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I’ve seen so much of this recently, I felt compelled to write about it. I believe we could save divorcing homeowners millions of dollars in unnecessary expenditures – specifically appraisal costs. And, it’s so simple but the knowledge is not widespread enough to actually make a dent in the following 3 costly mistakes divorcing parties make.
When negotiating the property settlement, the value of the house is sometimes a matter of great consternation. Not only are parties and attorneys spending lots of time around the table trying to agree on value and equity, but I have found that they are paying money to arrive at a settlement which, many times, cannot be financed and might be unworkable in the real world.
Here are the top three mistakes I see related to establishing the home’s value and it’s so-called “equity.”
1. Ordering your own appraisal
How can I put this diplomatically? Your appraisal doesn’t matter. Still not clear enough? How about this – it’s totally useless. Well, maybe that’s not totally true in all cases. But, when it comes to financing a buyout (Owelty agreement and lien) in divorce, NO appraisal may be used in that lending decision other than the appraisal which is ordered by the lender. In fact, the appraiser is not even allowed to look at someone else’s appraisal. It’s called undue influence.
I am still called on cases, to procure mortgage financing for divorcing parties, wherein an appraisal has already been ordered – at a cost of several hundreds of dollars, mind you. While I understand the need to establish value of the parties’ property, the fact is if the grantee needs or wants to finance the buyout, they will have to pay for another appraisal which the lender will order. This, effectively, makes any other appraisal useless.
It’s actually worse than that. One might tend to believe that an independently ordered appraisal will, at the very least, give the parties/attorneys a ballpark figure of value. After all, it will come from a licensed, professional appraiser. Right? Here’s a little known fact: appraisals are assigned to a client. When the lender orders the appraisal, the lender is the client. When an attorney or a divorcing homeowner orders the appraisal, they are the client. The appraisals do not transfer to another client. So, what does this mean? It means that the appraiser knows whether or not an appraisal is going to be underwritten by a professional underwriter who is accountable for a lending decision he/she makes; or, simply reviewed by an amateur or attorney who is probably not well versed in reviewing and critiquing appraisals.
I have seen lender-ordered appraisals report a value 20+% lower than an independently obtained appraisal. Let’s do the math on that.
Agreed value (agreement based on an independently-obtained appraisal): $100,000
Mortgage Balance: $ 70,000
Agreed Equity (another mistake which I shall correct in #3: $ 30,000
Agreed 50% buyout/interest: $ 15,000
Now, let’s say there are not even any closing costs in the borrower’s new loan (to include the $15,000 buyout). Here is the new loan
First mortgage $70,000
Owelty buyout $15,000
Now, we get the real appraisal which reports a value of $80,000, not $100,000. But, the homeowner needs $85,000 or 106.25% of their home’s value.
Ain’t gonna happen.
One more thing. It’s tempting to rely on an independently-obtained appraisal if there is no need for financing (buyout is not borrowed, paid out over time or the value is simply entered in a column under assets to calculate the division/awarding of total assets). You may think, what else can we do…there is no lending process whereby we can obtain this much-vaunted, underwrite-able, useful appraisal?
I suggest one of two strategies at this point. First, if the client will apply to me for a loan, I can order an appraisal through this lending process. Of course, I would like to know – in advance – if there is no intention to follow through with the financing. But, I can order the appraisal and deliver it to the client. Secondly, if you order an appraisal directly, tell the appraiser something like this: “I want this appraisal to be done as if an underwriter may review it for a lending decision. I intend to have my mortgage professional, Noel Cookman, and his staff review it for our case.” This will put them on notice that a serious review will be conducted.
These two strategies are still not as helpful as an actual lender-ordered appraisal that is underwritten by the lender making an actual lending decision. One of the reasons is that, underwriters have access to raw data and will be able to tell if other properties are “leap-frogged” over in order to find comparables that justify a higher or lower in value. I could write all day about this; but, hopefully I’ve drawn a clear enough picture of the reality of the situation.
I realize that there are multiple other factors the affect a person’s valuation of their property. For example, a divorcing homeowner may truly and rationally be willing to pay more for a property (technically a spouse’s interest in the property) than what numbers on a piece of paper say it’s worth. But, that is an intangible and non-quantifiable factor for which we can give very little guidance. In other words, I don’t tell people how much they should pay in a divorce buyout – my role is to try and make it work and inform them of limits to financing.
2. Not Receiving a Real Appraisal
…(preferring instead a realtor’s opinion (CMA, Comparative Market Analysis) or the value assigned to the property by the taxing authority (usually the county).
I don’t know which is worse. Getting a bogus appraisal or relying on CMA’s and county assessments. By the way, every county in Texas has its MIS-NAMED “appraisal district.” And, folks refer to the county’s opinion of value as its “appraised value.” After all, the government tells us that it’s an “appraisal” department and the value is listed as an “appraised” value. The county does NOT appraise ANY property – it assigns a taxable value and assesses taxes based on that assignment. Citizens generally seem to assume that their property “appraises” for a lower amount than that for which they purchased it more recently. And, in many cases, that appears to be true. But, not in all cases and – here’s the important part – no one knows what that differential is. So, there is still no way of knowing the true market value of a property without a real appraiser performing the real research in his/her report to a lender of an “opinion of value.”
