Question

When underwriting a loan, a bank will require an independent appraisal (valuation) of the property for which the loan is intended. It will then provide a loan based on the lower of the Transaction Price and the Appraised Value. Explain why a bank does that in terms of the market for real estate not being efficient, hence that the market mechanism for real estate does not work.

Answer 1

Real estate market is inefficient and lacks liquidity. Each unit is very different from the other so one cannot use comparables method. Also, it is very buyer-seller needs dependent. The seller night need the cash urgently so he might be willing to sell at cheap price compared to comparables. The buyer might have some synergy benefits from this unit hence he might be willing to buy at higher price compared to comparables. Note though that Real estate transactions involve cash dealing as well and not all deals are reported at correct price.

Many a times it so happens that to take higher loan, deal shows that the transaction took place at higher value. Hence, we cannot directly take the transaction price to compute the loan eligibility.

Also, appraised values are computed using some standard values and it may so happen that the real estate market fell after those standard values were calculated. Hence, we cannot also use the appraised value directly.

Therefore, we have to take the lower of the two-transaction price and appraised price.