How Do Appraisals Work?

One of the most important steps of the escrow process for a successful real estate transaction is the appraisal.  Often, it is the most suspenseful step leaving both buyers and sellers (and their agents) on pins and needles for a couple weeks.  Whether or not the buyer has an appraisal contingency in their accepted offer, the lender providing the funds will still require an appraisal. In fact, it is not uncommon for even a cash buyer to hire their own, independent appraiser, to weigh in on the value of the home before completing the purchase.

But how do these appraisers go about assessing something so subjective as the market value of a home? Ultimately, isn't any asset worth what someone is willing to pay for it?  While it is difficult to put a single number on the value of a home in a market that is constantly in flux, banks must be sure they are lending money on an asset that protects their investment and buyers want that extra confirmation that they aren't getting ripped off.  

Here's a brief overview of how real estate appraisals work in California:

1. Selection of an Appraiser: The lender usually orders the appraisal and will hire a state-licensed or certified appraiser. California has strict regulations governing appraisers, requiring them to have appropriate education, experience, and to pass a state examination.  The appraisers are independent and are not on the payroll of the bank This is to avoid fraud.

2. Property Inspection: The appraiser physically visits and 'inspects' the property. This is not to be confused with a general home inspection in which the property is scrutinized from top to bottom for hours looking for problems. During the appraisers 'inspection,' the appraiser will take note of the property's size, condition, function, and quality of its fixtures in a much more cursory way taking usually under an hour.  They'll also assess the neighborhood and any recent updates to the home.

3. Comparative Market Analysis (CMA): The appraiser will look at recent sales of similar homes in the area. These "comps" (comparables) are recently sold properties that are similar in size, condition, location, and amenities. By comparing the subject property with these recent sales, the appraiser can determine a market value.

4. Additional Methods: Depending on the property and situation, appraisers might also use:

   • The Cost Approach: This estimates the value by figuring out how much it would cost to replace the property (less depreciation).
   • The Income Approach: This is mainly used for investment properties and is based on potential income generation.

5. Report Compilation: Once all data is collected, the appraiser will compile an appraisal report. This report will provide a detailed explanation of how the appraiser determined the value of the property. It will include data on comparable sales, photos of the property, a sketch of the property, square footage calculations, and more.

6. Review by the Lender: Once the lender receives the appraisal report, they'll review it to ensure it meets their requirements. If the appraised value comes in lower than the sale price or the amount requested for the loan, this could pose an issue for the borrower. The lender might not approve the loan, or the borrower might need to make up the difference.

7. Appraisal Contingency: In California, purchase contracts often include an appraisal contingency, which means that if the home doesn't appraise for the purchase price, the buyer can back out of the deal without penalty.

8. Rights of the Borrower: Under federal law, the borrower has a right to receive a copy of the appraisal report.

It's important to remember that an appraisal is an opinion of value, albeit an educated one based on specific methodologies. Two different appraisers might come up with slightly different values for the same property. However, the processes and standards they adhere to are designed to ensure as much accuracy and objectivity as possible.

I'm often asked how the appraiser, 'happens' to come up with the exact sale price of the house more often than not.  Buyer's often assume, understandably, that the appraisal would be done blind, without knowing the actual contracted sale price.  However, this is not the case.  In reality, the appraiser is aware of the sale price and is basically being asked if that number is justified based on the market data.  Any while they usually determine that it is, it is not uncommon for them to determine that the sale price is a bit too high or too low. When they do not confirm the sale price, additional reviews are done to make sure their assessment is valid.

While that process may seems suspect, it does make intuitive sense.  The best indicator of the value of a home which is fairly and properly marketed is what someone is willing to pay for it.  For an appraiser to disregard the actual sale price of that home would be to ignore the most critical indication of it's current market value.