Regarding appraisals, what does the “lessor of appraised value or purchase price” mean? The regulatory guidance refers to this a little differently as “lessor of the actual acquisition cost or the estimate of value.” This article will help you understand what lenders are talking about and why they see this as an important distinction. Banks are required by FDIC Part 365 Real Estate Lending Standards and the Federal Interagency Appraisal and Evaluation Guidelines to evaluate any real estate collateral following certain standards of evaluation. So, what are banks looking for in appraisal estimations verses purchase price? More importantly, why it can be a deal killer? What can you do about it when the lender doesn’t see enough value in your commercial property?
Lenders and regulators have the same goal really in this lending concept. They are looking to reduce their credit risk in case of a loan default. If they lend more than the property is worth, they could suffer a larger loss when they foreclose and liquidate the property. So, they take the more conservative approach and use the lower value of the purchase price or appraised value.
Here’s an example to illustrate.
Let’s say you’ve placed a warehouse property under contract for $2,000,000 and the bank’s appraiser values it at $2,250,000, the bank can consider a loan amount of up to 60% of the $2,000,000 purchase price (because it’s the lesser value), or $1,200,000. The $1,200,000 equals only 53.5% of the appraised value. But since the Bank takes the lesser value of purchase price or appraised value, it uses the purchase price to calculate the maximum loan amount. By using the lesser value, the Bank is funding $150,000 less on the property. Why is this? Because if they had used appraised value you would be able to borrow $1,350,000 (60% of $2,250,000) instead of $1,200,000. This can be frustrating if the economics of the deal are sound, the economy is growing, commercial property values are increasing and you are confident that the market supports the appraised value. But the deal is still doable.
But what if the appraised value came in below the purchase price? Let’s say the appraisal valuation was $1,750,000. Ouch, that would mean the bank’s maximum loan amount would be only 1,050,000 (60% of $1,750.000). Or $150,000 less than if they had used the purchase price. So if you still want to buy the property the bank will be asking you to come up with an additional $150,000 at closing because they only lend 60% based on the lower of purchase price or appraised value. This can be frustrating because it will require more cash to close. The additional cash will reduce the cash on cash return as well. If the economics of the deal are sound, the economy is growing, commercial property values are increasing and you are confident that the market supports the appraised value that is a real disappointment. But, if you have the additional cash, the deal is still doable.
How to increase the appraisal’s estimate
There are a couple ways you can help the lender resolve a low appraisal estimate. The lender would really like to approve your loan. So work with them. Review the appraisal and look closely at the comparable properties (“comps”). Make sure the comps are fair and closely match your property. Look at the discount rate the appraiser used in calculating the discounted cash flows on your property. Review the comparable rents, locations, how old the buildings are. Point out any weaknesses in the appraisal report that lowers your commercial property’s value. You know your property better than anyone and know the strengths and weaknesses. Help the appraiser and lender understand your property better to help calculate a higher estimate of the property’s value.
So what if the deal isn’t doable with this lender? You paid for the appraisal and they are expensive! So, ask for it– its your right and take it to another lender. Lenders can accept appraisals ordered by another financial institution. So don’t let it stop you. The main requirement is that the appraisal was ordered in good faith by a lender, has the lender’s name on it– not your’s as the borrower.
Remember, when you are applying for a loan with a regulated financial institution, know that they will use the lower value. If you run into this problem, if you and lender cannot resolve the valuation with the appraisal, give us a call us. We have lenders who will lend based on the the higher of appraised value or purchase price.