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© 2009 Rockwell Institute
Financing Residential Real Estate
Lesson 9:
Qualifying the Property
Introduction
In this lesson we will cover:
la lender’s perception of value,
lappraisal standards,
lthe appraisal process,
lappraisal methods, and
lhow 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 serveas collateral for the loan?
Lender’s Perception of Value
Evaluation of property for underwriting purposes is based on an appraisal.
lAppraiser 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.
lLoan-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:
lRisk of default
LTV and risk
Lender’s Perception of Value
LTV affects:
lRisk of default�Lower LTV = larger downpayment�Borrower with large investment less likely
to default.
LTV and risk
Lender’s Perception of Value
LTV affects:
lRisk of default�Lower LTV = larger downpayment�Borrower with large investment less likely
to default.
lRisk of loss in case foreclosure required
LTV and risk
Lender’s Perception of Value
LTV affects:
lRisk of default�Lower LTV = larger downpayment�Borrower with large investment less likely
to default.
lRisk of loss in case foreclosure required�Sale proceeds more likely to cover debt.
LTV and risk
Lender’s Perception of Value
LTV affects:
lRisk of default�Lower LTV = larger downpayment�Borrower with large investment less likely
to default.
lRisk 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 Standards
Accurate appraisal is an essential element of loan underwriting.
lIf property overvalued:
�loan amount larger than it should be, and
�lender’s risk of loss is greater.
Appraisal Standards
In 1989, after S&L crisis, Congress passed Financial Institutions Reform, Recovery, and Enforcement Act.
�Based on FIRREA requirements, states passed appraiser licensing and certification legislation.
FIRREA
FIRREA
Appraisals used in “federally related” loan transactions must be:
�prepared by state-licensed or state-certified appraisers
�in accordance with Uniform Standards of Professional Appraisal Practice
Rules for federally related loans
FIRREA
Federally related loan is one made by bank or savings and loan association that is regulated or insured by federal government.
Rules for federally related loans
FIRREA
Federally related loan is one made by bank or savings and loan association that is regulated or insured by federal government.
�Exemption for loans less than $250,000.
Rules for federally related loans
FIRREA
Federally related loan is one made by bank or savings and loan association that is regulated or insured by federal government.
�Exemption for loans less than $250,000.
lSome states have made licensing and certification mandatory for all appraisers.
Rules for federally related loans
Appraisal Standards
In spite of FIRREA reforms, inflated appraisals appear to have played significant role in creating mortgage crisis.
Mortgage crisis
Appraisal Standards
In spite of FIRREA reforms, inflated appraisals appear to have played significant role in creating mortgage crisis.
New laws and regulations intended to:
limprove accuracy of appraisals, and
lmake appraisers more independent, less influenced by lenders and brokers.
Mortgage crisis
The Appraisal Process
Appraisal process generally involves these steps:
1. Define the problem.
2. Determine scope of work.
3. Collect and verify data.
4. Analyze data.
5. Determine site value.
6. Apply appropriate appraisal methods.
7. Reconcile results.
8. Issue report.
The Appraisal Process
In this step, appraiser identifies property to be appraised (subject property).
Appraiser also:
¡determines purpose of appraisal, and
¡specifies “as of” date.
Define the problem
The Appraisal Process
Scope of work includes:
¡ information needed
¡ type of analysis required
¡ tasks involved
Determine scope of work
The Appraisal Process
Data required depends on what type of property is being appraised.
Two general categories of data:
çGeneral data
çSpecific data
Collect and verify data
The Appraisal Process
General data – information about factors outside subject property that affect property’s value.
May include:
çregion’s economy, and
çneighborhood information.
Collect and verify data
The Appraisal Process
Specific data – information about subject property.
May include:
çsite,
çhouse, and
çother site improvements.
Collect and verify data
The Appraisal Process
Analyzing the data means judging the relevance of each piece of data collected.
Analyze data
The Appraisal Process
Site valuation: estimating value of subject property excluding value of any improvements.
Vacant land:
Site value = Property value
Improved property:
Site value+ Improvement value
Property value
Determine site value
The Appraisal Process
An appraiser may apply up to three different appraisal methods.
�Each method provides a separatevalue indicator.
Apply appraisal methods
The Appraisal Process
In reconciliation, appraiser weighs value indicators and decides on final estimate of property’s market value.
Reconcile results
The Appraisal Process
Last step is to prepare appraisal report, which presents value estimate and summarizes supporting data.
Issue appraisal report
The Appraisal Process
As a general rule, appraisers gather data about a property through in-person inspection.
Property inspection
The Appraisal Process
As a general rule, appraisers gather data about a property through in-person inspection.