Speaking of which, an appraisal is really an appraiser’s report of “opinion of value.” That’s right – it boils down to an opinion. However, from which person or entity are parties and attorneys most likely to receive a reliable, accurate, market-based opinion?
- a realtor preparing a Comparative Market Analysis based on price per square footage, etc.
- a government agency whose bureaucrats work in an office and do not visit the properties.
- a divorcing client sitting at the table arguing a certain value based on his/her neighbor’s alleged sale.
- a licensed, certified appraiser vetted by various lenders and approved to work on a panel in an Appraisal Management Company.
The point is, only an appraisal, conducted by a trained/certified appraiser, can give you and me the clearest look at a property’s market value.
3. Miscalculating Equity
I suppose it’s already implied that calculating “equity” on the wrong report of appraised value is, in itself, a miscalculation. But, there is one more important step in calculating equity – the consideration of two major factors especially when it comes to a buyout.
The first consideration is “transactional costs.” It’s important to distinguish between closing costs and “transactional costs.” A seller, for example, will have some closing costs (generally) but will have other “transactional costs,” both of which diminish their net proceeds or what is improperly called “equity” in their sold property. So long as we understand that “equity” is more of a fluid number than most people think, you can generally think of equity as the value of the property less the indebtedness (mortgage liability payoff, liens, taxes and other encumbrances) against it less the transactional costs.
I thought most people knew this. But, I’ve recently seen divorce settlements that subtract the outstanding mortgage balance from the assumed value (and I DO mean “assumed” because no appraisal had been secured on the property) and call that the equity.
The second consideration is “accessible equity.” This involves financing limits. Even though there are many ways to determine actual loan limits, I speak generally of the industry standard of “max LTV.” That is the Maximum Loan To Value ratio. And that limit is 95%....approximately. FHA’s max LTV ratio is 96.500% in purchases and 97.75% in refinances. VA does 100% financing but, it’s rare and inapplicable enough for it not to be considered in this discussion. So, 95% is a round figure and is the maximum financing generally available in “conventional” mortgages.
But, here’s the relevant application of these facts – it’s my statement to lawyers and customers: Homeowners can never access the top 5% (or more) of their home’s value – it gets eaten up in realtor fees (average of 6%) and other costs.
Therefore, I use the 95% calculation. That is, the value of the property times 95% less the indebtedness, less the transactional costs. If you use this formula, the parties will get closer to an equitable division of “accessible” equity. Here’s how it would work.
Assume the property is worth $100,000 and the indebtedness is $55,000. If the parties are seeking a 50/50 split, they might be tempted to calculate it like this:
$100,000 less $55,000 (indebtedness) less $5,000 costs equals $40,000. Half of that is $20,000. So, the grantee finances $55,000 mortgage payoff plus the $5,000 (costs) plus the $20,000 (buyout) for a total loan amount of $80,000 against a $100,000 property. We’ve already learned that equity is not merely the subtraction of the indebtedness from the value. So, we know that the new equity is not $20,000. At the very least, the equity might be $100,000 less the new loan of $80,000 less the finance costs of $5,000. That is, $15,000 which is $5,000 less than what the grantor just paid their ex-spouse for their interest. Not only that, but the principle of accessible equity means that the grantor cannot access the top 5% of the property’s value and is capped (generally speaking) at 95% LTV ratio or $95,000. So, the new “homeowner” now has only $10,000 of accessible “equity” in the property or $100,000 X 95% = $95,000 less the $80,000 mortgage less $5,000 finance costs.
Here’s how the 95% calculation works for both parties to end up with something close to equal “equity.”
$100,000 X 95% = $95,000
Less $55,000 (indebtedness), less $5,000 (costs) = $35,000. One half of that is $17,500.
Now, after the grantee obtains financing and pays the ex-spouse $17,500, here is what the new loan looks like:
$55,000 (first mortgage payoff) plus $5,000 costs plus $17,500 buyout = $77,500.
Now, how much “accessible equity” has the grantee retained in the property? Let’s see. The new loan is for $77,500 against a $100,000 property of which only 95% of its value can be accessed for financing. So $100,000 X 95% = $95,000, less $77,500 (first mortgage payoff) equals $17,500 which is the same amount the grantee just paid for their ex-spouse’s “equity” in the property.
Grant it, this is an imperfect and imprecise way to calculate even the accessible but it arrives at a figure much closer to real-world numbers than assuming that anyone can access 100% of their property’s value.
There is one simple strategy you can use to save your clients money and establish a rational value for a property. Have the client (who must finance a buyout) call me SOONER THAN LATER.
It’s really that simple. I will reinforce your bona fides in law and family law matters. I will tell the client how wise you are and how you are saving them lots of money by doing it right – that is, by following a protocol that will establish true, professional, under-writeable, accountable values.