Here is another great article by Sam Schneiderman, of Boston.com's Real Estate Now:
Regardless of what a buyer or seller thinks about a property's value, in the end, the only opinion that probably matters is the appraiser's.
When mortgage financing is involved, the lender sends an appraiser to the property to make sure that it is habitable, marketable, and worth at least what the buyer intends to pay for it. The appraiser's job is to do a brief walk-through of the property (not a home inspection) and develop his or her opinion of value based on an analysis of recent sales and current market activity. There's a saying amongst appraisers that they are the eyes and ears of the lenders.
Until fairly recently, appraisers developed their opinion of value by comparing the subject property to at least three of the nearest, most recent, and most similar sales available. Now appraisers are also asked to include pending sales and/or currently listed properties in their reports. By including currently listed properties or pending sales, the lender is able to better see whether or not current market values are trending up, down or remaining stable.
When appraisals were based solely on historical sales data, it was possible for a property to appraise higher than competing properties were offered for in the marketplace. Now that current listings and pending sales are included in the analyses, we are seeing more properties that don't appraise for the amount that buyers and sellers have negotiated, particularly when the inventory of unsold properties in some areas causes sellers to lower their prices in order to sell. This could also happen as a result of normal seasonal market cycles.
For most transactions, since it is no longer easy to challenge an appraisal, a low appraisal is cause for the lender to deny the mortgage. Based on fairly standard local purchase and sale language, when that happens, a buyer can choose to pay the difference between the appraised value and the agreed purchase price or cancel the transaction and receive the deposit money back. An alternative to canceling the transaction is for the buyer to ask the seller to reduce the purchase price to the appraised value. Since most sellers have already made plans to move on, most will usually agree to lower the price to the appraised value.