What Happens When the Appraisal Value of an Apartment Comes Back Lower than the Contract Price?
In the world of high-priced New York City real estate where apartment prices continue to command record-breaking prices, it is not uncommon for appraisals to be lower than the agreed upon sales price. Appraisals take place several weeks after the contract will have already been fully executed, so this generally puts the buyer of the property in a peculiar situation. Before we dive deeper into what actually happens when the appraisal shows a lower appraised value than the property purchase price, let’s explore the purpose of condominium and co-op appraisals and what they seek to accomplish.
Why are Appraisals Needed?
When a prospective apartment purchaser needs financing, they generally will submit mortgage pre-approvals along with their offer. Once an agreed upon sales prices has been negotiated between the purchaser and the seller, a contract of sale is drafted and reviewed by New York City real estate attorneys. Once the contract is executed, the property address and contract are passed along to the lender with which the buyer is working.
One of the first actions the lender will do is order an appraisal. The reason an apartment appraisal is necessary when borrowing money to finance the closing of the transaction is because the property needs to act as a form of collateral, should the borrower (apartment buyer) fail to pay the mortgage and foreclose on the property. If the bank recoups the apartment, it wants to make sure that the apartment is actually worth the money for which it was purchased.
By having an appraiser value the property, it helps the lender reduce its risk. Lenders will make their final decisions on whether they loan money to the apartment buyer not just on their credit, income and asset profiles but also on whether the appraised value matches or surpasses the purchase price. Additionally, due to the housing crisis and mortgage meltdown that took place in 2008, lenders are no longer able to send their own appraisers. Rather, the appraisers act as independent third parties. This is intended to encourage sustainable lending practices and prevent fraud and overextended borrowing on properties that are worth less than the mortgages that are taken out on them.
Appraisals are an Art, not a Science.
Each apartment in New York City is unique. Appraisers take many factors into account when they’re coming up with their pricing. Some of the things that they look for include:
Apartment location
Apartment size
Apartment finishes
Views vs. No Views
Which floor the apartment sits on
Building amenities
Condo or Co-Op
Neighborhood
Comps (comparable residences that have recently sold)
Comps are the easiest way for an appraiser to provide their expert opinion and draft up their report. However, sometimes comps don’t tell the whole story.
Appraisals are subject to the appraiser’s objectivity and subjectivity. If a buyer is seeking out a mortgage with two separate lenders, two independent appraisals will be ordered. Each appraisal will likely come back with slightly different valuations, which is reflective of the fact that there is a certain degree of subjectivity associated with the process.
What are Some Factors that Lead to Low Appraised Values?
In an ideal scenario, the appraisal will come back for the apartment at a price that is equal to or higher than the purchase price. However, this is not always the case. Here are several reasons that could result in lower than expected valuations:
Appraiser is not familiar with the neighborhood. Imagine an appraiser from Westchester County coming to Williamsburg, Brooklyn to value a property. There will be a level of disconnect. This sort of disconnect is a reality that needs to be appropriately managed.
Lack of knowledge of comparable units. An appraiser may see apartment comps that have sold for less but doesn’t realize that they were inferior finishes as compared to the property they valued. For instance, the subject property may have been renovated with a new kitchen and bathrooms, while other apartments in the building or neighborhood sold for less and were not renovated.
The neighborhood is gentrifying. When neighborhoods are going through gentrification, chances are that apartment values were significantly less in years prior. Some neighborhoods may not even have had condominiums or co-ops to compare against.
New development that has significantly higher valuations than neighboring properties. Buyers are willing to purchase newly developed condos at a premium. Without prior closed transactions to compare against, an appraisal for new development may come back lower. Despite properties being in contract with even higher valuations, these won’t count as comps.
Fire sale transaction recorded as a comp. If someone passed away or is going through hardship, they may be inclined to sell the property as quickly as possible at any price. This sale might come up as a comp.
Appraised Value Does not Equal Market Value.
When an apartment buyer sees the appraisal report and becomes aware that the appraised value came back at a lower price than what they are buying their apartment for, the initial reaction might be that they overpaid for the apartment. This is not the case. Appraisal values are subject to the anomalies referenced above.
What Happens if the Appraisal is too Low?
The buyer has numerous options at this point.
Get a second appraisal. The lender may allow the buyer to get a second attempt at hitting the right numbers. Additionally, the buyer may have already been going through the mortgage process with a second lender but held off on paying for the appraisal to see how the first one turned out. Now is the time to call the second lender and get the property checked out again. Also, one trick which works in new development prior to getting the second appraisal is waiting a few weeks for some other closings to take place first. This will increase the value of the comps. These comps may be closing with traditional lending or might even be all-cash buyers.
Ask for an exception. Did the appraiser miss some key details, such as the interior finishes or the building amenities? If the brokers (listing or buyer’s broker) can identify key oversights, the would-be buyer may be in a position to demand an exception. This might take a week and is no guarantee, but it is an opportunity.
Put more money down. If the buyer can cover the difference between the appraised value and the purchase price with cash, this is an easy solution that enables both parties to smoothly proceed with the transaction.
Renegotiate the deal. If putting a greater down payment on the apartment isn’t a viable option, and the lender is not flexible on the appraised value, your only other option short of killing the deal is to go back to the drawing board and see if the deal can be restructured. Several ways to restructure the deal include a combination of options:
Seller agrees to a price reduction of the apartment
Buyer puts more money down in return for the seller willing to also come down in the ask price, which enables both sides to effectively bridge the financing gap
Seller provides financing on the difference between the appraised value and the sales price, although this may overcomplicate the deal and may not work with the bank who is providing the bulk of the financing
Walk from the deal. If all efforts have been exhausted, then the only other solution will be to wind down the apartment transaction and cancel the contract. This of course has to be done through the guidance of the buyer’s and seller’s real estate attorneys. Also, the contract will have needed to include a financing contingency that allows the buyer to unilaterally void the deal if the financing cannot be achieved. Without this contingency in place, the buyer may be forfeiting their earnest money (down payment).