Monday, February 27, 2012

Appraising a House

A home appraisal is an inexact science.  Yet, everyone should know how the process works and what an appraisal does and doesn't mean.

How do you determine the value of a home?  It is a very relevant question in an age when home values can soar one year and then tank the next.  And even if you never own a home, knowing home values in your area can tell you whether or not it makes sense to rent or own.  If you can't do that math, then renting could indeed be a mistake.

An appraisal is usually done for the bank and for that reason, many appraisers are more and more reluctant to hand out copies of appraisals to homeowners.  One appraiser I know was sued by his wealthy investment banker client, who decided to buy a vacation home on Maine's trendy coast.  The client paid three million dollars for the house, at a time when houses in the area were selling for that much.  But then the market tanked, and the wealthy investment banker decided that he wasn't going to take a loss, so he sued my friend for providing a "faulty appraisal."

A load of horse-hockey?  You bet.  But after much legal wrangling, my friend's "Errors and Omissions" insurance company paid out several hundred thousand dollars to ameliorate the investment banker's loss.  Rich people get away with this shit, too.  You and I can't, as the amounts we lose would be dwarfed by legal fees.

But, in case you weren't paying attention, an appraisal is not a guarantee of home value.  It is just a scientific guess as to what the home may be worth, and in most cases, this guess is based on what other people are willing to pay, at the time, for similar properties.  And this is the most unscientific way to figure out the value of anything.  And in most cases, it is a guess prepared specifically for the bank, not you.

Like a hyped-up "dot com" stock, what the "last person in" paid is hardly an indication of the real value of anything.  And usually such amped-up valuations tend to correct (i.e., plummet) over time.

How is a home or property appraised?  Well, there are basically three ways, of which only the last (market value) is used for residential properties.  The other two are often included in commercial property appraisals (which can cost $1000 as a result, compared to say, $300 for a home) but are often no more accurate than market value appraisals, as they depend on market values themselves.

Let's explore these three appraisal techniques, as well as some ways you can use appraisals to your advantage, as well as how to work with your appraiser to make sure you get the value you are looking for.

Note that tax assessments or evaluations have little or no bearing on real value.   When the tax assessor says your house is assessed at $150,000, that does not mean the house is worth that much.  Usually, tax assessment values are 1/2 to 2/3 actual value.  They are just a placeholder number to value your home relative to other homes in the area.  Why this is so, is difficult to understand, other than if assessors used real numbers, they would have to reassess every home in the area on a yearly basis - or more often - which would be problematic.

But when you see someone saying, "Well the assessed tax value is X, so why is the house priced at Y?" you know you are dealing with a real rocket scientist.

There are three basic types of valuation:  Construction Cost, Income Model, and Market Valuation (Comps).

1.  Construction Cost:  At first, this would seem like a very concrete way to evaluate a property.  You look at a house, measure its square footage, and then come up with a number that represents the cost to build the house.  In most cases, however, this number is arrived at by multiplying the square footage with a "cost per square foot" to build, which is a number bantered about by builders and is only a rough estimate of construction costs.

A home comprises a foundation, framing, sheathing, roof, wiring, rough plumbing, insulation, interior sheet rock, flooring and trim, finish wiring and plumbing, appliances, HVAC, and paint and finish.  And each area of a house has a different cost per square foot.  A kitchen is more expensive to build than a closet, for example, due to the cost of cabinets and appliances and tile and finish work.  So these "cost per square foot" estimates are anything but accurate.  And they vary all over the place, as labor costs in some areas are much higher than others.

But even assuming this cost estimate is ballpark, the big wildcard factor is evaluating the land.  For a sample $300,000 house, the cost of construction might be $150,000 and the land value might be $150,000.  And this is not atypical, except in areas where land is cheap, such as very rural areas.

How do they come up with the land value?  Well, they use market values, or "comps".  So right off the bat, in our construction cost model, they end up going back to the market to determine prices of half the property, even if there is some "science" behind the valuation of the home.

And market values represent what people are willing to pay for the privilege of occupying a piece of land.  Near a major city, where people have high incomes and can pay more per month in mortgage payments, land values rise.  And if interest rates and tax rates are low, land values rise.  But if interest rates and tax rates go up, land values can go down, as people can only afford so much per month.  And right there is the problem with the "market valuation" or "Comps" technique of valuation, as we shall see.

