks to substantiate the value of the collateral -- the home being sold -- by looking to other, similar homes that have sold recently.

The preferred number is three, within the last six months (more recently, if possible).

But what if there aren't three good comp's?

Increasingly, lenders in CYA mode appear to be filling that vacuum with the most conservative assumptions possible -- scuttling more than a few local deals.

The result is . . . . even fewer upper bracket deals.

That's certainly not the whole story with respect to upper bracket housing -- the tiny little recession we're experiencing, elevated unemployment, a weak stock market, etc. are all contributing factors, too.

However, "appraisal issues" are increasingly exacerbating the problem.

Ignoring the Asking Price

Mispriced Properties: Exhibit A

Where: 46xx 1st Ave. South in Minneapolis

What: Bank-owned (foreclosure) 3 BR/2 BA 1917 stucco home with 2,000 square feet.

How (much): asking price -- $72,900; sold price -- $130,000

When: listed -- 4/19/2009; closed --8/18/2009

In my post yesterday (Seller's Motivation: Is it Relevant?"), I made the case that the Seller's motivation (usually) isn't nearly as important as most prospective Buyers think it is.

Often times, neither is the Seller's asking price.

At one extreme, Banks selling foreclosures have been known to price ridiculously low to foment bidding wars (at least, you'd assume it was purposeful; the other alternative is that they truly have no clue. Hmm . . . ). See Exhibit A (above).

At the other extreme, lots of Sellers today have been known to pick asking prices that reflect, shall we say, "wishful thinking."

Either they've been in their home for decades, and are genuinely oblivious to how dated it has become, or, they feel the need to "pad" their asking price, to give themselves "negotiating leverage."

Unfortunately, that's not how it works.

Realtors (and appraisers) know that home prices are set exactly one way: by identifying the 3 best Comp's (similar, nearby homes that have sold the most recently), then doing a detailed compare-and-contrast between the subject home and each of the Comp's to arrive at an adjusted value.

Refinancing "Ostriches": Pain Avoidance?

Top 4 Obstacles

Water, water everywhere, but nary a drop to drink.

--Samuel Taylor Coleridge, "The Rime of the Ancient Mariner"

Substitute "money" for "water" and you have a good sum-up of today's lending environment.

With mortgage rates at record lows -- around 4.75% for a 30 year mortgage -- you'd figure that anyone paying, oh, say, 6% or higher would refinance.

But that's not what I'm hearing from the lenders I talk to.

Anecdotally, here are the top 4 reasons -- at least according to the lenders -- why many refinancing candidates . . . don't. (To get the real scoop, I suppose you'd have to survey the non-refinancers.)

One. Paperwork/Inertia.

Refinancing a mortgage requires pretty much the same rigamarole as getting a purchase-money mortgage: applications, W-2's, income tax returns, etc. Some people never get around to it -- or peter out halfway through.

Two. Pain avoidance.

Of course, the big piece in any refinancing is the appraisal. Which means facing how much your home may have dropped in value since you purchased it.

Just like no one wanted to open their monthly brokerage statements a year ago, lots of homeowners now apparently don't want to confront current housing prices.

Which leads to . . .

Three. Sense of Futility.

In fact, a tighter lending environment makes it objectively harder to refinance ("Interest Rates Are Low, but Banks Balk at Refinancing" -- The New York Times; 12/12/09).

Who's shut out?

Homeowners who put little down and whose home values have been whacked -- and therefore lack the collateral banks require (see appraisal, per above); anyone who's lost their job; and anyone whose credit scores have been beaten up during the recession (south of mid-600's is a big problem).

Four. Fees.

There are rational reasons for not refinancing, too.

If you're going to move in a few years, you probably won't recoup the 3% or so it can cost to refinance.

The "It's-All-I-Can-Afford" Offer

Buyer's Budget as Negotiating Leverage

I'm seeing and hearing more instances of Buyers, in the course of negotiating for a home, instruct their Realtors (including, sometimes, me!) to tell the Seller that "that's all I can afford."

Is that a smart tactic?

I discourage it, for three reasons.

One. Sellers tend not to believe such representations.

The only way to really prove that the Buyer's offer is 100% of their budget is to put the Seller in touch with the Buyer's lender, then authorize the lender to share confidential information.

Most Buyers, understandably, would be reluctant to do that.

Instead, the convention has developed for lenders to generate a pre-approval letter verifying that the home in question is within the Buyer's budget.

Two. A home's fair market value and a Buyer's budget aren't related.

Whether Bill Gates or Joe Middle Class is the prospective Buyer, a home's value is still the same: whatever the "comp's" say it is. That is, how much the three most similar, nearby homes fetched, most recently. Period.

