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What are Construction Loan Appraisals?

Property appraisals for use in conjunction with home construction loans are completed using a set of building plans, a specification list or spec list, the cost breakdown, a site inspection and plenty of research. While some refer to this as an appraisal of “future value”, the corrected term is an “As-Completed” appraisal.

Beyond using building plans and a construction budget the appraisal process is very similar to that used for a standard purchase or refinance loan. The appraised value should reflect what the property will be worth once completed as long as it is built per the building plans and specifications. Like non-construction appraisals the heart of a good appraisal will be found within the grid of comparable properties recently sold, preferably in the past 3-6 months.

“Comps” should be similar in size, locations, age, design and general amenities. Standard practice for residential property appraising is to bracket the subject property by listing properties both above and below in total value and then make adjustments toward the middle so as to give the fullest picture possible and ensure true comparability

While not all lenders require all three sections to be completed, each appraisal will have sections dedicated to the Cost Approach, Sales Approach and Income Approach. The Cost Approach will take the budget into consideration and help the lender establish whether the amount budgeted is sufficient to complete the home as designed.

While a budget may be deemed sufficient the lender will also want to know that the borrower is not “over-improving” the property to the point they would have a hard time marketing it should the borrower stop making payments. The Sales Approach is usually the primary method for most appraisers with a construction assignment because there is often good comparable data about homes sold in the area.

With a list of sold homes in hand the appraiser can begin the “art” portion of appraising, that is drawing on experience and applying established standards to making dollar adjustments between the subject property and the comparables for things such as; view, lot size, bedroom and bathroom count, pool and spa, and a wide array of special features. The Income Approach is rarely appropriate in the appraisal of a residential construction project.

The vast majority of property appraisals for home construction loans will have a Sales Approach value that exceeds the Cost Approach value by 5-15% on average. Why is the margin between Cost and Value so important? While many lenders arranging renovation and addition projects base the maximum loan amount on the Sales Approach, projects that are “ground-up”, new construction on vacant land or a complete demolition with rebuild, generally set the maximum loan amount based on the “lesser of Cost or Value”.

Translation- the maximum loan amount is generally lower when Cost Approach is the driving force and thereby means the borrower may need a greater amount of cash out-of-pocket to increase equity at inception.

A common theme in many construction projects, and a large determinate as to whether a borrower can afford to build at all, is equity required and the total investment from the borrower. If the maximum loan amount and a borrower’s cash out-of-pocket will be determined by the “lesser of Cost or Value”, it will be important to document all the costs of construction for the appraiser.

The builder’s cost breakdown is the primary tool, but borrowers should be diligent in assembling supporting documentation for costs not represented in the builder’s budget, such as, design and architectural fees, engineering costs, permit and school fees, etc. By doing so the borrower can make sure the Cost is fully accounted for and therefore the maximum loan amount can be achieved and the cash out-of-pocket reduced. For example, if you pay an architect $20,000 for building plan before applying for the loan you will have spent $20,000 out-of-pocket. However, if you bring this to the lender’s attention they can increase your loan amount and reimburse you up to 80% of this amount.

If the borrower is purchasing a vacant lot, the Cost equals the purchase price of the lot, plus hard and soft construction costs. Hard Costs generally included materials and labor. This could be a single contract with the builder or involved additional smaller contract items like a pool and spa.

Soft Costs can include design, architectural, engineering, geological, plan check, permits and school fees among others. If you have already owned the lot for at least a year, the current lot value would be used in the loan-to-cost calculation, not the purchase price. No separate lot appraisal will need to be done.

The Cost Approach section of the construction loan appraisal will include a “site value”, and “As-Is value of site improvements”. The sum of these two numbers is generally used as the current lot value, although sometimes “As-Is value of site improvements” gets left out and should be addressed. The value of site improvements already completed, such as grading, retaining walls or septic tank, are not added to the total cost calculations because they are already reflected in “site value” and “as is value of site improvements.”

Softs costs need to be documented with cancelled checks and invoices, and hard costs will be reflected on a fixed price contract with the builder. Often construction is well underway when a borrower decides they want financing. In this case it is also critical the borrower document what has been spent with canceled checks and invoices in order to receive full equity credit, and potentially reimbursement. Occasionally, the Cost Approach exceeds the Sales Approach, meaning a borrower might be spending more to build a home than they could buy the home for. This doesn’t mean the project shouldn’t move forward, but deserves special consideration and further research.