What if the appraised value is less than our purchase price?

Question of the week:  What if the appraised value is less than our purchase price?

Answer:  With the current condition of real estate market in Southern California being what it is, this is a question asked very frequently by home buyers. It is also a topic we cover every year or so in the WR&MU, for those familiar with the process you may want to fast forward.

Playa Vista, Bixby Knolls, Corona, Hawthorne, Alamitos Heights, Cerritos, La Mirada, Palm Desert, from $300,000 condos to $1.6 million bungalows, home buyers are finding themselves in bidding wars. The supply was tight in many Southern California markets before the pandemic, and it is even tighter today as buyers are flooding the markets.

Earlier in the week I was working with a client and their agent writing an offer to buy a second home in La Quinta. The agent said, “we are writing an offer and there are two offers already in on the property.”

“I’m glad one of my clients is only going up against two other offers instead of five, six, seven, ten…” I replied.

“It’s only been on the MLS for a few hours.”

Instead of sending counter-offers to buyers’ offers with a specific price, sellers are sending the message, “send us your best and final offer.” The results are purchase prices being well above the listing price on most properties that originally went to market listed right at, or just above, the most recent sales.

With each home sold at a higher price than the last, buyers, sellers and agents are naturally nervous about appraisals and the values as determined by appraisers.

Before we look at what happens if an appraisal has a value lower than the subject property’s sales price, let’s take a quick look at the report itself.

Appraisals are almost solely used for transactions where the buyer is obtaining a loan to finance the purchase a property. Some buyers purchasing with all cash will obtain an appraisal, but it is not required and often sellers with an all cash offer will insist that the sale is not contingent on an appraisal showing a near or at the sales price.

Transactions where the buyer is getting financing for the purchase will need an appraisal, as the lender will require it before approving and funding a loan. Because of this the primary purpose of the appraisal is to inform the lender if the subject property is acceptable collateral for the loan, in price and general condition.

An appraiser determines his or her estimate of value of the property by using comparable properties (called comps) that have sold in close proximity to the subject property in distance, are similar in size and make-up (i.e. number of bedrooms and bathrooms) and fairly recently.

The typical report with have at least three, but generally four to five, properties that have closed escrow most recently, at least one property that is similar in type, size and proximity that is currently on the market and if possible one or two that are sold but not yet closed.

In the report the appraiser will make adjustment the comps’ values for square footage, location, view, pool, number of bedrooms and bathrooms, overall condition, garage, etc.

For instance if you are buying a three-bedroom, two-bathroom, 2350 square foot home that has a built-in barbecue bar with sink, fridge and other amenities and the house next door closed escrow two weeks ago and was also three-bedrooms and two-bathrooms, but was 2500 square feet and has a built-in barbecue bar plus a pool, the appraiser will adjust the closed comp’s sales price down for the lower square footage and the pool. Depending on the area, maybe $10,000 for the size of the home and $20,000 for the pool.

Another property sold across the street and was smaller also with out a pool, the appraiser will adjust that sales price up for the square footage.

Taking the sales price of the subject property into consideration, because by offering the price the seller accepted you are impacting the market, the appraiser will review many properties and their various features to determine an estimate of value.

If there are noticeable defects with the property, stains on the ceiling indicating a leak in the roof, missing flooring, large cracks in the walls, the appraiser will note these conditions and if they impact the value of the property or not. If there are defects noted the lender will almost always ask that they be corrected or addressed by a licensed contractor as to their impact on the property and whether they are an on-going concern. Perhaps the stains were left over from an older roof that was replaced.

Now that we have a report with value, what is it and what impact will it have on your application for a loan to buy the property.

If the appraised value is higher than the sales price, there are no issues. It is important to note that if the buyer pays for the appraiser it is theirs, they do not need to show it to anyone. As such, if an appraisal comes in with a value over sales price it is suggested that the seller is merely told the appraisal has sufficient value for the transaction.

If the appraised value is equal to the sales price then, again, no issues. It is not uncommon for appraisals to match, or come in just above, sales contract prices (for instance sales price is $499,750 and appraisal is $500,000). Appraisers are aware of their primary purpose is to inform the lender, “yes, the sales price is consistent with the local market;” or “no, the sales price is not consistent with the market.” Most properties, in balanced or near balanced markets, sell very near what has sold recently for similar properties. As a result, appraisals have values at sales price.

Now the question of the week, what if the appraised value is less than the sales price?