2.  Income Model:  The income model is useful for commercial properties but also a calculation you should make as a potential homeowner or renter.  Simply stated, the appraiser looks to market values for rents (again, relying on that old bugaboo, market value) and then backs out the costs of ownership to determine what price the property will support.

For example, suppose a 2-bedroom house in River City sells for $300,000 and rents for $1500 a month (plus utilities).  The taxes are $3000 a year and the insurance another $1000.  If the homeowner puts down 20% ($60,0000) and finances $240,000 at 5%, the monthly payment for Principle and Interest is $1288 plus $333 for insurance and taxes, making a total of about $1621.

Based on that number, you might think the home is a little overpriced - and worth perhaps $250,000.  If you were to be a landlord and buy the home at $300,000, you might have a negative cash-flow, particularly after repairs are factored in.  Of course, another factor to factor in is the tax deductions for mortgage interest and depreciation, which could make this a positive-cash-flow deal.

But regardless, oftentimes the Income Model paints a bleaker picture of home value than competing prices would suggest.  Oftentimes, but not always - all the investment Real Estate that I bought had a positive cash-flow from the get-go.   But that was in 1998, not in 2008.  Perhaps  today this is again the case - in some markets.  Perhaps not.

Note how small things like tax rates, interest rates, and even insurance costs can tip the balance.  $333 a month might not sound like a lot, but a 10% increase in these costs can turn a break-even property into a money-loser.  And it illustrates why shopping your homeowners insurance is so important.

If you are buying a home or renting, you should do your own income model evaluation, before buying.  Chances are, in most markets, you may be shocked to discover that owning is more expensive than renting.  And often this reflects a "forward-looking" view of the market.  People pay more for a home, as they are locked into a fixed price structure (they think, anyway) moving forward, and over time, their cost of home ownership maybe far less than renting.

Many folks also look at the other side of the equation - appreciation - and figure that even if the home is a break-even prospect, they will make lots of money in appreciation as the home rises in value.  This may or may not be true.   In a normal market, homes rise in value only 2-3% a year, making the appreciation argument rather weak.  In crazy markets, housing prices may skyrocket - but then plummet - leaving the homeowner bankrupt.

Owning a property and paying more than rent (or renting it out with a negative cash-flow) on the premise that you will "make a lot of money" on resale, is to me, a short-sighted strategy.

3.  Market Value:  99% of home appraisals use market value, or "Comps" which is short for comparables.  It arguably is the least scientific valuation of a property, as it basically states what other people are willing to pay for a specific property at the time the valuation was made.  That may be fine and all, but a mortgage is 30 years, and if a property drops in value due to people's perception of its value then you and the bank are screwed.

And Market Values are just that - perceptions.  The "invisible hand" of the marketplace is often blind as well, and tends to value things based on emotions, hoopla, fear, and greed.  And we see this in every aspect of the market.  Gold is shooting up in price because of fear and hoopla.  It has no "fundamental" value other than people's perception of its value.  You can't do an income model on Gold as it has no income.\

Similarly, IPOs and dot-com stocks are wildly overvalued because people get greedy and "want in" on the "next big thing" and frankly have no idea what they are doing.  Facebook stock will be bid through the stratosphere right after it drops its IPO.  But then, people will likely pull back and think, "Where is the money?" and the price will drop back.  Does that mean the company increased and decreased in real value?  No, only that the price the last yahoo was willing to pay for 10 shares of the stock went up - and then down.

So market value is how appraisers work.  They measure your house, look at its condition, and then compare it to other, similar sized and type houses in the area that recently sold.  And then they sort of average together a few comparables and come up with a price.  Scientific?  Perhaps a little.  Accurate?  In a stable market, perhaps.  Reliable?  Not really.  It only tells you what others were willing to pay for similar homes in similar areas in a similar time frame.

And to some extent, these prices become self-fulfilling predictions.  When you buy a house, you look at houses "in your price range" and then look to comparables that recently sold to see what others paid for similar houses before making your own offer on the house you want to buy.  You are not making a judgement on absolute value, only your value relative to other people - the great unwashed masses of Lemmings and how much debt they decided to get themselves into.