But sometimes lender considers drive-by appraisaladequate.
lAppraiser pays a brief visit to property after gathering info from other sources.
Property inspection
The Appraisal Process
As a general rule, appraisers gather data about a property through in-person inspection.
But sometimes lender considers drive-by appraisaladequate.
lAppraiser pays a brief visit to property after gathering info from other sources.
lDrive-by appraisals less common since mortgage crisis.
Property inspection
Summary
Value, Standards, and Appraisal ProcessÄMarket valueÄLoan-to-value ratio (LTV)ÄMaximum loan amountÄFIRREAÄFederally related loan transactionÄUSPAPÄScope of workÄGeneral and specific dataÄSite valuationÄDrive-by appraisal
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.
lAppraisal 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:
ldate of sale,
llocation of property,
lphysical characteristics of property,
lterms of sale, and
lconditions 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.
lSales should be within past six months.
�And if more than a few months old, mayrequire adjustment for area price trends.
Date of sale
Identifying Comparables
More recent comparable sales provide more accurate reflection of current marketplace.
lSales should be within past six months.
�And if more than a few months old, mayrequire adjustment for area price trends.
lIn 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.
lUSPAP 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:
lsale 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:
lsale between unrelated parties (arm’s length transaction);
lboth 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:
lsale between unrelated parties (arm’s length transaction);
lboth parties:�free of unusual pressure,�informed of property's qualities,�acting in own best interests; and
lproperty on open market forreasonable time.
Conditions of sale
Identifying Comparables
If subject property is REO, appraiser should use only other REOs as comparables.
lREO: property bank-owned after foreclosure
lREOs 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:
çtime,
ç location,
çphysical characteristics, or
çterms 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
ÄComparable salesÄCMAÄDate of saleÄLocationÄPhysical characteristicsÄTerms of saleÄConditions of saleÄAdjustmentsÄREOÄMarket Conditions Addendum
Appraisal Methods
Replacement cost method is based on premise that a property’s value won’t exceed cost of replacing it.
Replacement cost method
Replacement Cost Method
Step 1: Estimate cost of replacingbuilding and any other improvements on property.
Three steps
Replacement Cost Method
Step 1: Estimate cost of replacingbuilding and any other improvements on property.
Step 2: Estimate and deduct any accrued depreciation.
Three steps
Replacement Cost Method
Step 1: Estimate cost of replacingbuilding and any other improvements on property.
Step 2: Estimate and deduct any accrued depreciation.
Step 3: Add value of lot to depreciated value of improvements.
Three steps
Replacement Cost Method
Replacement cost
How much it would cost to construct a new building with equivalent utility.
Estimating replacement cost
Replacement Cost Method
Replacement cost
How much it would cost to construct a new building with equivalent utility.
Reproduction cost
How much it would cost to construct an exact replica of the building, at current prices.
Estimating replacement cost
Replacement Cost Method
Comparative unit method is simplest way to estimate replacement cost.
¡Also called square foot method.
lAnalyze cost per square foot for recently built comparables.
lMultiply estimated cost per square foot by number of square feet in subject building.
lMake appropriate adjustments.
Estimating replacement cost
Replacement Cost Method
Depreciation = Loss in value from any cause
lValue can be lost because of:
¡physical deterioration,
¡ functional obsolescence, or
¡external obsolescence.
Estimating depreciation
Estimating Depreciation
Physical deterioration
Includes wear and tear, damage, and structural defects that reduce the value of the property.
Physical deterioration
Estimating Depreciation
Functional obsolescence
Loss in value due to inadequacies such as poor design or outmoded features.
¡Also called functional depreciation.
Functional obsolescence
Estimating Depreciation
External obsolescence
Loss in value due to factors outside the property.
lDeteriorating neighborhood, zoning changes, or poor access to schools, shopping, or employment centers.
¡Also called economic obsolescence.
External obsolescence
Estimating Depreciation
Depreciation is either:
�CurableCost of correcting could be recovered in sales price when property sold.
Curable or incurable
Estimating Depreciation
Depreciation is either:
�CurableCost of correcting could be recovered in sales price when property sold.
�IncurableCost of correcting too much to recoverwhen property sold.
Curable or incurable
Estimating Depreciation
lPhysical deterioration or functional obsolescence may be curable or incurable.
�Curable depreciation due to physicaldeterioration is often called deferredmaintenance.
lExternal obsolescence is always incurable.
�Outside property owner’s control.
Curable or incurable
Estimating Depreciation
Appraisal submitted to underwriter in one of two ways:
¡ “as is”
¡ “subject to”
As is or subject to
Estimating Depreciation
“As is” appraisal reports deferred maintenance, but final value estimate is market value of property in its current condition.
