As you might expect with the cost of real estate in the GTA, most of our buyer clients have a mortgage for a portion of the purchase price. Depending on their situation it can range from as much as 95% of the purchase price to half or less.
Bank data suggest that about one‑fifth of home purchases are all‑cash and consumer surveys and industry estimates place the share of cash‑offer transactions in the broader range of 15–25 %. In the Toronto area, the percentage of purchases made entirely in cash has climbed into the low 20s and we’d estimate for the GTA that roughly one in five buyers pay for a property with no mortgage.
While lenders in Canada have done very well loaning money to people to buy real estate, it doesn’t mean they don’t follow some rules to make sure the property being purchased is worth the amount the buyer is asking to borrow.
Lenders use appraisers for this purpose, individuals who are trained and accredited in the ability to assess the value of real estate. While we wouldn’t go so far as to see appraisers are the natural enemies of real estate agents, it can be a difficult relationship. Real estate agents work in real time on the ground with their clients and have a current and up to date understanding of the market and the value of homes. Appraisers work from closed deals only and in a fast moving market (with prices either going up or down over the course of weeks), the appraised value they come up with can make the deal price seem wrong.
In addition, while appraisals are often described in scientific terms as if they are concrete, absolute statements of fact, they are more of an art than a science. Three different appraisers will provide three different values for a given property, sometimes with significantly different valuations. When was the last time you saw a scientific experiment or theory accepted as valid when the results keep changing?
When an appraisal comes in at higher than the purchase price, it generally doesn’t cause problems. The buyer is thrilled at the idea that they actually got a bargain on the home, the lender has no issues with proceeding with the mortgage at the agreed upon ratios and everything moves forward.
When the opposite happens, then things can get messy. Let’s talk about what happens when someone buys a home and the appraisal from the lender comes in at less than what they agreed to pay.
First, the basics.
A buyer submits an offer for a property at a price they are willing to pay. By definition, this is now market value, as the home went up for sale (on “the market”) and a buyer offered a purchase price that the seller accepted. Boom, market value established.
If the buyer has all the money for the property, then that’s it. As discussed though, most buyers have a mortgage of some amount, though, and this is where things get a bit more complicated.
A lender (be it a bank, credit union, private lender or your Aunt Sally) makes the decision to lend based on how much you make, how much you owe and your past record of borrowing responsibility. When we work with clients, we guide them through this process before we get too far along in the purchase journey. By providing job documentation, bank information and submitting to a credit history review, our clients are pre‑approved for a certain amount at a certain interest rate. A pre‑approval can be looked at as the lender saying, “OK, I’m comfortable loaning you this much money based on your situation.”
When a prospective buyer finds the home that fits their needs and budget, we negotiate the best price and terms possible and buy the home. If we can, we write the offer conditional upon financing approval. In a strong seller’s market, it can be very challenging to buy a home with any conditions, but in any market the logic remains the same. We want financing approval because the buyer needs to turn their pre‑approval in general terms into approval of a specific property.
Here’s an example.
Our client buys a home listed at $729,900 for $800,000 in multiple offers. While we would have preferred to have a financing condition in place, with other offers in play that had no conditions, our client made the decision to remove the financing condition. They had a pre‑approval up to $900K in place and had a down payment of $160,000 ready. This meant they had 20% of the purchase price and wouldn’t need to pay CMHC fees.
Though our client is willing to pay $800K for the property and has been pre‑approved for up to $900K in a general sense (based on income, debt levels and credit history), the lender must be comfortable that the property is worth that $800K. In essence, the lender needs to be confident that when it comes time to sell the property and recover their loaned amount (the outstanding mortgage due), they will be able to get their full amount back.
The lender sends in the appraiser and in a few days comes back with some bad news: the property that our client has bought firm for $800K is appraised at $750K, a shortfall of $50K.
Our client expected the purchase would look like this:
- Purchase price: $800K
- Mortgage: $640K (80% of $800K)
- Down payment: $160K
After the appraisal comes in lower than the purchase price, the lender says, in effect, “We were willing to loan you 80% of the purchase price, with you providing a 20% down payment. We are still willing to loan you 80% of the appraised value, but you need to come up with the shortfall.”
The purchase now looks like this:
- Purchase price: $800K
- Mortgage: $600K (80% of $750K)
- Down payment: $200K
As a result of the appraisal value, our client needs to find an extra $40K in order to close on the deal.
They may be able to find another lender to offer that $40K at a higher interest rate (as second mortgages are second in line after the primary lender for repayment and are therefore riskier) but it will depend on what the changed interest rate does to their debt‑servicing ratio. If they were already at their limit, then finding another lender may be difficult or impossible.
When a buyer has made a firm purchase of a property and runs into financing problems, it is possible that the deal won’t close. If the buyer can’t get the money to close on the closing date, then the seller won’t hand over the keys. To be clear, the buyer has a legal obligation to close on the deal as per the agreed‑upon terms. A legal obligation isn’t the same as actually having the money, though.
The deposit that was provided at or shortly after the purchase date (when the price was agreed upon and the papers signed) is held by the seller’s real estate brokerage. If the buyer cannot close on the deal, then the seller has the option of showing damages and keeping some or all of the deposit that the buyer provided. Determining damages can be complex and lawyers will be involved on both sides to determine if and how much of the deposit can be kept by the seller as a result of the buyer failing to close as they are legally obligated to do.
That sounds…messy.
It’s a messy situation and one that should be avoided at all costs. It truly is something neither side wants, as both the buyer and seller wanted to do the transaction and agreed upon terms that one side ended up not being able to complete.
Here’s how we work for our clients to avoid a situation like this.
When we work with buyers, we discuss the repercussions of a lower appraisal, changes in interest rates and other factors. If we are in a situation where we cannot have a financing condition, we make sure we have done our work beforehand to know the consequences of a lower appraisal and that the buyers have the ability to make up the shortfall if need be. We leverage this information with the seller and their agent, letting them know that our clients are solid purchasers who can close even if the appraisal value is lower. We’ve used this to get a seller to choose our clients over a higher offer price because the seller was more confident we would close without an issue.
On the selling side, we ask questions of the buyer and their agent to get at their situation with regard to financing. We want to know their down payment amount available, income and type of work, and their pre‑approval status. This is true regardless of whether the buyer includes a financing condition. While our seller may have recourse if the deal doesn’t close, our goal is to make sure that from offer to close we have a smooth process.
If you or someone you care about is considering buying or selling, make sure you work with a Realtor that understands how to make sure the deal actually closes. From the day of negotiations to the day the keys are exchanged, we’ll help you avoid surprises. If that sounds appealing, get in touch with us!
