As a private wealth advisor to high-net-worth individuals, you may be asked to provide input on the valuation of residential properties that your clients might own or want to purchase. Your clients might want to know whether they should take a mortgage on those properties as part of a long-term strategy.
Similarly, the valuation of residential property being inherited, deeded or included in a divorce settlement could be part of negotiations, planning considerations or retirement planning. For those reasons, it’s important to understand the process of a home appraisal.
There are many factors that go into advising a client on what to consider regarding their real estate assets. In some cases, you may have empty nesters who don’t need their large home anymore and want to potentially sell it and make investments or obtain mortgages on smaller properties.
Perhaps they are trying to figure out how to leave significant assets to their children or heirs, and for purposes of equity they are trying to value the properties and cash to figure out how the inheritance may be divided.
It’s very easy for a client to venture onto any number of public home valuation sites and see a number associated with a property they own or a property they want to purchase. Very often, your client will see a number and decide that this must be the value range, and that the transaction will occur at or very close to that value.
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More often than not, this is not the case! Therefore, some insight into how property valuation decisions are made can be very helpful in preparing your client — whether for use in legal proceedings or property disbursement, or in conjunction with mortgage (both forward and reverse) loans.
An Art and a Science
So how does an appraiser value a home? The first thing to understand is that appraisal is both a science and a subjective opinion. The appraiser uses facts and methods to assemble their appraisal, but the ultimate opinion of value is one they arrive at after consideration of those facts.
Just as two different accountants doing a tax return might arrive at similar but most likely different conclusions, rarely do two appraisers performing the appraisal on the same property come to the same value conclusion. But if they follow the methodologies of their craft, their opinions of value will usually be close (within 10% is considered a pretty authoritative range).
Appraisers generally use three methods to determine the value of a home: the income appraisal method, the cost appraisal method, and the sales comparison method. They will decide on the approach based on the nature of the property.
The sales comparison method is the most common one used for single-family residential properties. The appraiser constructs the opinion of value based on recent sales of similar properties, and adjusts for attributes and market conditions.
What if a property is very unique and has been completely remodeled or constructed in an area where there are very few sales or similar properties? In that instance, the appraiser might choose the cost approach. This methodology combines the land value plus the cost of replacement construction of the structures, as a starting point.
The income approach is a methodology used by appraisers that estimates the market value of a property based on the income of the property. The income approach is an application of discounted cash flow analysis in finance. With the income approach, a property’s value today is the present value of the future cash flows the owner can expect to receive. Since it relies on receiving rental income, this approach is most common for commercial properties with tenants.
Once the particular methodology is chosen, appraisers go through a rigorous analysis of the property, comparable sales and adjustments to derive an unbiased opinion of value. Appraisers have much to lose by injecting bias into a transaction including their business license and livelihood.
Appraisers attest on their reports that they have done the appraisal to a uniform standard (USPAP) and that they have no interest in the property being appraised. Unlike real estate agents, consumers, and mortgage brokers, they don’t have a financial interest in the transaction and their job is to arrive at a market supported value conclusion.
Therefore, it’s very common — particularly in a superheated real estate market like 2020/2021 — that an appraisal might not come in at the value that everyone in the transaction thinks a property is worth.
As a firm that provides thousands of appraisals per month around the country to various banks, credit unions and mortgage lenders, I can tell you that we see anywhere from 8% to 15% of appraisals come in “under” the expected value or purchase contract price at the present. Why is this?
A Tale of Two Appraisals
Let’s say that a property sells for $2.5 million in a stable market with an average of 2% appreciation per year. This uncompelled transaction value is the voluntary price on which the buyer and the seller of the property mutually agree. Once it is sold and recorded on the MLS (multiple listing service) and county records, this number becomes a “fact,” and is considered the closest thing to an actual market value.
Two months later, a property with the same amenities and lot size in the same neighborhood goes pending for $2.8 milllion in the MLS. If the market has appreciated only a few tenths of a percentage point in that time period, then all else being equal the value of that similar house is probably not $2.8 million, despite the fact that the buyer and seller are willing to transact at that value.
If the two arms-length parties are willing to pay cash, then the transaction can proceed without an appraisal and eventually will be recorded into the MLS database, and that of course will influence the value of all comps in the same neighborhood. But if lenders are involved, then they will use an appraiser to determine the home’s actual value so they don’t lend more money to the borrowers than the asset is worth.
Now it’s all up to the appraiser. In this scenario, if an appraiser determines that the market value of this similar property two months later is only $2,575,000, then that’s the number upon which the lender will base the loan. That means the difference between $2.8 million and the appraised value has to be paid by the buyer in cash, or the seller has to make concessions to bring the sale price down or help the buyer in other ways.
Client Decision Making
Let’s say the buyer in the above scenario is your client and they are using a loan to purchase the property. You might advise them given the market fact pattern that the appraisal is likely to not come in at the sale price, and that unless they really want this home for other reasons or are planning to never move again, this may not be the wisest financial decision.
Additional Reading: When Unmarried Older Couples Buy a Home
What about a client coming into an inheritance and counting on selling the above home for more than $2.6 million to meet other financial goals? Again, you might advise them that the home might not be worth that much, despite what they are finding on the internet for value, and that paying for a private appraisal would be wise prior to deeding it to an heir. This may allow them to maximize the fair splitting of assets if multiple children are involved. This could also easily apply to a separation or divorce where the two parties are trying to value the property in order to come to a settlement.
The possible permutations of the impact of an appraisal in this type of private wealth advisement are endless, but a good basic understanding of appraisal practice and market dynamics is a key element of decision-making. One recommendation would be to befriend or have relationships with appraisers in your local market, particularly ones that are Certified Appraisers skilled in higher net worth properties and who do asset appraisals or testify in court proceedings. Those experts can be invaluable to your practice and are worth getting to know and making a part of your team.
Mark Walser is president of Incenter Appraisal Management, a national appraisal management company (AMC) that provides property valuations, inspections and data products to mortgage lenders throughout the country. He can be reached at [email protected].