As is or subject to
Estimating Depreciation
“Subject to” appraisal’s value estimate represents what market value would be if deferred maintenance were corrected.
As is or subject to
Replacement Cost Method
Last step in replacement cost method:
lAdding value of land to depreciated value of improvements.
�Land value is estimated by salescomparison method.
Adding land value
Summary
Replacement Cost Method
ÄReplacement costÄReproduction costÄComparative unit (square foot) method
ÄPhysical deteriorationÄFunctional obsolescenceÄExternal obsolescence
ÄCurable and incurable depreciationÄDeferred maintenanceÄAs is or subject to
Appraisal Methods
Income method is based on the idea that a relationship exists between the income a property generates and its value.
Income method
Appraisal Methods
Income method is based on the idea that a relationship exists between the income a property generates and its value.
For single-family residential rental properties, appraisers use simplified version of income method called gross income multiplier method.
Income method
Income Method
In gross income multiplier method (a.k.a. gross rent multiplier method), appraiser looks at relationship between rental property’s income and price paid for property.
Gross income multiplier method
Gross Income Multiplier Method
Appraiser may use either annual or monthly multipliers.
Annual multiplier =
Sales price ÷ Annual rental income
Monthly multiplier =
Sales price ÷ Monthly rental income
Annual or monthly multipliers
Gross Income Multiplier Method
Appraiser applying gross income multiplier method locates at least three or four comparables.
�More comparables may be needed,depending on market.
lCalculates annual or monthly multipliers for the comparables.
lUses comparables’ multipliers as basis for selecting multiplier for subject.
Choosing appropriate multiplier
Gross Income Multiplier Method
Finally, appraiser multiplies subject property ’s rent by the chosen multiplier to find the property ’s value.
Using multiplier to estimate value
Gross Income Multiplier Method
Appraiser should use subject property ’s economic rent to calculate value.
�Economic rent = rent the property could generate in current market if it were available.
�Contract rent = rent the owner is actually receiving.
Economic rent vs. contract rent
Appraisal Methods
Reconciliation: When applying more than one appraisal method, appraiser must analyze and interpret results to decide on final value estimate for subject property.
lEssentially the same process as reconciling adjusted values of comparables to arrive at value indicator in sales comparison method.
Reconciliation and final value estimate
Appraisal Methods
Final value estimate:
lNot an average of value indicator figures.
lAppraiser gives greater weight to more reliable value indicators.
�Sales comparison method most reliablefor residential property.
Reconciliation and final value estimate
Summary
Income Method and Final Value Estimate
ÄIncome methodÄGross income multiplier methodÄAnnual multiplier
ÄMonthly multiplierÄEconomic rentÄContract rent
ÄReconciliationÄFinal value estimate
Dealing with Low Appraisals
Low appraisal
An estimate of value that is below the price agreed upon by the buyer and the seller.
Dealing with Low Appraisals
Low appraisal
An estimate of value that is below the price agreed upon by the buyer and the seller.
�If sale contingent on financing, buyer may not have to complete the sale.
Dealing with Low Appraisals
Low appraisal
An estimate of value that is below the price agreed upon by the buyer and the seller.
�If sale contingent on financing, buyer may not have to complete the sale.
�Low appraisal would mean smaller loanand bigger downpayment.
Dealing with Low Appraisals
Possible solutions after low appraisal:
�Buyer pays over value.
�Seller lowers price to appraised value.
�Compromise price.
�Request for reconsideration of value.
Possible solutions
Dealing with Low Appraisals
Prevent low appraisal by helping seller price property correctly.
¡Perform careful CMA.
¡Price personal property separately.
Preventing low appraisals
Dealing with Low Appraisals
Perform a careful CMA
Agent needs to be familiar with the most comprehensive and accessible sources of information about sales and listings.
Preventing low appraisals
Dealing with Low Appraisals
Price personal property separately
Underwriting guidelines require appraisers to exclude value of personal property from final value estimate.
¡Value of fixtures is included.
Preventing low appraisals
Dealing with Low Appraisals
When appraisal comes in low:
¡Ask lender for information.
¡Evaluate appraisal.
¡Update CMA.
¡Submit request for reconsideration only if lender likely to grant it.
Request for reconsideration of value
Dealing with Low Appraisals
Ask loan officer for following information:
1. final value estimate,
2. value indicated by sales comparison method, and
3. addresses of comparables used by appraiser.
Request for reconsideration of value
Dealing with Low Appraisals
Some lenders have their own form for requests for reconsideration.
Otherwise, present your information in the same format used in “Sales Comparison Analysis” section of Uniform Residential Appraisal Report form.
Request for reconsideration of value
Dealing with Low Appraisals
Some lenders have their own form for requests for reconsideration.
