Why Real Estate Appraisals Suck… and Why You Should Care

As a financial analyst and CFO, I’ve seen a lot of real estate transactions.  But not until recently did I appreciate how important the real estate appraisal process is … and how screwed up it is.

It used to be that the appraisal process was a joke: a pure formality as the banks competed to sell you a mortgage.

Not any more.  Anyone buying or selling real estate — for business or personal use — should know that the new rules have given appraisers narrow guidelines for valuation calculations, resulting in broad powers to squash your real estate deal.

If you know how real estate appraisals work, skip ahead. For those new to the process of determining the value of a property by comparing it to other properties that have recently sold (called “comps” or “comparable sales”), here’s the basics.

HERE’S HOW IT SHOULD WORK

There are generally 4 columns on a real estate appraisal calculation. The first contains details about your property (called the “subject property”). Column 2 has all the details about the first comparable recent sale. Column 3 has the second comp’s details; etc. The details of each property include age, condition, square feet, as well as number of rooms and bathrooms, the surrounding neighborhood, and rental income generated (as may be appropriate for commercial transactions).

In each row (going across the columns) the appraiser lists the value adjustment, positive or negative, that compensates for the physical differences between a comparable recent sale and your property. So let’s say that Comp #1 has one more bathroom than does your property. In the row for bathrooms, the appraiser might subtract $10,000 for the bath — reducing the price of Comp #1 to show what it would be worth if it did not have that extra bath (and thus was more like your property).

This method of subtracting value for things that are better than your property and adding value to things that are less desirable, makes the Comps a closer estimate to the value of your building.

In the end, you will see 3 comps priced relatively close to each other, and the appraiser will take a weighted average to determine the value of your home or property.

HOW IT ACTUALLY WORKS

In theory, the real estate appraisal process works great. In practice, however, I find it both arbitrary and blatantly wrong for 3 reasons:

1. CONDITION:
   When you walk through a million-dollar custom home, you know that the materials used are not the same as in the starter home down the street. Granite counter-tops have more value than Formica. And Viking appliances are worth more than Kenmore.But appraisers rarely give credit for those differences. They try to pick homes that look similar, but once the house makes the list as a “comparable” property, there is no value assigned for upgrades and finishes.
2. AGE:
   When does something go from being “old and cheap” to being “historic and expensive”? My client’s appraiser compared an authentic factory loft (built by renovating a 1920’s factory building) to a brand new loft style condominium, which was built to look old and industrial.The appraiser judged the new construction to be more valuable than the unique and historic factory lofts. And so, the subject property was penalized for being almost 100 years old.To make matters worse, the appraisal ignored the fact that the authentic loft renovations were completed in the 1990’s and the subject property had been given a complete makeover again in 2015. The age of the underlying brick building was the only thing that mattered.
3. SQUARE FOOTAGE:
   This is the real deal killer. Pay attention to this closely. In the neighborhood of my client’s subject property, condos were selling for $250 to $300 per square foot. This is generally true no matter how large or how small. A 600 square foot efficiency loft was priced at $150,000 — or $250 per square foot. Likewise, a 3,000 square foot 2 bedroom condo was listed for $750,000 — also $250 per square foot.However, when doing the comps, the appraiser “adjusted” the price of the comps using just $83 per square foot. You read that right. When the size of the comps is smaller than the subject property, the industry practice is to use just 30% of the square foot price to adjust the value.

DO THE MATH

With these three issues in plain sight, imagine the impact on my client’s deal: a 100 year old factory loft with 2,500 square feet was being compared to recent sales of a new, 1,500 square foot condo down the street.

• There was no adjustment for my client’s gourmet kitchen, Jacuzzi tub, high-end light fixtures, or exposed brick walls
• My client’s industrial conversion loft appraised to be less valuable than the “fake” but similar-looking new construction — by almost $100 per square foot!
• Although the property was 1,000 square feet larger than the comp, which sold for $250 per square foot, it was given only $83,000 adjustment (for space that was nominally worth $250,000 additional)

In the end, the real estate appraisal concluded that the property was worth almost 15% less than the previously agreed contract price for my client’s property.

Fortunately, some quick and friendly negotiation helped my buyer and seller close the deal anyway. But an appraisal at 15% less than the contract price could have ruined the day: Some sellers would have balked at lowering their price; some banks would not be able to write a mortgage on such a property; and some buyers would not have been able to come up with the extra money to close the gap between price and value.

It was a hard lesson to learn. Appraisals often get laughed off because they almost always seem to confirm the negotiated contract price. So when you find one that screws up the deal (and discounts the best aspects of the sale property) be ready to argue the math!

Want to talk valuation of your next deal?  Call FUSE anytime.

David

photo credit: arbyreed Three Houses on Boardwalk via photopin (license)