How to Read an Appraisal Report for your Investment Property – Video 1 & 2
Kathy Fettke: Welcome to the Real Wealth Investor Academy. This module will be on How to Read a Residential Appraisal report. We’ve got one of the best here with us today to walk us through it. Rich Paddock is a certified residential appraiser and senior partner of Paddock Appraisal Service Inc. in Modesto. Welcome, Rich.
Rich Paddock: Good afternoon.
Kathy: So glad you could be with us here. Now, you do a lot of education. Correct?
Kathy: Do you mostly train appraisers?
Rich: Usually training appraisers. A lot of times training realtors on how to read appraisals and understand the appraisal process.
Kathy: Very good. That’s what we want to do here today, but this is more for the investor to make sure that they’re getting something they can depend on, which wasn’t necessarily the case in 2005 and 2006. I don’t know that appraisers could do much warning that properties were overpriced because that’s not really your job.
Rich: No. We could project what the market was doing. The biggest issue is that the investors didn’t want to listen to it.
Kathy: Are you seeing that happen today?
Rich: Yes. Most appraisers that I deal with feel that we’re back in a bubble, but it’s a minor bubble that’s similar to the 1990s.
Kathy: Okay, but it could get worse?
Rich: Yes. We don’t see the big collapse like we did because we don’t see values going through the roof. Money is very inexpensive but not as cheap as it used to be.
Kathy: Okay. We’ve got this uniform residential appraisal report in front of us. You wanted it to be empty for a reason. I wanted to use a sample one, but you said, “No, that can be confusing”. We’ve got one that is blank. Where do we start here? What do we need to pay attention to on this page? [02:10]
Rich: For your listeners, let me lay out some ground work. The users of the uniform residential appraisal report have changed the format of the report and the content, so when an investor or a borrower reads a copy of an appraisal today, on it they’re going to see a lot of acronyms and computer code because Fannie and Freddie have decided to go the way of most companies where all of their product is web-based. As we go through the report, I’ll explain what a reader will see in terms of a narrative explanation but what they may also see in terms of a computer code and what that computer code actually means.
Kathy: Where do we start here?
Rich: I’m just going to start at the top is a box called the subject. That should include anything that’s relevant to the subject property: who owns it, who the borrower is, an assessor’s parcel number. Lenders like appraisers to put in the tax here and what the current taxes are or what the taxes may be. It’s really just a way to identify the property and what type of appraisal it is. Was is for a purchase, or re-finance or something else? You drop down the next box that’s where the contract is. That’s primarily for the lender that’s going to loan the money. They want to know did the appraiser read the contract and did that contract have any content that would influence the appraisal process. If it does, the lender wants the appraiser to put it in there.
For a borrower’s standpoint, the information on a contract, they are already aware of. That part of the appraisal is really not of importance to them.
Rich: The next box to the neighborhood, now we’re getting to the important part of the appraisal report. This is where it’s going to show up that an appraiser is not geographically competent to appraise in a specific area where either the borrower’s property is or the investor’s loan may be placed. If an appraiser is knowledgeable of the area– I’m going to assume that a borrower is reading this report and it’s for a house that they own, so they’re real familiar with the neighborhood. If the descriptions in that neighborhood section don’t match the borrower’s idea of what the neighborhood is, that’s a little red flag for the borrower or the reader of the report to come to the conclusion that maybe the appraiser doesn’t really know the market area that well, and the reader needs to be cautious from that point on.
Kathy: Now, where would you be able to notice that?
Rich: The narrative. You can ignore the checkboxes and the one unit housing that’s up in the upper right-hand corner and present land use. Those are going to vary, and those are statistical data that the appraiser gets. However, all appraisers will put a narrative description under neighborhood boundaries, and in that neighborhood boundaries, they are required to put specific items like Main Street is that on the north. South Street is on the east. Lee Street is on the south. The Southern Pacific rail line is on the left.They have to delineate the boundaries of the neighborhood.
The next line says neighborhood description. They describe what is in the neighborhood. Is it mostly single family homes? Is there some commercial? Does a river run through it? Is there a big park in the middle of it? Is there something that is detrimental or beneficial to the neighborhood that’s within those boundaries? That neighborhood also restricts the appraiser’s selection of comparable sales and listings.
The next line you go down to is market conditions, and that’s, again, narrative. A reader should be able to see what the appraiser’s opinion is of what is happening in the market. Is the market increasing in value? Is it increasing rapidly, and the appraiser should be stating that they’re seeing values go up 2% a month or 1% or in those lines. Is it falling? Is there something planned for the immediate area that’s going to affect the market conditions in that neighborhood? Like there’s a freeway that’s being surveyed that runs down the side of the neighborhood and is going to be an eight-lane major freeway going from a two-lane.
