Appraisals are a critical component of the lending process. In any home sale/purchase transaction that requires financing, the lender will mandate an appraisal on the property. So what exactly is an appraisal?
Often confused, a home appraisal is a separate analytical report from the home inspection. An inspection identifies potential physical issues with the house to prevent costly repairs down the road. An appraisal is a third party expert opinion on the current value of a piece of property. Lenders rely on the appraisal report to ensure that they are not over-loaning on a property. In the event a borrower defaults on the mortgage and the property goes into foreclosure, the lender recoups the money it lent by selling the home. If the bank loaned above the value of the property, then the lender is unlikely to recoup their investment.
An appraiser is an independent and objective third party who does not have any financial stake in the transaction apart from his fee for performing the appraisal. Appraisers are state-licensed and work in regions and neighborhoods they are familiar with so they have an expert knowledge of any environmental or other concerns that may affect the value of a property. Typically, the homebuyer pays for the property appraisal when applying for a home loan and the cost varies greatly depending on the size of the home and the experience of the appraiser.
There are two basic methods of appraisal used for residential properties. First, there is the sales comparison approach whereby the market value of the subject property is determined via “comparable” analysis. The appraiser typically visits the home in question and obtains specific home information and statistics and then compares the data with “comps,” properties of similar kind in the same geographical area that have recently sold. The second method is the cost approach, which evaluates value by determining how much money it would require to replace the property if it were to be destroyed. This approach is more commonly used in evaluating new construction.
The appraiser gathers information for the appraisal report from a number of sources, but the process always begins with a physical inspection of the property inside and out. Additionally, the appraiser may look at county courthouse records and recent sales reports from the multiple listing service. The appraisal report typically includes:
- An explanation of how the appraiser determined the value of the property.
- The size and condition of the house and other permanent fixtures, along with description of any improvements that have been made and the materials used.
- Statements regarding serious structural problems, such as water damage and cracked foundations.
- Notes about the surrounding area, i.e. proximity to schools, new or established development, lot size, relevant aspects affecting desirability and resale, and so on.
- An evaluation of recent market trends of the area that may affect the value.
- A comparative market analysis that supports the appraisal including maps, photographs and sketches.
Next week we will discuss how to prepare for an appraisal and what happens if the appraiser returns a value lower than your contract price.