Nuts and Bolts of Appraisals and the Appraisal Contingency

If you are buying or selling real estate, you may have heard the term “appraisal contingency“ thrown about by your real estate agent.  But do you really understand what it means?  Do you know how it affects you?  Whether you are buying or selling real estate, if the transaction is being financed, the appraisal contingency is very important.

Let’s back up a second. What is an appraisal?  Well, when you engage a lender to finance your transaction, they will typically order an appraisal to determine the value of the property you are purchasing. The actual appraisal is handled by a third-party company. Neither your loan officer nor your bank is personally handling the appraisal.

What does the appraisal entail?   Well, once the appraisal is ordered, an appraiser will be sent out to look at your property. Usually the appraiser will not only go inside and look around, but also evaluate the exterior of the property. Oftentimes appraisers will ask a lot of questions about various facets of the property.  Many appraisers are very detailed — they want to know the age of the various elements of the home, what upgrades were done, etc. They also want to make sure there is no overt issue.  For example, they want to know if there are missing or broken appliances, bathrooms missing plumbing fixtures, or kitchens with bare walls and no cabinetry.  Occasionally you may have an appraiser that just does a drive-by appraisal and/or pokes around the outside, but most appraisers do go inside and take a look around the home. Additionally, appraisers evaluate other relevant information about the property. For example, they will look at the values of other similar homes nearby that closed recently.

After the appraiser is done with the evaluation, he will prepare an appraisal and assign a value to the property. That value could be equal to, more than, or less than the purchase price of the home. Let’s evaluate each of these situations individually:

1.  The appraised value is equal to the purchase price. If this is what happens, everyone is satisfied.  The lender will continue to process the file and everything will move along.

2.  The appraisal is more than the purchase price. In this scenario, the buyers are typically ecstatic. They are buying property for less than what the seller thinks it is worth.  They are building in additional equity right at the beginning. You would think that the sellers would be upset that they are selling the property for less than what it is worth, but this is not usually the case. Why? Because the sellers seldom know what the appraised value actually comes out to.

3.   The appraisal is less than the purchase price. In this situation, no one is happy. The seller is definitely not happy because basically, the seller has just been told that his home is not worth what he thought it was worth, and that the buyer’s bank is not going to loan based on the purchase price. Often times in this situation, the buyer goes back to the seller and asks him to reduce the purchase price.  Sellers don’t like to take less money — no surprise there.  But if the seller does not agree to drop the price, the buyer may walk away.  Sometimes the buyer badly wants the home and buys it at the full purchase price despite the low appraisal.  This, of course, makes the buyer unhappy. Other times the parties reach an agreement somewhere in the middle. The buyer pays more than what the property is worth, the seller takes a bit of a haircut, and the bank still does the loan, but only lends based on the appraised value, not the purchase price.

What does it mean for a bank to do the loan based on the appraised value? Let’s take an example. Let’s say you are buying a home for $100,000 with 20% down, but it only appraises to $90,000.  For the sake of this example, let’s agree that the seller refuses to reduce the purchase price but the buyer wants the house desperately and is willing to pay $100,000 for it anyway.  In this case the typical bank will still do the loan with 20% down, but they will base it on the appraised value of $90,000, not the purchase price of $100,000.  Therefore the buyer will end up borrowing less (in this situation the buyer will borrow $78,000 instead of the original $80,000).  The buyer’s down payment will also be less, because it will be 20% of $90,000 instead of 20% of $100,000. So the buyer will make a down payment of $18,000.  However, the buyer will also need to bring in the difference between the purchase price and the appraised value.  Since the difference between the purchase price and the appraised value is $10,000, the buyer will need to bring those funds into closing. This will be in addition to the $18,000 down payment. So now, the buyer is bringing in $28,000 because of the lower appraisal. Had the property appraised to $100,000, the buyer would only need $20,000 at closing.

This is a rather simplistic example, and in reality, sometimes the appraisal is a few thousand dollars short and sometimes it could be short a lot more than that. I’ve had deals in the six-figure range where the appraisals are $60,000 or more short. That’s a lot of money on a $750,000 house.

So now that you know the nuts and bolts, what is the actual appraisal contingency?

The appraisal contingency is language which is typically added to the contract by the buyer’s attorney, allowing the buyer to negotiate the purchase price in the event the appraisal is low.  The appraisal contingency allows the buyer to simply walk away from the transaction and receive a refund of his or her earnest money in the event no agreement is reached on the new purchase price. This is extremely important because the buyer could easily be in a situation where he does not have the cash to make up the difference between the appraised value and the purchase price, functionally making it impossible for him to proceed, but at the same time opening him up to a very angry and potentially litigious seller, as well as the loss of his earnest money.

Most residential properties in the Chicagoland area are bought and sold using the same one or two form contracts. It is important to know that these contracts do not include an appraisal contingency. The buyer must seek competent real estate counsel to ensure that this provision is included in the attorney review process.