Financing Residential Real Estate Lesson 9: Qualifying the Property

Introduction In this lesson we will cover: a lender’s perception of value, appraisal standards, the appraisal process, appraisal methods, and how to deal with low appraisals.

Lender’s Perception of Value In addition to qualifying the buyer, underwriter must qualify the property being purchased.  Is the property worth enough to serve as collateral for the loan?

Lender’s Perception of Value Evaluation of property for underwriting purposes is based on an appraisal. Appraiser analyzes property and issues objective estimate of its market value. Appraisal

Lender’s Perception of Value Widely accepted definition of market value: “The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.” Market value

Lender’s Perception of Value Lender uses property’s appraised value to determine how much money to loan with the property as security. Loan-to-value ratio expresses relationship between loan amount and property’s value. Appraised value and loan-to-value ratio

Lender’s Perception of Value LTV affects: Risk of default LTV and risk

Lender’s Perception of Value LTV affects: Risk of default  Lower LTV = larger downpayment  Borrower with large investment less likely to default. LTV and risk

Lender’s Perception of Value LTV affects: Risk of default  Lower LTV = larger downpayment  Borrower with large investment less likely to default. Risk of loss in case foreclosure required LTV and risk

Lender’s Perception of Value LTV affects: Risk of default  Lower LTV = larger downpayment  Borrower with large investment less likely to default. Risk of loss in case foreclosure required  Sale proceeds more likely to cover debt. LTV and risk

Lender’s Perception of Value LTV affects: Risk of default  Lower LTV = larger downpayment  Borrower with large investment less likely to default. Risk of loss in case foreclosure required  Sale proceeds more likely to cover debt. Lower LTV = Lower Risk LTV and risk

Lender’s Perception of Value Lenders tend to charge higher interest rates and loan fees on high-LTV loans.  Offsets additional risk for lender. LTV and cost of loan

Lender’s Perception of Value Lenders use LTVs to set maximum loan amounts.  Maximum LTV rules applied depend on type of loan. Maximum loan amount

Lender’s Perception of Value Maximum loan amount for transaction based on:  sales price, or  appraised value,  whichever is less. Maximum loan amount

Appraisal Methods Three ways to appraise real estate:  sales comparison method,  replacement cost method, and  income method.

Appraisal Methods Sales comparison method uses sales prices of comparables to estimate market value of subject property.  Preferred by appraisers. Sales comparison method

Sales Comparison Method Competitive market analysis (CMA) is informal version of sales comparison method of appraisal.  Used by real estate agents.  May use current and expired listings as well as sales. Appraisal is based on actual sales, not listings. Sales comparison appraisal vs. CMA

Sales Comparison Method Appraiser needs at least three good comparables. Identifying comparables

Sales Comparison Method Appraiser needs at least three good comparables. In choosing comparables, appraiser concerned with: date of sale, location of property, physical characteristics of property, terms of sale, and conditions of sale. Identifying comparables

Identifying Comparables More recent comparable sales provide more accurate reflection of current marketplace. Date of sale

Identifying Comparables More recent comparable sales provide more accurate reflection of current marketplace. Sales should be within past six months.  And if more than a few months old, may require adjustment for area price trends. Date of sale

Identifying Comparables More recent comparable sales provide more accurate reflection of current marketplace. Sales should be within past six months.  And if more than a few months old, may require adjustment for area price trends. In slow market, may have to use sales more than six months old and make adjustments.  But never more than a year old. Date of sale

Identifying Comparables Comparables should be from neighborhood where subject property is located. Location of sale

Identifying Comparables Comparables should be from neighborhood where subject property is located. If there aren’t any, appraiser can look elsewhere, in comparable neighborhoods.  Make appropriate adjustments. Location of sale

Identifying Comparables Comparable property should have physical characteristics similar to those of subject property. To indicate value of subject property, comparable’s price adjusted: Physical characteristics

Identifying Comparables Comparable property should have physical characteristics similar to those of subject property. To indicate value of subject property, comparable’s price adjusted:  down if subject lacks feature; Physical characteristics

Identifying Comparables Comparable property should have physical characteristics similar to those of subject property. To indicate value of subject property, comparable’s price adjusted:  down if subject lacks feature;  up if subject has extra feature. Physical characteristics

Identifying Comparables Appraiser must take into account influence terms of sale may have had on price paid for comparable.  Buyer may pay more for property if seller finances or pays points. Terms of sale

Identifying Comparables Appraiser must take into account influence terms of sale may have had on price paid for comparable.  Buyer may pay more for property if seller finances or pays points. USPAP requires appraiser to state whether market value estimate is stated in terms of:  cash,  cash-equivalent financing, or  other precisely defined terms. Terms of sale

Identifying Comparables A comparable reliably indicates value only if sale took place under normal conditions: sale between unrelated parties (arm’s length transaction); Conditions of sale

Identifying Comparables A comparable reliably indicates value only if sale took place under normal conditions: sale between unrelated parties (arm’s length transaction); both parties:  free of unusual pressure,  informed of property's qualities,  acting in own best interests; and Conditions of sale

Identifying Comparables A comparable reliably indicates value only if sale took place under normal conditions: sale between unrelated parties (arm’s length transaction); both parties:  free of unusual pressure,  informed of property's qualities,  acting in own best interests; and property on open market for reasonable time. Conditions of sale

Identifying Comparables If subject property is REO, appraiser should use only other REOs as comparables. REO: property bank-owned after foreclosure REOs usually less valuable than otherwise similar properties, due to:  vandalism and deterioration  difficulties of institutional sales Conditions of sale

Sales Comparison Method Appraiser rarely can find three homes exactly like subject property. Must make adjustments to account for differences in:  time,  location,  physical characteristics, or  terms of sale. Adjustments

Sales Comparison Method The more adjustments necessary, the less reliable the comparable is as an indication of subject property’s value. Adjustments

Sales Comparison Method Appraiser selects estimate of subject property’s value from within range established by adjusted selling prices of comparables. This process is called reconciliation. Reconciliation

Sales Comparison Method For most residential properties, appraiser must complete Market Conditions Addendum to the Uniform Residential Appraisal Report. Addendum gives lender picture of local housing market. Market conditions

Summary Sales Comparison Method  Comparable sales  CMA  Date of sale  Location  Physical characteristics  Terms of sale  Conditions of sale  Adjustments  REO  Market Conditions Addendum