Real Estate Investing: If the Property Doesn’t Appraise…

hana-5

Purchasing a property with all cash is pretty straightforward. The buyer and seller agree to a purchase price and the buyer transfers the funds over. End of story.

Not very dramatic, right? Unfortunately, not many investors who are just starting out have deep enough pockets to be able to purchase a home outright. But if you have a good, stable job and have been financially responsible for awhile, you should be able to qualify for conventional financing with most lenders. Financing is great because it gives you the capability to purchase something that would otherwise be outside your means. As a qualified buyer, you typically only need to put down a downpayment of 20% to 30%. These days, leverage is even more powerful because the market’s low interest rates actually help you maximize the returns on your investment capital. And if you buy right, the icing on the cake is that someone else (your tenant) will be paying down your mortgage for you!

Pretty sweet, right? So, what’s the catch?

Behind the Appraisal

Well, one of the biggest hurdles an investor can run into when purchasing a property using financing is if the property doesn’t appraise. Just like with how a buyer performs their own due diligence prior to closing escrow, a lender must also do the same to protect themselves. A lender mitigates risk by making sure that the property being purchased is actually worth the price the buyer is willing to pay.

However, the whole appraisal process is rather subjective. And quite frankly, the guidelines in place today are rather archaic when it comes to financing for residential investment properties.

If you are an investor purchasing for cash flow (semi-passive income), your bottom line is your cash-on-cash returns, and your net monthly cash flow each month. In your mind, a property should only be valued on the merit of how much rent it can fetch each month.

Unfortunately, that’s not what the appraiser looks at when they determine the “correct” value for your property. Unlike with commercial real estate loans which use the “Income Approach”, residential real estate transactions are always appraised using the “Sales Comparison Approach”.

The “Sales Comparison Approach” can be extremely problematic because it only takes into account what homes are selling  for around your property (a few miles radius).

Example

Here’s an example of when the whole appraisal process breaks down for a residential property. In Chicago, there are few 3-flat buildings. Each unit typically contains 3 bedrooms and 1 bathroom (9 bedrooms and 3 bathrooms total). If fully redeveloped (pristine condition), each unit can reasonably be expected to generate $1100/month in rent.

If you were an investor looking for a 3-flat, you might come across the following deal:

Chicago_3flat_numbers

At a purchase price of $270,000 and a downpayment of 25%, you would need to come up with $67,500 in investment capital. Each month, the property would cash flow $643.22 after all expenses and after setting aside 10% for vacancy and 10% for maintenance. The cash-on-cash return comes out to 11.43%. In today’s market, that’s a pretty good deal.

Let’s say you liked these numbers and wanted to proceed with closing this deal. During the loan process, your lender orders an appraisal, which again uses the “Sales Comparison Approach”. Because 3-flat units are so rare (most buildings are 2-flats), the appraiser has trouble locating enough adequate “comps” to use in their analysis. They might research the area and only find a few transactions for 3-flats in the last six months, or year. Some of the sales might have been foreclosures, while others might have been fully redeveloped like the one you are trying to purchase. However, if the “comps” are all over the place, the appraiser won’t have sufficient data to put their stamp of approval on the agreed upon purchase price of $270,000.

If there’s uncertainty, the appraiser could come back with any number. Most likely, they will err on the side of caution and appraise the property for far less than the purchase price.

Seller Takes All

In this example, let’s say the appraiser comes back with “correct” value of $220,000.

$220,000. That’s a long, long ways away from $270,000. If that’s the case, it means that the lender is only comfortable enough to finance your deal at $220,000. Unless the seller budges, you would have to come up with the difference ($50,000) yourself.

Here’s what the revised numbers would look like:

chicago_3flat_numbers2

As you can see, the cash-on-cash return drop from 11.43% to 9.70%. Yes, the cash flow each month increases (from $643.22 to $849.13), but that’s only because you are putting in more money to close the deal. Although not shown explicitly in the numbers above, the cash-on-cash return is calculated factoring in a total downpayment of $105,000 ($55,000 which is 25% of the $220,000, plus $50,000 to cover the appraisal gap up to $270,000).