Kathy: Would an average appraiser know that?
Rich: Yes. If they’re geographically competent, they will know all that information for that neighborhood. A good appraiser not only follows what’s happening in a neighborhood, but they follow what’s happening in the city and the surrounding area in the county, so they should be aware of incoming transportation hubs, incoming major employers. Let’s say that Amazon is going to open a distribution center at the edge of the city and bring in 6,000 jobs. An appraiser that’s geographically competent and knows the area well is going to be aware of that information.
Kathy: Now, why is that? Do you subscribe to news feeds, or is it just word of mouth, or is it certain companies are better at really understanding these market conditions? Because that seems like a lot of information to have to stay on top of.
Rich: Most appraisers are detectives on a continuous basis. The good appraisers are always reading anything that they can find that can affect values in any fashion, negative or positive. Good appraisers will know about something that’s about to happen. In a neighborhood like I’m describing, if they are aware that there’s something in the general area that is changing, they’re going to zero down to this neighborhood and go, “Okay, will this affect this neighborhood? Will there be a change in traffic flow or traffic patterns or crime because of what’s about to occur?”
That’s been the problem in the past, an appraiser may have come from San Diego to Sacramento and completed an appraisal in Sacramento and has never read anything about what’s happening in Sacramento, even though it’s the capital of the state. That appraiser is liable to miss something that could adversely affect an investor’s portfolio or may not provide an accurate value of the property for a borrower. That’s the first section that has a lot of narrative that a reader can get a sense of, does the appraiser know what they’re talking about, and is the writing level that the appraiser uses indicate that the appraiser is somewhat educated and is not a clerk or somebody that’s just filling out the form for someone else to sign.
Kathy: That’s been a real issue these past few years. Hasn’t it?
Rich: Yes. When licensing came into effect in 1991 or 1992, you just had to be able to breathe to get an appraisal license. Government agencies that provide employment suggestions for individuals said, “Go get an appraiser license. You can make a lot of money. You don’t have to have education. You have to have some classes. You need to know what an appraisal is and how appraisals work”. There was no formal education. There was no time and grade, no work experience required. That no longer applies.
In today’s market, if an appraiser comes to your house or property, they’ve had anywhere from two to four years of formal education, usually have a bachelor’s degree of some kind. They’ve had to have anywhere from 2,500 to 4,500 hours of experience which is 2 to 4 years before they can get their license level. Appraisers today are very educated, except there’s a handful that came out of that 1990s period that still don’t quite have the education level, but they’re pretty rare now. Any questions on the neighborhood section?
Rich: Site, again, that just describes what is on the site for the property, removing all improvements like the house or garage or building or whatever. It’s just going to describe how the property is owned. Again, if the appraiser is knowledgeable and exercises due diligence, then they’re going to tell the reader what the zoning actually is and what can be used on that site.
If you’ve got a house that’s, let’s say, is 70 years old and the surrounding homes have all been converted to commercial, that’s zoning on that site probably is no longer residential. It’s commercial use. You can still sell it and use it as a residence, but it’s zoning has changed. An appraiser that knows their work is going to tell the reader, “This is what this is zoned”. The reader of the report, if it’s their property, that’s just another red flag. If the appraiser does not tell them that it’s what the correct zoning is, then the reader is going to go, “Okay, I’ve got some other issues.”
The appraiser will describe everything on the site too. Is there public utilities? Do they have a well? Do they have a septic? Are the well and septic typical for the area, or is water and sewer in the street and it should be hooked up? The appraiser will also be able to tell a reader if the property in a flood zone or not. Then it’s up to the reader to decide with this information, what they do with it. Any questions about the site?
Kathy: No. That’s great.
Rich: The improvement section, the next block is just going to describe the improvements. This general description of how many units are on the property, whether it’s attached or detached. Is it existing or is it under construction or proposed?
All appraisers are now required to define what type of home is on the site. If it’s a ranch style, craftsman, contemporary, eclectic, farmhouse style. Appraisers now have to determine that style of home, and that’s a Fannie and Freddie requirement. They tell the reader what year it was built, what its effective age is. The effective age is purely important for the reader, including the borrower because that’s the appraiser’s interpretation of how well the house has been maintained. If a house is 60 years-old but the effective age that the appraiser says is only 15 years-old, then a reader is going to interpret that the subject is equal to a house that is 15 years-old but has been maintained but never upgraded. They’re going to assume that the 60 year-old house has been upgraded to the type of amenities as a 15 year-old house would have in it.
The rest of the check boxes and fields in there just describe what the amenities of the home are. Type of roof, is it shake; composition shingle; concrete tile, clay tile; exterior walls, wood, stucco, so forth, all the way to the interior. Is it drywall? Is it plaster? Are the floors ceramic tiles, or are they sheet vinyl? Are they linoleum? Is there car storage?
