As a mortgage professional, you know the appraised value of a property is a key factor in determining the loan-to-value ratio and may affect the interest rate for your clients. But did you know the same property can have different appraised values depending on the terms of reference (TOR) the appraiser follows? In this post, we explain why this happens and what you can do to avoid surprises and delays in the mortgage process.

What are Terms of Reference?

Terms of reference (TOR) are the guidelines or instructions a lender provides to an appraiser for conducting an appraisal. They specify several things, including: the scope of work, the purpose and intended use of the appraisal, the type and definition of value, the types of comparable properties to be used in the report, and any other requirements or limitations the lender may have.

TOR can vary from lender to lender, and even from product to product within the same lender.

How do Terms of Reference Affect the Appraised Value?

The appraised value of a property is the result of the appraiser's analysis and opinion based on the available data and the applicable valuation methods. One of the most common and reliable methods is the direct comparison approach, which involves comparing the subject property to similar properties that have sold recently in the same market area.

The appraiser adjusts the sale prices of the comparable properties to account for any differences in factors such as location, size, condition, quality, features, and market conditions. The adjusted sale prices of the comparables provide an indication of the value of the subject property.

However, the selection and adjustment of the comparables are not arbitrary or subjective. They are governed by the TOR the lender sets for the appraisal. The TOR affect the appraised value: by limiting the distance to the subject property, by limiting the date of sale of the comparables, and by limiting the maximum net and gross adjustments made in the direct comparison approach. Let's look at each of these factors in more detail.

Distance to the Subject Property

The distance to the subject property is the physical distance between the comparable property and the subject property, measured in kilometers or miles. The closer the comparable property is to the subject property, the more likely it is to reflect the same market conditions and demand.

The TOR may specify a maximum distance the appraiser can use to select the comparables. Examples of requirements: the comparables be within 5 km of the subject property, or within the same neighborhood, or within the same municipality. This ensures the appraiser uses the most relevant and representative data for the valuation.

However, the distance to the subject property can also affect the appraised value in another way. If the appraiser cannot find enough comparables within the specified distance, they may have to expand the search radius or use less similar properties. This can result in lower or higher adjustments, and consequently lower or higher appraised values.

If the subject property is in a rural area where sales are scarce, the appraiser may have to use comparables that are farther away or have different characteristics. This often results in higher adjustments.

Maximum Net and Gross Adjustments

The maximum net and gross adjustments are the limits the TOR may impose on the amount of adjustments the appraiser can make in the direct comparison approach. The net adjustment is the total percentage of adjustment for a single comparable property, calculated by adding the absolute values of the individual adjustments. The gross adjustment is the total percentage of adjustment for all the comparable properties, ignoring negative signs.

In the Direct Comparison Approach to value, the appraiser with make dollar adjustments to a comparable property in order to make it "similar" to the subject property. The adjustments will be in dollars (or whatever currency used in your country), and the net and gross adjustment percentages are calculated.

For the following example, we'll translate the "dollar" adjustments into percentages to make it easy to follow along: If the appraiser makes three adjustments equal to -10%, +5%, and +15% for a comparable property, the net adjustment is 10% (-10% + 5% + 15%). In the same scenario, the gross adjustment is 30% (10%+5%+15%).

The maximum net and gross adjustments are intended to ensure the appraiser uses the most similar and reliable comparables for the valuation. The lower the adjustments, the more comparable the properties are. Therefore, the TOR may specify a maximum percentage the appraiser can use for the net and gross adjustments.

An example requirement can be expressed like this: “The net adjustment does not exceed 20% and the gross adjustments do not exceed 30%.” In the lender’s eyes, this ensures the appraiser uses the most credible and consistent data for the valuation.

Date of Sale of the Comparables

The date of sale of the comparables is the date when the comparable property was sold. In some cases appraisers are able to use “firm sales” that haven’t closed. The closer the date of sale is to the effective date of the appraisal, the more likely it is to reflect the current market conditions and trends.

Appraisal TORs specify a maximum time period the appraiser can use to select the comparables. For example, the TOR may require the comparables be sold within the last three months. This ensures the appraiser uses the most current and accurate data for the valuation.

However, the date of sale of the comparables can also affect the appraised value in another way. If the appraiser cannot find enough comparables within the specified time period, they may have to use older sales and will often make time adjustments in these scenarios.

What Can You Do to Avoid Surprises and Delays?

As you can see, the appraised value of a property varies depending on the TOR the appraiser follows. This can cause surprises and delays in the mortgage process, especially if the appraised value is lower than the purchase price or the expected value. To avoid this, here are some tips you can follow as a mortgage professional:

• Know your lenders’ TORs before sending them the mortgage application. This way, you can have an idea of what to expect and communicate it to your client.
• Choose an appraiser who is familiar with the market area and the type of property. This way, you can ensure they have access to the most relevant and reliable data and they can comply with the TOR. When using an AMC, pick the one with the best reputation score for the area.
• Provide the appraiser with any information can help them in the valuation process, such as the purchase agreement, the listing details, the property features, and any recent renovations or improvements. This way, you can ensure they have a complete and accurate picture of the subject property, and they can justify any adjustments they make.
• Review the appraisal report carefully and look for any errors or inconsistencies. If you find any, ask the appraiser to explain or correct them. If you disagree with the appraised value or the methodology, ask the appraiser to reconsider by providing additional information, such as a recent sale that might make a good comparable. If you are still not satisfied, you can request a second opinion from another appraiser or appeal to the lender.

By following these tips, you can help your clients avoid any potential issues or delays in the mortgage process. Remember, the appraised value is not a fixed number. It is an opinion based on the available data and the applicable TOR.

By understanding how the TOR can affect the appraised value, you can be better prepared and informed as a mortgage professional.