Buyer’s Side of the Story

The original scenario only required a downpayment of $67,500. Without negotiating, this new deal would require you to come up with $105,000, which may or may not be possible. Not only would you need to bring in a lot more money to the closing table, you would also have to accept a smaller cash-on-cash return.

Probably not what you had in mind when you first signed the purchase contract! So, at this point, it’s time to renegotiate!

Seller’s Side of the Story

From the seller’s perspective, of course they won’t want to discount the property $50,000. A common argument against reducing the price from the seller’s side might be that the cash returns you are getting are already “excellent”. They may also argue that the replacement cost for such a building (new construction) would cost far more than even the original purchase price (this may be true, but decide for yourself if this actually means anything). Continuing with this line of thinking, the seller will probably further insist that the purchase price is justified, it’s just that the comps around it haven’t caught up yet…

Lastly, the seller might protest reducing the price any further because they will either be selling for a loss, or making very little profit. Expect to hear this type of response, but again, use your own judgement and internal filter to help process this information. Maybe the seller did perform extensive renovations, or redevelopment to justify the higher selling price?

Regardless, as a buyer, your job is to secure the best deal for YOU! Don’t worry about trying to help the seller out so much; help yourself out, first and foremost.

Buyer Takes All

A buyer’s ability to negotiate will be largely influenced by the state of current housing market conditions. If properties are flying off the shelves and the economy is booming, you will have a tougher time talking down the price.

In a downmarket, however, the buyer is the one in control. When I was purchasing houses in 2012, it was common for a buyer to include this clause in the purchase contract, along with the appraisal contingency: “The purchase price of the property will be at the mutually agreed upon contract offer, or at the appraised value, whichever is lower.

The above clause protects the buyer, regardless of how the appraisal turns out.

If the appraisal comes in lower than the agreed upon contract price, the buyer will purchase and obtain financing at the appraised value. In the 3-flat example above, the buyer would purchase the 3-flat at $220,000 since the appraised valued came in lower than the purchase price of $270,000.

If the appraisal were to come in higher than the contract price, the buyer would purchase the property at $270,000, which was the original agreement. So, even if the appraisal were to come back at $300,000, the buyer wouldn’t have to worry about having to pay more. In this scenario, the mutually agreed upon contract offer would be the lower of the two values.

In general, a low appraisal is the only thing that causes trouble in negotiations. It isn’t customary for a buyer to have to pay anything higher than the original purchase price agreement (I have never seen this happen). That is, a higher appraisal value will just be tossed out since it doesn’t do any damage.

In the Buyer Takes All scenario, the following would happen:

Original Purchase Price: $270,000
Original Downpayment %: 25%
Original Downpayment: $67,500

Appraisal: $220,000
Loan Downpayment %: 25%
Loan Downpayment: $55,000

Final Purchase Price: $220,000
Final Downpayment %: 25% ($55,000/$220,000)
Final Downpayment: $55,000

Equal Downpayment Condition

As a buyer, if you don’t want to fork over the $50,000 difference to close the deal, I don’t blame you. Closing a real estate deal ALWAYS involves a buyer and a seller; it’s a two way street, so of course there should be room to negotiate.

If the seller doesn’t want to come down the full $50,000 either, then the next progression would be to find a compromise. A logical starting point would be keep the buyer’s downpayment amount the same.

Here’s how to do that:

Original Purchase Price: $270,000
Original Downpayment %: 25%
Original Downpayment: $67,500

Appraisal: $220,000
Loan Downpayment %: 25%
Loan Downpayment: $55,000

Difference Between Downpayment = $12,500 ($67,500 – $55,000)

To bridge the gap between the original purchase price and the appraised value of the property, you would try and equalize the downpayment (money you as the buyer would be bringing to the closing table).

Since the new loan at the appraised value would require you to bring $55,000 in downpayment funds to closing, you would tact on $12,500 to the appraised value of $220,000 to keep the buyer’s costs the same. The new purchase price would be $232,500.

In the Equal Downpayment scenario, the following would happen:

Original Purchase Price: $270,000
Original Downpayment %: 25%
Original Downpayment: $67,500

Appraisal: $220,000
Loan Downpayment %: 25%
Loan Downpayment: $55,000

Final Purchase Price: $232,500
Final Downpayment %: 29.03% ($67,500/$232,500)
Final Downpayment: $67,500

Half Way Split

To keep the downpayment the same, the new starting point for negotiations would be at $232,500, as shown above.