The readers need to remember when they’re looking at appraisal that it is not designed for their benefit. It’s designed for someone to make a loan on the property, and so the details regarding the subject property are specific to that process. Some things that a reader may see in there they may disagree with, but the appraiser and lender have a “language code” that they determine between themselves what that code means. Sometimes those code words don’t make sense to a reader. It doesn’t reflect poorly on the appraiser or the content of the report. It’s just a use of language that a novice reader that has never read an appraisal before may go, “My house isn’t like that”, when really, it’s just a code between the appraiser and their client, the lender, as to what is actually there.
Kathy: Okay. Very good.
Rich: No questions on that?
Kathy: No, you’re just doing a great job here.
Rich: Okay. The narrative part that a reader can really focus in is you could drop down to the last half of that improvement section. That becomes narrative. Additional features is going to describe anything. We typically state in there that the kitchen has granite counters, cherry cabinets, ceramic tile flooring, Jenn-Air appliances. We describe in a narrative fashion what we were seeing in the house so we can relay to, typically the lender or the underwriter, a feeling of the quality level and the types of amenities that are in the home.
You have a picture in your mind of what I just described of granite slabs, cherry counters, ceramic tile flooring and Jenn-Air ranges. If I changed that to Formica counters and stained vetsch cabinets and vinyl tile flooring and low end appliances, the vision in your mind change from one to another. That’s what we try to do to the reader of the report. A borrower can look at that narrative and that section and go, “That describes my house. It’s pretty sparse, but it describes my house”. Now, if there’s errors in that portion, that’s just another little red flag for the reader to go, “Okay, the appraiser was in the house for only five minutes, and he really didn’t see what I had that I consider of value.”
Kathy: I see.
Rich: Now, the very next line below the additional features where it says describe the condition of the property, that entire section is going to be in computer code. I forwarded you a second PDF that says Uniform Appraisal Data Set, which you can post. That talks about condition ratings and definition. They go C1 through C6, which is condition and Q1 through Q4, which are quality ratings. Those are Fannie and Freddie definitions that are required to be placed in that box, which tells a computer how to rate the subject property.
Most appraisers, including us, will add some narrative after that if we have room that says the property has been well maintained, and it’s good quality or its quality level is typical to the neighborhood, or there are some significant detrimental conditions and here’s what they are.
Physical deficiencies are typically are blank unless there’s something major like the foundation has failed or the roof has failed, because if a lender sees anything in that box, the likelihood of the loan proceeding past that point is very slim because that now the security for the loan is in jeopardy.
If your reader or borrower sees something in that field, that should be reporting some detrimental condition, whether they’re aware of it or not, that is adverse to the property, whether it’s something with the site, something with the home, the garage, some type of improvement failure. Okay?
Rich: Then the final box under improvements is the lender or investor wants to know, “Is this house typical?” They don’t want to hear that, “No, it’s not typical because all the homes in the neighborhood are single storey and my subject is a three-storey with multiple additions”. If there’s descriptive narrative in that section of the report, again, that’s going to be an indication to the reader that there are problems with the property.
Kathy: Now under the comps. This is where it gets a little confusing sometimes.
Rich: Yes, this is going to be the challenging part. In all of these fields, the subject information is entered on that left-hand column. The comparable information is all accurate information that is obtained through a third party. Either a realtor, public records, or the appraiser has appraised that comparable before and has the information that’s related to each property.
None of those fields are opinions until you get to the adjustments. When someone’s reading across those lines, I’m going to go half-way down towards sales condition. Just above the total room count, bedrooms and bath at the line right there [See Video 1:10]. The condition of the property is going to go back to those acronyms I was talking about whether it’s C1 through C6.
Those are going to be the opinion of the appraiser because your idea of the condition of a property may be different than my idea of a condition of the property. You may not care if you dust once a year and I may prefer to dust once a day. The condition ratings can differ which is why Fannie and Freddie came up with these specific definitions. There can be changes between a C3 it could go up into a C2 or drop down into a C4.
A reader just needs to understand that the condition and quality are the opinion of the appraiser that’s putting the appraisal together. Everything else there is accurate data like the size of the site, the age of the comparable so forth. Have you got a specific question on this field?
Kathy: Just where are we now? Were you saying summary of sales comparison approach? Is that the part you were just talking about?
Rich: Yes. It’s in that sales comparison approach section.
Kathy: Got it. Okay. All right. Reconciliation is the next one.
Rich: Yes, reconciliation. Let me backup to the sales comparison approach for a minute. In the sales comparison approach that’s the meat of the evaluation analysis that the appraiser completes. That’s going to tell any reader how the appraiser came up with their opinion of value. They are going to make adjustments for different quality and condition. They’re going to make adjustments for different ages, different living areas as well as a difference in heating and cooling, number of garages, designs, etc.
