First in the Deal Killer series. How an appraisal can derail a deal.
When it comes to financing a commercial property, there are several steps that take place during the underwriting & due diligence phase. Many of these steps occur in-house with a lender’s underwriting or credit team, but some of these steps are performed by a third party without a financial stake in the deal’s outcome. One of those is the appraisal. An appraisal is simply an objective, expert third party establishing the value of a property. Gone are the days where the borrower can order their own appraisal, or even direct the lender to a “friendly” appraiser. Nowadays, loan officers have to choose from their list of approved appraisers, and all parties hope for the best when the report comes back.
Since lenders will typically commit to lend a certain percentage of the property’s value for acquisition deals, the “value” is determined by the lesser of purchase price or appraised value. For refinances, the appraised value is the only value to rely on.
So, what can go wrong with an appraisal?
First off, with any acquisition loan that is size constrained by LTV, if the appraised value comes in “light”, or below the purchase price, the originally proposed loan amount will be reduced. For instance, if a lender offers a 65% LTV loan on a $2,000,000 purchase price, the proposed loan is $1,300,000. If the appraisal comes in a $1,800,000, the 65% LTV loan is reduced to $1,170,000, a reduction of $130,000 of loan proceeds which will need to be made up for with equity. Sometimes, the loan is reduced far enough causing the increase in equity to be too much for the investor to put down. This is usually the #1 reason an appraisal causes a deal to fall apart.
Secondly, if a borrower is refinancing a property and there is an existing lender that needs to be paid off, the new loan amount needs to at least cover the existing amount, otherwise, the borrower has to bring more equity to the deal. A lower new loan amount can be caused by either an appraisal coming in light and/or the new loan has a lower LTV than the existing loan. Either way, this can be detrimental to a borrower and again cause them to bring in additional equity.
Thirdly, some lenders look at the “dark value” of a property submitted by an appraiser as an additional underwriting metric. The dark value is the value of the property should it “go dark” (become vacant). These lenders will lend a certain percentage of dark value, often around 100%. So, if the proposed loan is $1,000,000 with a max 70% LTV/100% LTV on Dark Value, and the appraised value comes in at $1,500,000 but the dark value is $900,000, the loan will pencil from an in-place LTV standpoint ($1,000,000 loan on $1,500,000 value is 66%), but the dark value kills the deal.
Lastly, when it comes to renovation loans, lenders will look at an After Repair Value (ARV), meaning, what will the property be worth once the renovation is complete and the property is stabilized. For example, a lender may lend 70–80% of total cost on the way in, but the loan cannot exceed 65% of ARV on the back end. So, how does a lender determine ARV… with an appraisal! Let’s look at an example: The total cost of a project is $2,000,000 ($1,500,000 purchase and $500,000 rehab) and a lender offers 80% Loan-to-Cost but not to exceed 65% ARV. With an 80% loan, total loan proceeds are $1,600,000 (80% x $2,000,000). So, the loan is initially constrained by that 80% Loan-to-Cost, but let’s see if the loan amount is further constrained by the ARV. If the appraisal comes back and the ARV is $2,300,000, 65% of that value is $1,495,000. So, because the loan is limited to 65% of ARV, the total loan amount will be reduced to the lesser of 80% LTC or 65% of ARV. Because the loan amount is reduced in our example, the borrower will need to put more equity into the property, which again, can hurt the deal.
In the end, the appraisal is ordered by the lender and the main purpose is to establish value. More often than not, the appraised value does not negatively effect the deal, however, there are those instances above where it can derail a project.