Well, not always at least. The question has come up from numerous buyers I know on whether they should they buy a property that appraises for less than the purchase price. I know this one is going to spark some debate, so rather than try to sway you one way or another I’m going to explain this whole appraisal thing in a bit more detail so you can better understand what is going on and you can make your own determination on how representative appraisals are of actual market value.
What is an Appraisal?
You are likely only going to see an appraisal on a property if you are financing a purchase. The lenders are typically the ones who order appraisals since they want to know the “value” of a property before they lend money on it in case you default and they have to take possession of the property. They don’t want to end up with a property that isn’t worth that they loaned out on it. An individual can order an appraisal too if they want, you just don’t see it as much.
An appraisal is a thorough assessment of everything related to a particular property that may help determine the true value of that property. How big is the house, how old is the house, comps from other houses nearby, etc. It is a fairly thorough assessment and worth educating yourself on if you aren’t familiar with what all goes into an appraisal. I discuss the factors in detail here, but it’s worth looking up. Or look through the appraisal of a property you may have purchased and see what factors were considered. Once an appraiser factors all of these things in, he determines the “appraised value” of the property. This appraised value, in theory, represents the true value of the property.
If you are financing a property, an appraisal is critical because it will affect your loan amount. Let’s say you are buying a $100,000 property and you are required to put down 20%, so $20,000. That means you are actually getting the loan from the bank for 80% of the purchase price (the full purchase price less the 20% down payment), so the loan is actually for $80,000. In order for the bank to lend you that full $80,000, the appraised value has to come in at or above the purchase price of $100,000. As long as it comes in at $100,000 or higher, you are fine and you can still plan for the $20,000 down payment.
However, if the appraised value comes in lower than $100,000, things change. The bank is going to expect you to put down the difference between the purchase price and the appraised value, on top of your normal 20% down payment. Let’s say the appraised value comes in at $91,000. That means the appraiser who went to assess the property determined the house is only worth $91,000. You can still purchase this property and get the same loan as you had planned, except now you will have to pay an additional $9,000 out of pocket to cover the difference between the appraised value ($91,000) and the purchase price ($100,000).
This is what I mean when I talk about a “low appraisal”. If a property gets a “low appraisal”, it means it appraised for less than the purchase price. Again, this is okay and you can still finance the property, but you do have to make up the difference in cash at closing.
The Problem with Current Market Appraisals
You’re already asking- Whoa! Why would I buy a property that is valued less than the asking price?? Don’t worry, I feel you. However, there are discrepancies with many markets’ appraisal systems today. As a result of the market crash and part of the recovery process, many markets’ appraisal systems are broken. With the appraisal systems being broken, it is causing many appraised values to be exceptionally inaccurate of the true worth of a property. I’m going to use an example of a turnkey rental property in Indianapolis to explain where and why discrepancies can happen. I use turnkeys as an example because they are fully rehabbed, in great condition, and rarely ever listed on the MLS. It will make sense in a minute.
Indianapolis, like most states, has insane amounts of bank-owned sales, foreclosures, and short sales. Welcome to our real estate crash, it’s what we’ve been left with. Due to the high number of bank-owned sales and the like, turnkey providers have set up shop. Turnkey providers go in, they buy up large numbers of these houses, they fix them up and they sell them off the market to investors and a lot to hedge funds. Great! Well, yes except it throws some things off.
Let’s say you go to a turnkey provider in Indianapolis and you pick out a property to buy. It is in an area where several other turnkey properties have sold and hedge funds have been buying like crazy. Turnkey properties inevitably sell for much higher than the bank-owned properties because they are fixed up and don’t need work and, well, the bank doesn’t own them. The hedge funds have been buying a lot of turnkey properties and even for the non-turnkeys, hedge funds still tend to pay higher prices. Now let’s say that 70 out of the last 100 houses to sell in a particular area were to cash-paying investors (turnkey investors and hedge funds), 25 of the 100 were foreclosures, and 5 houses were to primary homebuyers at normal price.
Because Indianapolis is a “non-disclosure state”, cash buys are not required to be reported. So an appraiser going out to assess the “value” of the property you want to buy isn’t going to see the cash-purchased turnkeys. He can probably see the foreclosure sales, but those are inevitably going to be really low because they are foreclosures. And then he can see the price of the houses purchased by the primary homebuyers.
What this translates to is an extremely skewed set of comparables to use in his appraisal. Why? Because all of the turnkey buyers and hedge fund buyers probably paid right around what you are planning to pay for yours, which should be considered in determining the value of your property but they aren’t because they weren’t recorded because they were purchased for cash. The foreclosures are priced really low, so that drags down the “value” of your property. And then the higher-priced properties, the ones sold to the primary homebuyer, count in the assessment but because it’s so few properties they don’t carry a lot of weight. Make sense?
Basically, since that was about as clear as mud, the comparables used in a lot of appraisals today are unfair. One of the biggest determiners of a property’s “value” is recent sales. If all the recent sales that are similar to your property’s purchase price aren’t recorded and therefore not used in the appraisal, the appraised value is negating actual comparables that should in fact be used in the appraisal. The recent sales that are used in the appraisal are those of foreclosed homes which will be much lower prices, so that’s not fair either because there is a huge difference in the worth of a foreclosed nasty home and a recently freshly rehabbed home. They aren’t fair comparisons. But due to different state laws, there aren’t necessarily requirements to make sure they are more fair than that.
The biggest state in the last couple years to suffer from a broken appraisal system has been Georgia. The Atlanta market has been one of the biggest hotspots for investors for a while now, but all the while appraisals there have been in the toilet! Any investor planning to buy a property using financing in Atlanta has been warned (or should have been warned) that there is an extremely high likelihood that the appraisal on that property will come in low. Some have come in as much as $40,000-50,000 low!
Others not so much, I think I bought one that was only $7,000 low, but despite the low appraisals investors have still been buying properties there like crazy. Why? Because they understand that current appraisals aren’t necessarily representative of actual market values. If it is known that a particular market has a broken appraisal system, that fact should definitely be taken into consideration when you think about the worth of what you are paying for a property.
To Buy or Not to Buy?
You have a property under contract, the lender orders the appraisal and the appraisal comes back only to show it is lower than the purchase price. Now what? Do you buy it or do you bail? Well, it depends.