Valuation Discrepancy

What is Valuation Discrepancy?

A valuation discrepancy in real estate refers to a notable difference between the price a buyer is willing to pay (or a seller is asking) for a property and the value determined by a professional appraisal. This gap can arise from various factors and significantly impact the feasibility and terms of a real estate transaction. For investors, understanding and managing these discrepancies is critical, as they directly influence financing, negotiation power, and ultimately, the profitability of an investment.

In a typical transaction, the lender relies on the appraised value to determine the maximum loan amount. If the appraisal comes in lower than the agreed-upon purchase price, the buyer is faced with an appraisal gap, requiring them to either cover the difference in cash, renegotiate the price with the seller, or potentially walk away from the deal.

Common Causes of Valuation Discrepancy

Valuation discrepancies are not uncommon and can stem from several sources, often a combination of market dynamics, appraisal practices, and property-specific nuances.

Rapidly Changing Market Conditions

• Hot Markets: In a seller's market with high demand and low inventory, bidding wars can drive prices above recent comparable sales, making it difficult for appraisals to keep pace.
• Cooling Markets: Conversely, in a declining market, appraisals may reflect recent lower sales that haven't yet been fully absorbed into seller expectations or buyer offers.
• Interest Rate Fluctuations: Rising interest rates can reduce buyer affordability, putting downward pressure on prices that appraisers may capture faster than market sentiment.

Appraisal Methodology Differences

• Comparable Sales Selection: Appraisers rely heavily on recent comparable sales (comps). Discrepancies can arise if the appraiser uses different or fewer comps than the buyer/agent, or if the chosen comps are not truly similar.
• Adjustments: Appraisers make subjective adjustments for differences between the subject property and comps (e.g., square footage, features, condition). These adjustments can vary.
• Valuation Approaches: While residential appraisals primarily use the sales comparison approach, commercial properties often incorporate income and cost approaches, which can yield different values depending on the data and assumptions used.

Property-Specific Factors

• Unique Features or Condition: Properties with highly customized features, unusual layouts, or significant deferred maintenance can be challenging to appraise accurately due to a lack of direct comparables.
• Recent Renovations: Extensive renovations might not be fully reflected in an appraisal if the appraiser cannot find recent sales of similarly updated properties in the immediate vicinity.
• Off-Market Sales: If a property was sold off-market or through a private transaction, the lack of public data can make it harder for appraisers to find relevant comps.

Impact on Real Estate Investments

A valuation discrepancy can have significant repercussions for real estate investors, affecting various stages of the investment process.

• Financing Challenges: Lenders typically base their loan-to-value (LTV) ratio on the appraised value, not the purchase price. A lower appraisal means a smaller loan, requiring the buyer to bring more cash to closing to cover the appraisal gap.
• Negotiation and Deal Closure: A significant discrepancy can derail a deal. It forces renegotiation, potentially leading to a price reduction, seller credits, or the buyer having to walk away if terms cannot be met.
• Investment Returns: Overpaying for a property due to an unaddressed valuation discrepancy can negatively impact an investor's cash flow, return on investment (ROI), and overall equity position from day one.

Strategies for Addressing Discrepancies

When faced with a valuation discrepancy, investors have several options to consider. Proactive due diligence and a clear understanding of market dynamics are key.

Step-by-Step Process for Resolution

1. Review the Appraisal Report: Carefully examine the appraisal for any factual errors, incorrect property details, or overlooked features. Ensure the comparable sales used are truly relevant and recent.
2. Provide Additional Comparable Sales: If you or your agent have identified stronger, more relevant comparable sales that the appraiser may have missed, present them to the lender for reconsideration. The lender may then ask the appraiser to review these new comps.
3. Renegotiate the Purchase Price: Approach the seller to see if they are willing to lower the price to meet the appraised value or a point closer to it. This is a common solution, especially in a cooling market.
4. Cover the Appraisal Gap: If the discrepancy is manageable and the investment still makes sense, the buyer can choose to bring additional cash to closing to cover the difference between the appraised value and the purchase price.
5. Challenge the Appraisal: While difficult, you can formally challenge an appraisal if you believe it contains significant errors or misjudgments. This typically involves submitting a rebuttal with supporting evidence to the lender.
6. Walk Away from the Deal: If the discrepancy is too large, the seller is unwilling to negotiate, and covering the gap is not financially viable, walking away may be the most prudent decision, assuming your contract includes an appraisal contingency.

Real-World Example: Residential Property

An investor, Sarah, makes an offer of $450,000 on a single-family rental property. She plans to put 20% down, needing a loan of $360,000. However, the appraisal comes back at $420,000. This creates a $30,000 valuation discrepancy.

• Original Offer: $450,000
• Appraised Value: $420,000
• Lender's Max Loan (80% LTV on appraised value): 0.80 * $420,000 = $336,000
• Required Down Payment (20% of appraised value): 0.20 * $420,000 = $84,000
• Appraisal Gap: $450,000 (offer) - $420,000 (appraisal) = $30,000
• Sarah's New Cash Requirement: $84,000 (down payment) + $30,000 (gap) = $114,000

Instead of bringing an extra $30,000, Sarah's agent successfully renegotiates with the seller to lower the price to $435,000. Sarah now only needs to cover a $15,000 gap ($435,000 - $420,000), making the deal feasible.

Real-World Example: Commercial Property

An investor, David, is looking to purchase a small office building for $1,200,000. His internal analysis, using a 7.0% capitalization rate on the projected Net Operating Income (NOI) of $80,000, suggests a value of approximately $1,142,857 ($80,000 / 0.07). The lender's appraiser, however, primarily uses the sales comparison approach, finding recent sales of similar buildings ranging from $1,250,000 to $1,300,000, leading to an appraised value of $1,275,000.

• David's Valuation (Income Approach): $1,142,857
• Appraised Value (Sales Comparison Approach): $1,275,000
• Purchase Price: $1,200,000

In this scenario, the appraisal is higher than David's offer and his internal valuation. While this might seem favorable for financing, it highlights a discrepancy in valuation methods and market perception. David must decide if the higher appraised value justifies his initial offer, or if his income-based valuation is more accurate for his investment goals, potentially leading him to negotiate a lower price closer to his calculated value, even with a favorable appraisal.