Too Much of a Good House
By Charlie Elliott Jr., MAI, SRA

The phone rings, and there is a concerned mortgage lender on the other end. She is calling the appraiser about an appraisal on a property in the pipeline for one of her loans, scheduled for closing this month. At this point, we will put the call on hold and get back to it shortly. In the interim, we will explore some of the details of the property, which is the subject of the appraisal.

The home is a to-be-built log home package, designed to sit on 60 acres of beautiful land, about one hour from the city. The setting is great. It is right on top of a small mountain and has streams, pastures and hiking paths, which is just perfect for the young doctor, who fell in love with the rural setting. The doctor is a good credit risk with a significant income, but has little cash. He spared little in the planning of the home, opting for expensive features, such as high ceilings, tile floors, granite counter tops and a four-car garage for his four-wheel toys. The contractor has proposed to charge the doctor $700,000 to construct the 5,000-square-foot home on the site, which is under contract for $150,000. The doctor is excited about the land, since it is out in an area where there is little development and which should offer a lot of peace and quiet. He will need an $800,000 loan to go with the $50,000 in cash that he has.

Now back to our telephone call that we put on hold. The lender has a concern in that the appraiser only appraised the property for $600,000. As you will recall, the projected cost of the project is to be $850,000 and the loan request is $800,000. She begins by asking the appraiser if there could be some mistake. The appraiser, realizing that the time has come for professional diplomacy, states that the home on the proposed site will no doubt be a beautiful project. He also states that, unfortunately, he does not believe that any mistake has been made. He says that, in his opinion, based upon the facts of the case, the property has a market value substantially lower that the projected cost. He further elaborates on all of the research he did and how he derived data from the market, which directed him to the conclusion that he came to. He offered the following facts:

The appraiser then proceeded to inform the lender that, while the cost derived from the market confirmed the proposed cost of the project, adjustments had to be made to the cost approach, representing “functional obsolescence,” which reduced the value of the property by $250,000 below the estimated cost to build. He further said that when properties of similar construction and utility sell for less in a market than the cost to construct, the lesser of the two determine value.

The situation, described above, occurs quite often in today’s market. In a few words, the problem stems from an owner building a home that is too expensive for the market for which it is in. When the appraiser used the term functional obsolescence, he was right. To be more specific, there are many forms of functional obsolescence that properties may suffer from. In this case, the proposed property is experiencing “super adequacy” or what some would term overbuilding for the neighborhood.

This can best be explained by going back to the basic reason for having the appraisal. It is performed to determine market value in case it becomes necessary to sell a property in order to help satisfy a debt. If a new or typical buyer in a market would not be willing to pay as much as the initial owner, it cannot be sold for what it cost, and, therefore, the market value of the property is less than its cost. Sometimes individuals with expensive taste are said to have a desire to build a monument to themselves. Could this be the case with our doctor? In such cases not all is necessarily lost. This problem can quite often be remedied by the owner either scaling back the magnitude of the project or by investing more money in the down payment and getting a smaller loan. Making a large down payment does come with its risks to the owner since he will be confronted by the same value constraints if and when he decides to sell the property.