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Recently, I counseled my sister-in-law. She is selling her house and the appraiser was scheduled to visit.
Although this column is commercial real estate focused, some of the same appraisal principles apply – plus my associate suggested I write something about the process and how slight assumption variations can cause wide swings in value.
So to all y’all out there with a bad number, here’s why.
Reason one. Lender review. Since the financial music stopped in 2008, banks have been very careful to ensure appraisers don’t have un-tethered reign. Consequently, appraisers are engaged by the lender – not the buyer or seller – and a strict review process is conducted once the appraisal is submitted. I’ve had appraisers assure me we were OK – only to have the review disagree.
Reason two. Rear view mirror. Comparable sales and leases are tantamount to a fair valuation – and are known in appraiser speak as the market approach. However, past history – done deals – only show you where you’ve been – not where you’re headed. In an up-trending market, a sale that occurred three months ago may dramatically understate the current conditions.
Reason three. Assumptions. Market approach – has a second cousin – the income approach. Necessary for a proper look are recent lease transactions and the capitalization rate investors are paying. You remember capitalization rate – or cap rates, right? – a percentage measure of the net income divided by the purchase price. Well, in order to get there, an appraiser must assume a lease rate – tough to do because lease comps are not readily shared by commercial real estate professionals and a cap rate. As a cap rate is a measure of risk – the higher the risk, the higher the cap rate – the rate used can swing a valuation dramatically. Simple math – Income of $100,000 with a cap rate of 4.5% yields $2,222,222. But increase the cap rate to 5% and we get $2,000,000 – a delta of almost a quarter million dollars.
Last year – in this space – I provided four solutions if find yourself on the short-end of a valuation. In case you missed it, you can quickly catch up by clicking this link. The punch line – Seller reduces the price, buyer ups his down payment, parties cancel the deal, and/or compromise.