All of those adjustments are typically market-derived adjustments that the appraiser has calculated in some form or a fashion at other times during other appraisals, or that is known for an adjustment. I’m going to give you an example, in my area here in Modesto the market typically will only pay $5,000 to $10,000 for a pool in a piece of property even if the pool costs $80,000. If you go to sell the house and there’s the pool, the market is only going to pay five to $10,000 for the in-ground pool.
On the adjustment grid, if the subject doesn’t have a pool but a comparable does have a pool, then the reader should expect to see a negative $5,000 – $10,000 adjustment. But, those adjustments can vary, because in other areas like company or the country a pool could be a big plus or it could be a real negative. If you are in Alaska the pool is a detriment. It’s not an added asset or as if you’re in some place where pools are common and your house doesn’t have one. The market adjustment may be what it costs to put a pool in. Instead of the $5,000 or $10,000 it may be $80,000. Even if the house was selling $200,000 because everybody else has pools but you don’t.
Kathy: It just depends on how many of the local comps either have it or don’t have it?
Rich: Correct. An appraiser’s evaluation process is no different than a sophisticated buyer because we look at so many houses, and we look at the value of specific items and different transactions. We have a pretty knowledgeable eye as to what the value of an item is going to be. Like what the value different is between a two car and a three-car garage, or what the value difference is between two baths and one bath.
Appraisers, by continually doing appraisals, develop a value for each specific market. Now, some markets change. High custom home areas. The values are going to be larger, versus the low-end range where two bed and one bath are common. You’ve got a two-bedroom, two bath house in that area, the market may not pay anything for that extra bath. An appraiser that is geographically competent works those areas all the time, is going to know that.
I’m just going to drop out of the market grid self-comparison approach. It drops down into a field that a lender required which a reader doesn’t have to really worry about. It’s telling the lenders that you did look at the transfer history of the subject and comparables that they sell recently or three years ago.
The lender wants to know, “Did you consider that in your analysis?” From a reader’s standpoint, a borrower’s standpoint, it’s not relevant unless they’re looking at that and they see that their neighbor’s house was a comparable and they know that it sold prior to the sale 30 days ago and the appraiser doesn’t mention it. That’s just another red flag to put with all the other red flags. Okay, the appraiser isn’t doing diligence in research in the appraisal process.
Reconciliation, that’s just going to tell a reader of report what was the appraiser’s opinion of value? This is where everybody has a hard time understanding that if the subject is selling for a $100,000, and I have three identical homes that all sold for a $100,000, and I come down to this line and I say, “It’s my opinion. It’s only worth $50,000.” You can’t challenge that, because that’s my opinion.
You may not believe it, which you, as a lender or a borrower, that’s acceptable, but you can’t challenge the opinion. You can challenge the reasoning of why did the appraiser get there, and if the appraiser says, ” Well the owner threatened me with a gun while I was there, so it’s my opinion. It’s worth $50,000.”
Now if he says, “Yes, they all sold for $100,000 that’s worth $150,000. The user of the appraisal, like the lender or investor is going to go, “Why are you so high on your opinion?” Not, “Your opinion is wrong, but why is your opinion so high?”
The rest of the report is pretty much blank lines for a narrative or for an appraiser to add narrative. There’s a lot of information that all appraisers place in this area that is required by the federal government such as, “No, I was not paid extra money to do this appraisal.” “No, I’m not going to buy this house if I appraise it too low.” There’s a lot of certifications that go in that section of appraiser’s have placed in there at the requirement of the government.
Cost approach is pretty self-explanatory. It’s just a method the appraiser uses to show the reader what the land value is, here is what it will cost to replace the structure and garage and fences and so forth. Here is what the depreciation is if it’s a15-year old house and you expect it to survive for 60 years it means there is 45 years flap, there is some depreciation. The final indicated value using in the cost approach, if the appraiser is knowledgeable, it should be fairly close to what his opinion of value was in that $100,000 example I gave you.
Lately, in our area the cost to build so exceeds what you can sell the home for. That the cost approach is always significantly higher, and what we do is we use that to show the investor, “This area is still depressed because you can’t have new construction in our area because a builder could never sell their home for what it cost them to build.” That’s more for an investor especially to see that they’re still in a depressed market so if they were in acquisition position of acquiring real estate this is a great time to be acquiring real estate in this area because it can only go up until it reaches that point where it costs the same to build as to sell.
On the form, the income approach is never used in a single-family home. It’s there because Fannie and Freddie require it, but it’s not a method of evaluation. The rest of appraisal is pretty much what Fannie and Freddie have required appraisers to have in a report. Well the attorneys were Fannie and Freddie, but you have to have in the appraisal and that’s all the assumptions and limiting conditions.