Otherwise, present your information in the same format used in “Sales Comparison Analysis” section of Uniform Residential Appraisal Report form.
¡Write a cover letter and attach sales comparison analysis to it.
Request for reconsideration of value
Summary
Dealing with Low Appraisals
ÄLow appraisalÄFinancing contingencyÄCMA
ÄPersonal propertyÄFixturesÄRequest for reconsideration of value
Real Estate Finance Lesson 9 Cumulative Quiz
1. An appraiser in a residential loan transaction is concerned with a property's:
A. assessment value B. liquidation value C. market value D. use value
2. The principle of value that states that the maximum value of a property is determined by the cost of obtaining an equally desirable property is:
A. anticipation B. conformity C. contribution D. substitution
3. Lenders will base the loan amount on:
A. the appraised value B. the sales price C. the appraised value or sales price, whichever is less D. the appraised value or sales price, whichever is more
4. Which federal law requires appraisals used in federally related loan transactions to be performed by state-licensed or state-certified appraisers?
A. Fair Credit Reporting Act B. Financial Institutions Reform, Recovery, and Enforcement Act C. Real Estate Settlement Procedures Act D. Truth in Lending Act
5. Which of the following loans would be considered the least risky to a lender?
A. $80,000 loan amount for a $100,000 property B. $180,000 loan amount for a $200,000 property C. $255,000 loan amount for a $300,000 property D. $380,000 loan amount for a $400,000 property
6. Which of the following is the final step in the appraisal process?
A. Apply the appropriate methods of appraisal B. Define the problem C. Issue the appraisal report D. Reconcile the results to arrive at a final value estimate
© 2009 Rockwell Publishing 1
7. Which of the following is not one of the three basic methods of appraising real estate?
A. Income method B. Replacement cost method C. Sales comparison method D. Square foot method
8. A key difference between an appraisal and a competitive market analysis is that a CMA may use _____, while an appraisal may not.
A. current listings B. expired listings C. recent sales D. Either A or B
9. Which of the following is not one of the key factors in determining whether a recent sale is a suitable comparable?
A. Conditions of sale B. Cost of construction C. Date of sale D. Location of property
10. In a typical market, an appraiser should make adjustments to compensate for inflationary or deflationary trends when using a comparable that sold:
A. within the previous three months B. within the previous six months C. more than several months in the past, but less than one year D. at least one year in the past
11. A subject property has a hot tub. The comparable sale does not have a hot tub. A hot tub adds $5,000 in value to a property. The appraiser should:
A. add $5,000 to the sales price of the comparable B. add $5,000 to the value of the subject property C. subtract $5,000 from the sales price of the comparable D. subtract $5,000 from the value of the subject property
12. An appraiser finds it would cost $380,000 to construct an exact replica of the subject property. This is an example of:
A. depreciated cost B. replacement cost C. reproduction cost D. square footage cost
© 2009 Rockwell Publishing 2
13. An older house has problems with peeling paint and warped siding. This is an example of:
A. deferred maintenance B. external obsolescence C. functional obsolescence D. incurable depreciation
14. An example of external obsolescence would be:
A. a house with four bedrooms and only one bathroom B. a leaking roof C. lack of seismic retrofitting D. rising crime rates in the subject property's neighborhood
15. The gross income multiplier method is appropriate primarily when valuing:
A. a single-family residence used as a rental B. a 10-unit apartment building C. an office complex D. an owner-occupied single-family residence
16. The subject property rents for $1,500 per month. A nearby property rents for $1,450 and sold for $290,000. Another nearby property rents for $1,550 and sold for $310,000. What is the subject property's most likely value?
A. $290,000 B. $295,000 C. $300,000 D. $310,000
17. The process of analyzing value indicators from the various appraisal methods in order to arrive at a final value estimate is known as:
A. extraction B. interpolation C. reconciliation D. regression
18. If an appraisal comes in low, why is this likely to lead to the termination of the transaction?
A. A buyer may be reluctant to pay more for the property than it's worth B. A lender may not issue the loan because the property does not offer adequate collateral C. A seller may withdraw from the sale because the property was listed too low D. Both A and B
© 2009 Rockwell Publishing 3
19. If a low appraisal occurs, a real estate agent should approach this person to find out the final value estimate and comparables used:
A. appraiser B. loan officer C. seller D. closing agent
20. Including personal property in a purchase agreement is inadvisable because:
A. adding personal property will increase the sales price, while the appraiser will not include personal property in the appraisal
B. an appraiser will include the personal property in the appraisal, increasing the risk of a larger loan amount that the buyer can't qualify for
C. fixtures are never considered part of the real property D. it is a violation of the license law
© 2009 Rockwell Publishing 4