That's how Realtors assign value. It's how appraisers determine value. And that's how the Seller's expectations will be framed.

Put it this way: imagine your reaction if the Seller raised their price because you could afford to pay more.

(Can this be a factor in negotiations? You 'betcha. How much do you want to wager that ex-Green Bay quarterback Brett Favre, who's reportedly house-hunting locally, is buying through a corporation or other third party?)

Three. It can spook Sellers.

Signaling that the Buyer is at the very top of their budget can just as easily make a Seller skip the deal as bring them to heel.

That's because any hiccup -- like a jump in interest rates, or the home not appraising -- can derail the sale.

In fact, when I represent Sellers, one of my favorite questions to ask the Buyer's lender (yes, I always call) is how "stretched" or "comfortable" the Buyer is buying the home in question.

Hearing that "it's a close call" would hardly be confidence-inspiring.

Better Tack

Instead of putting a spotlight on the Buyer's finances -- except to establish that they're qualified -- I've found that a better tactic is to focus on value.

Specifically, to make the case that, based on the home's location, features, condition, etc., the Buyer's offer represents fair market value. If not more.

And rattle off all the competing, nearby homes for sale and how they (favorably) compare (assuming that that's true; if not, it can boomerang).

As a general proposition, home sellers usually accept the price they think is the highest they're going to get -- not the highest they believe any particular Buyer can afford to pay.

P.S.: One exception to the foregoing can be when the home's price starts to move out of the range that can be financed with a "conforming" loan (up to $417k). Above that, Buyers need a jumbo loan, which is both much more expensive, and harder to obtain.

"Bracketing," explained

The Goldilocks Approach to Appraisals

Just like Goldilocks preferred the porridge that was neither too hot nor too cold, appraisers like to see a home that prices in the middle of its peer group.

In appraiser lingo, such a home is said to "bracket."

In plain English, that means it's priced more than a slightly inferior home, and less than a slightly superior home.

For purposes of doing a Comparative Market Analysis ("CMA"), the subject home's peer group typically consists of the three, most similar closed sales, ideally no further back than six months. Depending on the part of town and activity, sometimes three months is now considered the max.

In fact, the subject home is supposed to "bracket" twice: before the comp's have been adjusted -- and after.

Adjustments are all the things that differentiate the comp from the subject home. It can be another bathroom, more (or less) finished square feet, a new Kitchen, better (or worse) condition.

Regardless, if the subject home doesn't "bracket" a second time, after the comp's have been adjusted . . the deal can be in trouble.

"April Showers, May Flowers"

Appraisal Issues Back on the Front-Burner

As the saying goes, "April showers bring May flowers."

In the real estate market this Spring, the equivalent is, "April multiple offers bring . . . May appraisal issues" (OK, so it doesn't have the same ring to it).

One of the consequences of a home selling in multiple offers is that the winning bidder may easily drive the ultimate price well past what's supported by the comp's ("comparable sold properties"). That's especially the case in neighborhoods where all the recent sales are foreclosures being dumped by their bank-owners.

What happens if the house doesn't appraise? There are generally 5 possibilities:

One. The Buyer puts up more money.

Two. The Seller reduces their price.

Three. Some combination of #1 and #2.

Four. Neither #1 nor #2, in which case the Buyer's financing fails, and the deal derails.

Five. Buyer or Seller challenge the appraisal and/or the individual appraiser (and try to get another one).

Until recently, option #2 was a fairly common outcome.

Now, depending on how much equity the Seller has -- or doesn't -- that option can be off the table.

Appraisal Issues Return

More Locked Barn Doors . . .

Yet another example of "locking the barn door after the horse has escaped" is newly vigilant appraisers.

Anecdotally, I'm hearing of more sales, especially in the upper brackets, that are derailing because of appraisal issues.

In a typical deal, the appraisal occurs several steps along. Before you even get to that point, the Purchase Agreement has to be negotiated, and any Inspection issues surmounted. By then, both the Buyer and Seller (and their agents) have been in regular contact for days, sometimes weeks.

Once the Inspection Contingency has been removed, the focus turns to the Buyer's financing, which in turn hinges on a successful appraisal.

In a rising market, that's seldom an issue.

However, in a falling or flat market, appraisers take their marching orders from defensive lenders who have become much more conservative. As a result, there can be a gap between what appraisers see, and what Buyers and Sellers agree is fair market value.

What then?

Most Financing Contingencies provide that if the Buyer can't get their financing within a specified time period, the deal is automatically cancelled.

So if the Buyer wants out, they can typically get out.

If instead the Buyer and Seller are still committed to the deal, the Buyer can put up more money to cover the appraisal shortfall; the Seller can reduce the price; or both parties can try to challenge the appraisal.