But, it is all we have to work with.  So we use it.  But don't think for a minute that an Appraisal is the word handed down from God on the value of your home.

* * *

There are some things it helps to understand when getting an appraisal and also scenarios where you might want to pay to have your own home appraised, prior to sale.

Drive-By Appraisal:  These are falling from favor, as banks are finding they need to do their "Due Diligence" again.  But during the height of the Real Estate madness, many banks would do "Drive-By" appraisals or "Zip Code" appraisals on houses.

Houses were changing hands so often, and appraisers were so backed up, that doing a detailed appraisal with a measuring wheel and comps, often seemed a waste of time.  If you owned the "Jefferson" model townhome in Happy Meadows Mews development, chances are, it was worth what another "Jefferson" sold for six months earlier.  Why bother spending $300 to find out what a few clicks on a keyboard could tell you?

Some banks took this further, using the zip code to determine average home prices in the area, and then using a formula to determine whether the home price was within one or two standard deviations of the mean.  This really saved a lot of time.

And the upshot?  While it may have made Mortgage Fraud easier to do, the net effect, compared to hiring an appraiser and having a physical appraisal and report done, was basically nil.  Appraisers appraise to market values.  And if market values go berserk, well their appraised values will as well.

Again, an Appraisal is just sort of a "Cover Your Ass" (CYA) document for the bank, and is generally not intended for the homeowner.  A detailed appraisal and a drive-by or zip-code type are not necessarily accurate reflections of current or future market values, nor is one type inherently more accurate than another.

In the market environment today, however, you are less likely to see drive-by or zip-code appraisals anymore.

Helping your Appraiser:  If you are having an appraisal done, you need to be there when the appraiser arrives.  And you need to do your homework, in more than one sense, if you want the house to appraise.  First, clean the house and fix any broken stuff you can.   If you are selling your house, you need to do this, anyway.  If you are getting an appraisal for a refinance, you can make the house look its best.   If it is a property you are buying, obviously, you can't do this.

But more importantly, go online and pull some "Sold" listings for comparables for the area.  Your Real Estate Agent (or their assistant) can help you with this.  Remember, Comps are SOLD properties, not listings.  Pick homes that are close to yours in terms of distance, style, and price range.

Some appraisers are lazy when picking comps, and will pick homes that are wildly different than yours or in far worse neighborhoods.  As a result, your property may under-appraise.

When the appraiser arrives, be nice and friendly and helpful.  Hand him the printouts of the comps you found to be helpful.  You can't insist he use them.   Then be sure to mention, offhand, in the discussion, the target price you are looking to appraise at.  Many appraisers will end up centering on that price, as they are only human.  If they are not aware that the house needs to come in at a certain price, your appraisal may end up being too low.

Be sure to point out improvements and upgrades to the appraiser.  Hardwood floors, upgraded kitchen, newer appliances and physical plant, roof, windows, etc.  These affect value somewhat, and in many cases, some appraisers miss these things.

If you work with your appraiser, you can help get the house to appraise at the market value needed to get that mortgage, for you or your buyer.

One might argue that the opposite can be done - to try to spike the appraisal to get a lower home price.   If a house fails to appraise (see below) you might be able to go back and argue that the sales price is too high, and thus force a lowering of the price.  My gut reaction to this, as well as home-inspection games, is that it is underhanded and sneaky, and the Great Wheel of Karma catches up with people who play that way.

As a seller, I would walk away from a buyer who makes an offer and then tries to use an appraisal or home inspection to force a concession in price later on.  But then again, as a seller, I realistically price my properties.  Games are just a waste of time, so I don't bother playing them.

Using an Appraisal to Sell a Home:  If you are trying to sell your house in a slow or crowded market, having an appraisal done can be a good way to find a price point for your home.  And if you want to move a property, it can help to have it appraised and then list it for "below appraised value!"

If the house sells quickly, the bank the buyer uses may even accept the appraisal for their purposes (in the past, anyway, an appraisal less than six months old was usually accepted) and thus save your buyer the $300 to $500 appraisal fee.

Of course, this tactic is a little disingenuous, as appraised values are all over the map, and you can "tweak" an appraisal by suggesting values to your appraiser as well as suggesting comps.   But then again, most people have this idea that appraisals are the word of God handed down by Moses himself, and engraved on stone tablets.  But an appraisal is just that - an estimate of worth.

We have used this technique twice, not only to help us price a property, but to sell it.  And in both cases, we listed the property for slightly less than appraised value and watched it sell in a matter of weeks.

Some folks might argue this misses out on that last few thousand dollars in sales price that you could get.   But I disagree.   When a home is costing you $1500 to $4000 a month in carrying costs, is it really worthwhile to let it sit on the market for 10 months to get an additional $10,000 to $20,000?  I think not.

When Your House fails to Appraise:  Sometimes a house fails to meet its target value for appraisal.  And the reasons for this are many and often have nothing to do with the value of the home.

1.  The house is overpriced:  Clearly overpriced homes won't appraise, unless you have a particularly stupid or crooked appraiser.  If you are a buyer, and a place comes in way below asking price, then maybe this is a blessing  in disguise.

2.  The Appraiser Spikes One:  If an appraiser always meets the bank target for appraisal, then someone down the road could argue that all they are doing is validating the proposed transaction and not really valuating the house.  And for this reason, sometimes you get an appraiser who gives a low appraisal - below the target the bank is willing to lend on - just to show he isn't anyone's patsy.  They literally may "spike" 1 out of every 20 appraisals.  It is a delicate game, as an appraiser who doesn't "play ball" stops getting phone calls from Real Estate Agents and Banks.

3.  Bad Comps:  If you don't suggest comps and also present the home in its best form (and point out upgrades, new roof, etc.) the appraiser may come in low.  He shows up at the house, and no one is home.  He is pissed off, so he pulls some "comps" from a nearby ghetto, including a foreclosure sale and a "fixer-upper".  He underestimates your square footage, and puts down the house is in "average" condition, when in fact you have a new bath and kitchen, as well as brand-new roof and HVAC.  This is why it is important to BE THERE when the appraisal is done (even if the appraiser says it is unnecessary) to help steer him in the right direction.  The appraiser wants to give you the number you are looking for - but you have to give him the supporting evidence (the comps, condition) to validate that conclusion.

4.  Grudge:  Real Estate Agents have their favorite appraisers and tend to use certain ones.  If an agent hires a stranger, they may be less inclined to do a good job on the appraisal, and if they have to "spike" one to show they are independent, they are more likely to do it for a stranger than for a good customer.  In addition, if you piss them off by failing to show up at the appointed time, they may take it out on your appraisal.  Unprofessional?  Perhaps.  Humans are only human.  But I have been to an appraisal where the appraiser came out of the car with a clear chip on his shoulder, and only later was it revealed that he and the Real Estate Agent had a history and some disputes.  He came in below price and the homeowner was screwed in the process.

If the house fails to appraise, the sales contract (or Re-Fi or whatever) may be null and void.  This means, as a buyer, you have a way out (no financing) or you aren't going to get your home equity loan.  Both may be a blessing.

In some instances, the buyer, if they want the house badly enough, may come up with more down payment to lower the mortgage amount to a point where the bank is happy.  In other cases, the seller may have to lower their price.   Or both parties agree to meet in the middle.  Since, by this point, the house has been off the market for a few weeks, it makes sense to try to salvage the contract, rather than have to re-list the house and find a new buyer.

If you do re-list the house, do you have to disclose the low appraisal to a new buyer?  Good question, and I would talk to the Real Estate Agent in your State for specific advice.  To me, this does not constitute a "material defect" in the property like a leaky roof or asbestos, but rather a market valuation by one person.  But it never hurts to check local laws.

* * * 

As you can see, an appraisal is important, and yet means nothing.  It merely states what the market says a house is worth at the time a sale is made.   It is no guarantee of price or determination of underlying value.  It is just a number, puled out of the air.  And while the appraisal system may help validate the bank's decision to loan and your decision to buy or sell, in most instances, the appraised value merely bootstraps decisions that are already made.

Knowing how the system works can help you understand what an appraisal means and moreover, help you to make sure your appraisal will come in at the optimal price for your property.