If the seller refuses to sell at $232,500, more negotiations need to take place. The delta that exists between the original purchase price of $270,000 and the new starting point of $232,500, would be $37,500.

If the buyer and seller agree to split this difference exactly in half (I’m not advocating this as the best solution for a buyer), this means that the buyer would pay $18,750 more than the starting point price of $232,500. The seller would reduce the purchase price by $18,750, from $270,000. The new purchase price would be $251,250. Total downpayment for the buyer would increase from $67,500 to $86,250.

Here’s the full breakdown:

Original Purchase Price: $270,000
Original Downpayment %: 25%
Original Downpayment: $67,500

Appraisal: $220,000
Loan Downpayment %: 25%
Loan Downpayment: $55,000

Final Purchase Price: $251,250
Final Downpayment %: 34.33% ($86,250/$251,250)
Final Downpayment: $86,250

Renegotiate Further

If none of the above scenarios can be agreed upon, you can keep negotiating to find the right compromise. The Seller Takes All and Buyer Takes All scenarios are the two extreme ends of the spectrum. The Equal Downpayment Condition can be seen as the neutral point compromise, while the Half Way Split tends to favor the seller.

Second Loan

Another alternative would be to ask the seller to give you a second loan on the property. In essence, the seller would act as a second lender for you, covering the spread between the purchase price and the appraised value.

First Loan (Primary Lender): $220,000
Loan Downpayment %: 25%
Loan Downpayment: $55,000

Second Loan (Seller): $50,000
Loan Downpayment %: 0%
Loan Downpayment: $0

Final Purchase Price: $270,000
Final Downpayment %: 20.37% ($55,000/$270,000)
Final Downpayment: $55,000

In this example, the interest rate used was 5.20%. If this is the interest rate you can get from your primary lender, ask the seller to also give you the same interest rate. With conventional financing, you are probably looking at either a fixed 15 year loan, or fixed 30 year loan. Work with the seller and see what they can offer you.

This compromise can work because the seller doesn’t have to budge on their selling price of $270,000. For the buyer, it still works because you’re still purchasing the property at the agreed upon contract price, but you don’t have to come up with a larger downpayment. In fact, your downpayment ($55,000) would be less than had you gotten financing at $270,000 ($67,500).

Other Concessions

If price negotiations still don’t result in a complete compromise, the buyer and seller can always focus on other concessions to bridge any narrow gaps. For instance, if the property inspection report reveals that the roof on the property is aging, or if the water heaters and furnace are nearing end of useful life, work with the seller to get these items repaired, or replaced.

If you are working with a turnkey company, insist that they give you: 1-year rent protection guarantee (you get paid regardless of evictions or tenant non-payments), 1-year maintenance guarantee (seller warranties all work, materials, labor), closing cost credit back, seller paid for insurance premium, etc.

There are lots of items you should be able to bring in to the bargaining table…

Re-Appraise the Property

Appraisals by their nature are highly subjective and the valuation will fluctuate greatly between different appraisers. If it’s possible, you can try and ask the lender to order an additional appraisal to get a second opinion. I have never done this myself, and I don’t believe this is possible with every lender. YMMV, but it doesn’t hurt to ask…

Start Over

If all else fails, you can start the entire loan process all over again with a different lender. By switching lenders, you’ll get to work with a different appraiser who may (or may not) get you a higher value. It’s a gamble, though, and there are risks involved. Keep in mind, if you decide to start the loan process over, you’ll be out of pocket for: first appraisal, loan origination fee, etc.

If the second appraisal fails, you’ll be out of pocket even more money, and you’ll lose a lot of time. Depending on the market environment, this may also mean having to miss out on a lower interest rate loan, if rates are rapidly rising.

Don’t Give An Inch!

There are buyers out there who will ALWAYS refuse to overpay. If you are one of them, stand your ground and don’t give an inch. Stick to the Buyer Takes All scenario, and if the seller still won’t budge, walk away.

