If you’ve ever used real estate as collateral for a loan, you were likely required to have the property appraised. Understanding how a land lender uses an appraisal is important for you since it will influence the loan terms you ultimately receive. You’ve probably heard a lender use terms such as “advance rate” or “loan-to-value”, which are simply the loan amount divided by the appraised value (or if you are purchasing land, usually the lower of the appraised value or purchase price). The loan amount your lender is willing to extend will be based primarily on your financial condition, credit history, repayment ability, and loan structure. But, in addition to these factors, the type and value of collateral you offer to secure the loan can also play a significant role in determining your maximum loan amount. This article focuses on how a property’s characteristics affect the loan advance rate, and highlights five key areas of a land appraisal that lenders consider in making this decision. Many times the lender will be familiar enough with the property and market to make this decision before the actual appraisal is received, but the same logic discussed in this article will be used either way to determine the loan-to-value the lender is comfortable with.
Keep in mind as you read further that the reason a lender requires collateral is to repay the loan in case the borrower is not able to pay according to the loan terms. As you would imagine, the time when a lender acquires a collateral property and has to sell it is usually the absolute worst time to own that particular type of property. Because of this, a lender’s view of the current and potential future value of collateral securing a loan is typically very conservative. Lenders run a low-margin, highly-leveraged operation and if we’re wrong very often we won’t stay in business too long.
The sales comparison approach is a primary driver of the value estimate in many real estate appraisals. But in a number of land markets today, comparable sales can be difficult to obtain due to limited recent transactions. Lenders spend a good deal of time reviewing the comparable sales used by the appraiser, and the lack of recent comparable sales is a sign that either the market is slow or the property is very unique. Either cause generally leads to a lower advance rate for the loan. A lack of sales driven by a depressed market could mean that values are still falling, and when sales transactions do return they will be at lower levels than the old comparable sales used by the appraiser. The appraiser will attempt to adjust values down on the comparable sales to account for this (and may use current property listings as a guide), but this is a very difficult task with lots of uncertainty. Concerning unique or high-dollar properties, the loan-to-value offered is usually lower than a “standard” property because only a limited pool of buyers would be interested in or financially able to buy this tract. This is certainly not always the case as some very unique properties hold value in down markets because similar tracts are in short supply. But, as stated before, your lender will take a conservative view and will probably offer to finance a smaller portion of a property perceived to have a limited market.
Another focus of lenders in the comparable sales portion of the appraisal is the variability in values. If the adjusted values determined by the appraiser are in a wide range, the lender will consider where in this range the appraiser’s final value estimate for your property ends up. If it’s at the high end, expect a larger discount from the appraised value to the loan amount offered. Again, lenders almost exclusively acquire collateral properties when the market for the tract is poor, so the lower end of an estimated value range is the most appropriate for use in determining advance rates.
Before the appraisal is even finished, your lender has likely (or should have) investigated the sales history of the property offered as collateral. In general, multiple sales of the property in the last several years or significant price increases not justified by physical property improvements are red flags to a lender of an overheating market. This is not always the case, but if your lender believes the run-up in prices is unsustainable, expect an offer for a lower loan amount. Also, if the collateral tract is a property you already own, many lenders will take into account your original purchase price in setting a loan amount (especially if your purchase was fairly recent). Cashing out equity in land tends to be more difficult than the same practice was for homes several years ago, and we know how that one turned out. This practice was also common in the agricultural land market during the late 1970’s and early 1980’s, and at the risk of beating a dead horse, we know how that one turned out as well.
Lenders typically rely on title searches and surveys for a “legal” review of a property’s physical access, but an appraisal can give some valuable information for a “functional” review. To better explain the difference, consider a property’s access. The title work and plat will identify the legal access to the property, but the appraisal could identify some potentially troubling functional concerns about the means of accessing the tract. For instance, I have seen properties where the only legal access is across a low area prone to flooding. The legal documents would indicate access was available, but a review of the appraisal may show a factor that could severely reduce the marketability of the tract. This should not substitute for a site visit by the loan officer, but you would be surprised how often that doesn’t happen.
A site visit is also the best way for a lender to get a feel for the property’s “neighborhood”, but comments from the appraiser can also help determine what is typical for the area. Similar to the comparable sales review, a more unique and/or special-purpose will oftentimes have a more limited group of potential buyers. This effect is heightened in a downturn of a particular property market. Count on a smaller pool of potential buyers influencing an offer from your lender for a lower advance rate.
Income Approach to Value
This section of a land appraisal is one of the most important for a lender to consider. In many markets, property values are greater than what the tract’s cash flows alone can support. Intangible benefits (recreation, historical significance, etc.) as well as future potential higher and better uses for the land can drive prices above what current cash flows and discount rates would suggest is an appropriate value. Experience has shown that in a depressed market (i.e. the time when collateral values are most important to a lender) property values tend to fall toward their “cash flow value” as the intangible benefits are not valued as highly by potential buyers. The long term cash flow-generating capacity of a tract will typically provide a “floor” under the price, so this base price level is a primary consideration to a lender in determining how much to loan on a particular piece of land. The greater the difference between the purchase price/appraised value and the “cash flow value” of a tract, the lower the advance rate your lender will be willing to offer. You should expect to have a larger down payment requirement for a recreational tract compared to another agricultural tract with reliable and consistent cash flows.
In summary, the dynamics of the lending business require a conservative approach to setting advance rates, and your lender will consider what could happen to a particular property’s value in the tough times before making their decision on how much to lend. Property characteristics and history that indicate lower marketability, speculative appreciation, or limited cash flow capacity will drive down the advance rate offered to you. Being aware of these factors as you have discussions with your lender should serve you well in negotiating the best financing terms for your situation.
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