After half a decade of falling home values, the real estate industry has become well versed in the language of declining markets. Buyers have learned to be skeptical, buyers’ agents have sharpened their teeth advocating for lower purchase prices and appraisers have become increasingly conservative in order to meet the demands of an equally conservative lending industry.
Enter: 2012 Twin Cities Real Estate Market. New to the scene and largely forgotten by all arrives a balanced market which quickly reveals itself as an inclining market.
This new market was initially greeted with skepticism and disbelief by much of the real estate industry and there are those who are still cautiously keeping it at arms length for fear of becoming too attached. Fueling this incline are improved local unemployment numbers (creating more qualified buyers) and a shortage of inventory.
You may ask, "So what could be wrong with this picture?" Retooling the real estate industry for an inclining market, an industry which has been heavily burdened by recent financial failure and therefore has become increasingly conservative, and which industry is geared for profit but governed by risk-management (appraisals, mortgage insurance and underwriting guidelines) is like trying to change an ocean liner's course with a canoe paddle.
Example - The Multiple Offer Appraisal Dilemma:
Three buyers see a newly listed and well priced property come to the market. Due to the shortage of quality inventory, all three buyers set up showings on day one and all three buyers write competing offers. As each buyer becomes aware of the multiple-offer situation, each increases their offer in order to put their "best foot forward". In our example, all three buyers make an over-asking-price offer in an attempt to secure the purchase. (This is far more common than you may believe given the current inventory shortage). Due to the conservative approaches of the buyers and their respective agents, all three offers are only slightly over list and therefore relatively close in price. In short, three able-and-willing buyers make offers to purchase the same property for essentially the same price. The seller, of course, must choose one. Typically, the seller chooses the highest offer and the purchase process steps forward into the realm of property inspection, then financing. This is an example of a typical multiple-offer situation in an open-market environment. This is the the best and most accurate means of determining Market Value for any property.
Market Value, however, does not equate to Appraised Value. If the purchaser is using financing, the lender orders an appraisal of the subject property in an attempt to determine if the contract purchase price can be supported by area comparable properties. A lender will lend based upon the lower of either the purchase price or the appraised value. An appraiser's process is governed by guidelines which are intended to help determine a market-supported value for the subject property by way of making adjustments to area comparable properties. Logically, an appraiser must look backward in time to find sold properties. Ideally, those sales would have occurred within the last 90, or possibly 180 days (depending on the availability of comparable sales) and within close proximity to the subject to use as a basis for value.
In the case of an inventory shortage, the home pickings may be slim, making it difficult to support the value of a high quality property or a less common property type (such as a muti-family home located in a predominantly single-family area). In order to find enough comparable sale data, an appraiser will often use sales which may be up to a year old, and which span a greater distance from the subject property. The increased distance lowers reliability and the use of older sales creates another significant problem:
An appraisal is a lagging indicator of value. An appraisal demonstrates the ability to support the value of a current purchase based upon data from past sales. When comparable sale data is sparse, or nonexistent, an appraiser will look back 12 months, and in some cases 24 months to find comparable sales. If we were to go back 12 months from the present, we would find ourselves in a buyer’s market - a very different purchase environment from where we stand today.
In a declining market, the “lagging indicator” nature of the appraisal would actually help current sales appraise for the necessary purchase price as past sales would have occurred at a higher market value. Conversely, in an inclining market (like the one we are now in), past sales will tend to fall short of supporting current sales as the market value today is higher than the market value of the comparable sales used in the appraisal. In an inclining market, Market Value will have a greater tendency to exceed Appraisable Value. In short, buyers are willing to pay more for properties than their lenders will lend upon. The net effect is that the real estate industry itself slams on the brakes of market recovery. (Am I the only one that thinks that this is a stupid problem?)
Solution (Since it is safe to assume that the appraisal standards won’t be changed to correct this obvious deficiency, let me offer up some practical suggestions)
- Realtors need to prepare their clients on both sides of the transaction for the possibility of low appraisals due to the newly inclining market.
- Low appraisals create the danger of a loss of buyer confidence in the transaction. Buyers should now recognize that a low appraisal does not always mean that they overpaid for a property.
- Buyers should be prepared for the possibility of bringing extra money to closing to account for a discrepancy between purchase price and appraised value.
- When comparable sales are lacking and therefore a low-appraisal is anticipated, savvy sellers should consider negotiating a contingency plan as part of the initial purchase agreement, which would pass on at least part of the liability of a low appraisal to the buyers.
- Realtors need to hone their creative skills to keep deals together.
- Loan officers should offer multiple financing scenarios to their clients which take into account appraisals that come in both at, and below purchase price value.
Why would a buyer be willing to endure the hassles brought on by a low appraisal in a purchase transaction? Buyers who find themselves navigating these issues in a purchase will most likely realize in time that they had purchased an appreciating asset. We all must pick our poison. Considering the historically low interest rates and the fantastic home affordability, I for one will choose the pain of perseverance over the cost of waiting.
Adam Duckwall, Edina Realty, St. Paul, MN
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