However, I believe that being extra firm doesn’t always work out for the best. Like with most things in life, you have to keep an open mind and adapt to the changes around you.

When I was under contract for Rental Property #1, the housing market was on the rebound and prices were starting to surge upward. The listing price for the property was $250,000 and my winning bid was $323,000. Right from the start, you could argue all day and night about how much I overpaid. Why in the world would anyone overpay $73,000 for a property!?!

At the time, there were many people who thought I was absolutely insane. However, I had already lost a REO bid a few months earlier, so I didn’t want to miss the boat completely. It’s all hindsight now, but even back in 2012, I got this strong sense that the housing market was entering “recovery mode”.

Because the purchase price was so much higher than the listing price, naturally I was worried about the property not appraising. The appraisal came back at $315,000.

Luckily for me, I was still operating in a market where buyers’ were still in control. Although the market was recovering, the perception wasn’t prevalent, and most sellers at the time were willing to renegotiate low appraisals. In my own case, the lady selling the house wasn’t from California and had already overstayed longer than she wanted to. She was eager to sell, so I was able to use the clause: “The purchase price of the property will be at the mutually agreed upon contract offer, or at the appraised value, whichever is lower.

I didn’t have that clause written anywhere on the contract, but I suggested it after the appraisal came back in. Luckily, she took me up on the offer (and I got her to throw in $$$ for a new water heater), so I didn’t have to go back to the drawing board.

Still, I was more than comfortable with overpaying, and even had the renegotiation broken down, I probably would have caved and just paid the $8000 difference. I was THAT convinced that the the property I was purchasing was the right buy.

Of course, the market today isn’t where it was two years ago. You have to use your own judgement to determine whether or not it makes sense to overpay. As always, run your cash flow numbers and returns, and make sure all the numbers make sense.

I had the luxury of overpaying because we were still in a downmarket and the property was selling for half of its peak price. In less than two years, the property has appreciated considerably; according to Zillow, it’s worth about $480,000 today.

Summary

A low appraisal can be a huge sticking point when trying to purchase a property. It forces buyer and seller to renegotiate on prices and concessions, overriding the original mutually agreed upon contract. Depending on the situation, there isn’t always an easy or obvious solution. However, real estate will always be a transaction involving two parties, buyer and seller. So, there should be room for some give and take. Using the techniques outlined above, you as a buyer can work your way into negotiating a deal that makes the most sense for you. If ever in doubt, don’t be afraid to walk away. For the right property, hopefully there is a working compromise somewhere in place.

Happy hunting! 🙂

 

Print Friendly, PDF & Email
Sharing is Caring:

8
Leave a Reply

avatar
5 Comment authors
FI FighterDone by FortyIntegratorDave @ The New York BudgetNo Nonsense Landlord Recent comment authors
  Subscribe  
newest oldest most voted
Notify of
No Nonsense Landlord
Guest

Lots of great information. Remember, a buyer needs to make money for themselves, not enrich the seller. Make offers, do not be afraid of making offers on multiple properties.

Know what return you must have, for the type of property you are buying. Lower quality tenants demand higher returns as the maintenance costs are much higher.

Above all, know your market. Know what a deal is. Know when to pounce, and what to offer BEFORE you find a deal. The great deals are gone in a day or two – or even less.

Dave @ The New York Budget
Guest

Another great post! Thanks FI Fighter!

Integrator
Guest

I think underappraisals are becoming a little more common place now because appraisers are cautious about excessive appraisals in light of what happened in the last few years. In a market with less inventory and multiple bidders, buyers are prepared to pay over list to get what they want. Fortunately, we didnt have any appraisal problems when we bought recently.

Done by Forty
Guest

I’ll be going through the appraisal process in the coming weeks with our first ever rental property, and this is one of the items I’m worried about. I’m hoping that the appraisal comes in way higher than our negotiated price of course, but there’s a 7% wiggle room (93% of purchase price) where we’d have to simply bring more funds to the table. It was one of the items I wasn’t happy about in the agreement, but chose to use our leverage to get other items (i.e. – lower costs). If we fall in that 7% range, we’re going to just have to throw more cash into the deal…

Close Menu