The Construction Loan and the Appraisal
by Charlie Elliott Jr.

While many in the mortgage and appraisal fields normally think of an appraisal being prepared only on an existing home, this is not always the case. Most if not all homes built with the aid of construction financing in today’s market require a pre-construction appraisal.

This appraisal is prepared, as the name implies, prior to the construction of the home. Typically the owner will have selected a building site as well as a set of plans and specifications for the home prior to applying for the loan. Upon application it becomes the responsibility of the appraiser to appraise the subject property in accordance with the plans and specifications provided by the owner, assuming all work is complete. In the appraisal field this type of appraisal is often referred to as a “hypothetical appraisal” or a “subject to appraisal.”

In the past, construction lending has been in a niche market, much unto itself. Many mortgage lenders have considered it to be a risky market and have done little, if any, construction lending. Many savings-and-loans of the past would defer participation in such loans to commercial banks, rather than assume the risk associated with the construction, and hope to make a permanent loan on the property once the construction process was finished.

As has been the case with so many other things lately, this has changed. As mortgage companies have become more aggressive in obtaining market share, they have also been willing to assume the additional responsibility of providing construction financing, not only in an effort to benefit from the revenue associated with the loan during construction, but to also obtain the permanent loan once the construction is complete. Many mortgage companies have established one-stop products available to customers building new homes. These products oftentimes require only one closing, therefore, eliminating the additional expense and services associated with a second closing, including a second appraisal. This type of loan, referred to as a “Construction to Perm” loan, has become more of the norm in recent years rather than the exception.

As mortgage companies have sought new home loans, many have developed large processing centers to facilitate the construction phase of the loans. Many have not only used their retail sales forces, but have also begun to rely highly upon brokerage companies as a wholesale source for construction loans. With this have come a large number of pre-construction appraisals, generated from a variety of sources on a variety of different types of residential property.

From my experience, I believe that there is room for improvement in the area of pre-construction appraisals, particularly where wholesale originators are involved. Typically, problems arise in the form of delays, such as many back-and-forth phone calls, various amended documents and sometimes the loss of loan customers due to their frustration with the situation.

This does not have to be the case, and there is plenty of blame to go around when this occurs. Most of the problem stems from orders for appraisals that contain inadequate information about the project contemplated. This, many times, does not come to light until the package reaches the desk of the underwriter. Lack of communication is probably the case here, between and among the lender funding the loan, the wholesale broker and the appraiser.

In an attempt to assist the lender who may have limited experience and/or direction with pre-construction appraisals, which are designed to be used with permanent loans destined to be sold on the secondary market, I offer the following suggestions. When ordering the appraisal please insure that:

1. There is a complete set of plans and specifications submitted to the appraiser. These plans should be sufficient for the appraiser to develop a full understanding of the project to include the quality of the construction. We are talking about detail specifications and working drawings here, not copies of artist renderings of homes from a house-plan magazine.

2. A plot map is included showing the placement of the home on the site. Un-recorded property plats, representing portions of tracts of land or undefined parcels of land showing no plot maps, are unacceptable.

3. If applicable, a copy of the sales contract for the purchase of the site should be included.

4. The appraiser is provided a signed copy of the builder’s construction contract to include a summary breakdown of the costs for all components of the project to the extent such information is available.

It is not unusual for a borrower to attempt to save money by entering into an agreement with a builder with incomplete or inadequate plans or to avoid hiring a surveyor to do a proper survey on a building site. Not only is this a time bomb waiting to explode between the builder and the borrower, but the same problem will also exist between the borrower and the lender if it is permitted. Furthermore, the appraiser will not be able to comply with Uniform Standards of Professional Appraisal Standards if he cannot properly define the improvements to be built. While having adequate descriptive information about a property is always important to an appraiser, this problem is magnified when dealing with “to be constructed” improvements, as there is little that can be observed from an inspection of the vacant site relative to what will be constructed on the site.

In summary, the construction-to-perm loan is a specialty product allowing the loan originator another arrow in his quill of services to be offered to a client. It can provide lucrative opportunities for the lender when properly handled. It can also prove to be a big fat waste of time and can result in damaging relationships when not handled properly. Some of the best advice I know of here is that of the Boy Scout motto, “Be prepared.” The list above should go a long way in the direction of setting the stage for a smooth construction-loan-appraisal transaction.