Why backup contracts are important in appraising

Why backup contracts are important in appraising

How backup contracts tell a story of value in an appraisalI recently spoke at a local Birmingham, AL real estate office to a group of agents to help them understand appraisals better. One topic that came up was back up contracts. They did not know that this information could, and should, be provided to real estate appraisers. I helped them understand why backup contracts are important in appraising and how they can help provide support for the appraiser’s final opinion of value.

What is a backup contract?

A backup contract is a signed agreement for purchase of a home that puts the signer/buyer next in line to purchase the home if the first deal falls through. Some common reasons that a deal might fall through is that the buyer is not able to obtain financing or maybe there was a problem with the home inspection. Back up contracts are common in a hot market where inventory is low, and demand is high, and where several buyers are competing to purchase the same property.

What a backup contract can tell us and how appraisers view them

A backup contract can indicate a couple of things:

  • There is a good demand for the subject property since more than one party is interested in it
  • There is a possible shortage of supply and buyers have a limited number of homes to choose from

Appraisers are required to analyze any and all offers or contracts on the property they are appraising. Considering backup contracts within the context of other value indicators can give an appraiser additional information when appraising a property. The various indicators of value that appraisers consider include recent sales, active listings, pending sales, the current contract on the property as well as backup contracts.

Closed sales provide an indication of recent activity that has already occurred. The more recent the better because the price will reflect current market activity taking into consideration supply and demand as well as seasonality in pricing.

Active listings reflect the state of the current market and typically reflect the upper end of the price spectrum since the list price is usually negotiated downward. Appraisers like to include active listings and apply a list price to sale price ratio adjustment. By including this information it provides information about alternative properties that potential buyers may consider.

In my opinion one of the best indicators of value are pending sales. When I say pending sales I’m talking about a property that is under contract and has passed all the preliminary hurdles to getting closed such as financing, home inspection, and appraisal. A pending sale is the most recent indication of what is happening in the market at the same time as the property that is being appraised.

The actual contract on the subject property is also a value indicator that many don’t even consider. If the contract is arm’s length, meaning that both buyer and seller are equally motivated and acting in their own best interest, then the contract can also be used with the other value indicators to reconcile a final opinion of value.

In addition to the pending contract on the subject property, taking backup contracts into consideration can also give clarity based on the reasons I noted previously. It can indicate good demand for the subject property or it can also point to a shortage of inventory with potential buyers fighting for a smaller inventory or homes. If all the stars are in alignment 🙂 all of these indicators could possibly provide support for the upper end of the price range.

Question

Can you see how important it is to know about backup contracts during an appraisal? Can you think of anything else to add? I’d love to hear your take on the matter so leave a message below and we’ll discuss.

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Comments

  1. I agree, Tom. Real estate agents serve their clients well when they help communicate well with the appraiser about the story of the market when it was on the market. Part of this story is conveying how buyers respond. How many offers were there? What price levels? And as Gary said, what are the terms of the offer? Why was this particular offer accepted instead of the others?

  2. When I speak at real estate offices, we spend quite a bit of time talking about this. It is so important for real estate agents to help appraisers understand what the context of the contract is. Sometimes there are higher offers, but the this offer was selected because of a better down payment or higher earnest money, etc…

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