There are four options when this happens:

  • Seller agrees to drop the price to the appraised value
  • Buyer agrees to continue purchase at the sales price
  • Buyer and seller agree to a new sales price between the original sales price and the appraised price
  • Neither party agrees to budge on price and the transaction is cancelled

 The first and last options are the most rare results of a low appraisal, more likely are the middle options.

When this happens, when the buyer agrees to continue the transaction at a price higher than the estimate of value on the appraisal, there are implications for the loan.

One of the primary factors in the rate and cost of a mortgage is the loan-to-value (LTV). Loan-to-value is calculated by dividing the amount of the loan by the value of the property. For instance, if you are buying a property for $600,000 and have a loan amount of $480,000 your LTV is 80%; if you loan amount is $450,000 your LTV is 75%.

A lender determines the LTV for a loan application by the lower of the sales price or appraised value. On the example above, the LTV at the time the application was made for a $480,000 was 80%. If the appraisal value is $590,000 the LTV for a $480,000 loan is now 81.36%. Because the LTV is over 80% the buyer, if they keep the loan amount at $480,000, will require mortgage insurance, adding $85-100 per month to their house payment for a minimum of two years.

To avoid the MI the loan amount will need to be 80% of the appraised value, $472,000.

In this scenario let’s look at two scenarios for the buyer to avoid paying the mortgage insurance by getting a loan with 80% loan to value.

Option 1: The seller will not move off the sales price of $600,000 and the buyer agrees to continue with the transaction. We learned above that to avoid mortgage insurance the buyer’s loan must be $472,000 for 80% LTV, so the buyer increases the down payment from the original $120,000 to $128,000.

Option 2: The buyer and seller agree to adjust the sales price to split the difference between the original sales price and the appraised price, $595,000. The buyer’s loan is $472,000 to avoid MI, the new down payment is $123,000 as opposed to the original down payment of $120,000.

Depending on how close a loan amount is to the maximum loan amount threshold for a conforming ($510,400) or high-balance conforming ($765,600), not only is the LTV a possible issue, but so is the price of the loan and underwriting guidelines that could make the loan more difficult to obtain.

We are in a market with tight inventory and rising prices, which most appraisers will (should) account for when completing reports. When a market is either increasing or decreasing rapidly in value appraisers may also make “time adjustments.” When appraisers first start making time adjustments for reports there can be some push back from underwriters and lenders, especially if the adjustments are for higher values. After receiving multiple reports with time adjustments, they become routine and accepted by underwriting. We are in the transition stage right now for some markets seeing upward adjustments.

To conclude, appraisal values lower than sales prices create issues, however depending on the difference value, the issues can be overcome with some flexibility.

Have a question? Ask me!

For the first time in a while we have data impacting rates. For the past several months most economic data has had minimal impact as investors priced bad economic news into markets in March. Today we had a reversal as economic news did have an impact on rates. The Labor Department released its monthly jobs report today and the data was better than expected, causing a sell-off in bonds and mortgages putting upward pressure on rates. For the fourth month in a row the labor market continued its rebound in August, adding 1.37 million jobs and lowering the unemployment rate almost two percent to 8.4%. For context, in February the unemployment rate was 3.5% and payrolls are still around 11.5 million workers below what they were before economic shutdowns due to the pandemic. Overall the report was positive enough to cause investors to sell off fixed income assets and push prices lower, and rates higher.

Rates for Friday September 4, 2020: Today’s bump in rates takes out a dip we had earlier in the week and as of mid-day Pacific rates are the same as they were last Friday, and the one before that.

The rate spread for cash-out, no point, higher loan-to-value and other factors for refinances still are historically higher than normal. Call for details and quotes as rates can vary significantly depending on the situation.

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS:

30 year conforming                                            2.75%      Flat

30 year high-balance conforming                    3.00%      Flat

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

Last year this week the WR&MU came to you from Kauai, Hawaii where Leslie and I spent the week celebrating our 25th anniversary. Today it comes to you from the very warm (we have no A/C in the house) home-office where I am a sub-tenant of McCormick LA Public Relations (Leslie’s company) on our anniversary. I am very lucky to have such a wonderful partner who has stood with me, and supported me, through the years in the mortgage industry. Which is secondary to being a wonderful mother, wife and friend.

Next week will likely be an abbreviated WR&MU as I have my annual license renewal class all day Friday as a webinar—I’ll be channeling the 4th grader going to class on Zoom and trying very hard not to be distracted and pay attention.

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog