Appraisals, Appraisers, and the Appraisal Contingency

UPDATED FOR THE MID 2023 MARKET SHIFT

From about mid 2020 through mid 2022 when the market shifted, many sellers would only accept offers without an appraisal contingency. That’s because it removes one more potential off ramp or point of renegotiation for the buyer. In other words, the deal is more solid.

So while the lender would still require the appraisal to establish the value of the collateral, the buyer has to purchase the home no matter what value the appraisal comes in at when there is no appraisal contingency. That is unless they wanted to default and potentially lose their earnest money deposit (aka good faith deposit or initial deposit).

Even though this practice is not as common now as it was a few years ago, it may not be gone forever. Nothing in Real Estate ever is. If rates drop down to the mid 5% range and inventory stays low, expect a more competitive market again.

One of the most common questions buyers have when they see "No Appraisal Contingency” in the counter offer or their agent advises them to offer it initially is “what exactly does that mean?”. (In the height of the 2020-2022 feeding fenzy many listing agents asked the buyers to waive the appraisal contingency right up front.)

Here’s what you need to know about appraisals, appraisers, and the appraisal contingency.

WHAT IS AN APPRAISAL?

An appraisal is an opinion of value of real property that is determined by an appraiser acting as a neutral third party. The emphasis in the prior sentence should be on “opinion” as often 2 appraisers will come up with 2 different values even using the same comps.

For most residential properties, an appraiser determines a property's fair market value based on the location, condition and recent sales of similar homes in the surrounding area. Income properties or historical properties may use other methods than the “sales comparison” (comp) methodology. Since by definition every parcel of Real Estate is unique, appraisers make adjustments to the comparable sales.

Appraisers are licensed and go through rigorous training. Not every appraiser is licensed at the same level. While the public most often thinks of appraisals in the context of a purchase / sale or refinance, appraisals are also done for other reasons such as to settle an estate or as part of a divorce proceeding.

WHY YOU NEED AN APPRAISAL

Unless you are paying cash and not obtaining any financing, the lender will require an appraisal of the subject property as collateral for the loan. If the property or loan amount is above $2M, the lender may require 2 appraisals. There are instances where the lender might do what is referred to as a “desk” appraisal meaning they don’t go inside the house but that its rare. Desk appraisals are often no more accurate than the AVMs - automated valuations you see from many websites and widgets.

Lenders will loan the lessor of the contract price or appraisal price based on the loan program and required loan to value requirement. As such, you will rarely see appraisals for purchases come in higher than the contract price. It is common for properties to not appraise at the sales price - what is considered an appraisal short fall.

WHAT IS AN APPRAISAL CONTINGENCY?

Unless waived, purchase contracts contain an “appraisal contingency” clause.

If the property does not appraise at the contract price and there is an appraisal contingency, the buyer can unilaterally cancel the contract, rebut the appraisal, or renegotiate the sales price.

The newest version of the CA Residential Purchase Agreement (RPA) does allow the buyer to stipulate an appraisal amount lower than the contract price.

For example, the purchase price may be $1,500,000 but the contract states that if the property appraises for less than $1,400,000 the buyer can cancel. While that is now an option it is a relatively new one and it remains to be seen whether it changes anything in competitive situations.

WHY DIDN’T THE APPRAISAL COME IN AT THE SALES PRICE?

Appraisers are fundamentally addressing a different question than buyers.

In forming their opinions, appraisers primarily* look at closed sales in a neighborhood in as most recent a time frame as possible. That means appraisals are backward looking.

Appraisers also have to "bracket" a property with sales above and below the subject property. You might ask how they find sales above the purchase price when prices are going up. They do that by making adjustments to other properties that may have sold for more. An appraiser will adjust down from there. (* if there aren't enough closed comps, appraisers will also look at what is in escrow and what is on the market but not give those sales as much weight.)

Buyers are looking at what they can buy today. In a seller's market, that is always going to be higher than the closed sales. Where the major disconnect occurs is that even the most recent closed sales reflect the market 30 days ago at a minimum and it's really more like 45 days. That's because there is the gray area while properties are in escrow and haven't yet closed. Conversely when prices are going down, recent comps may be beneficial in that they could be at higher prices than the property you are trying to buy. Part of the standard appraisal form will note the direction prices are generally moving in.

CAN I DISPUTE THE APPRAISAL?

The technical term is “rebut” and yes, there can be an appraisal rebuttal which will be prepared by either the lender or the buyer’s agent.

Most appraisal rebuttals are not successful unless the appraiser used an inappropriate comp or missed a relevant one. But it is always worth giving it a try.

DRIVE BY APPRAISALS

There should probably be a better name for these - particularly in Southern CA. A drive by appraisal means that the appraiser does not come in the home, only confirms that it exists. For some properties, the value is entirely evident without seeing the interior. For others, the algorithms can readily determine the price.

A concern with these kinds of appraisals would arise where there have been a lot of updates internally adding to the value of the property and those would have to be really seen by the appraiser to establish value.

BEST PRACTICES FOR BUYERS

No matter how competitive the market, buyers should only do what they are comfortable with and what fits within their budget - even if it makes it more difficult to find a home.

If you are stretching your downpayment and are at your maximum debt to income ratio (DTI), you should not considering waiving this contingency - it might lead to a loss of your earnest money deposit (EMD).

If you are putting down more than 20% for a loan program that only requires 20% down or if you have extra cash reserves, then you can consider waiving this contingency.

What some buyers do is to use their cash reserves to make up the appraisal shortfall and then wait 6 months of so for the values to go up and then do a cash out refi or get a HELOC.

WHERE TO CHECK YOUR OFFER TO MAKE SURE YOU HAVE AN APPRAISAL CONTINGENCY

In the current form of the CA RPA (6/22 revision), the appraisal contingency is in L(2) of the grid. Check that carefully to make sure that there is enough time to get the appraisal done (the default is 17 days) and that the correct boxes are checked. For other states or deals not using the standard RPA check with your agent.