I remember it vividly. I had just started articling when a senior partner, one of those guys with a corner office, called me over and said: “Meltzer, I need you to close this deal for me. Here’s the file. Be at the Registry Office at 2 pm.” I was a new articling student. I knew nothing and had no idea what I was supposed to do. So I asked him “What do I need to know about this?” His answer has stuck with me ’til this day: “Our client is selling. You only need to remember one thing – Get the cheque. Nothing else really matters.”

I’ve been thinking about this lately as I’ve been seeing some buyers pay previously unheard of and unsupportable prices, the kind we reflected upon in Making Sense of the Market. You see, while it’s great to be able to pay a huge price and land your dream home and it’s great to be a seller and receive that huge price, there’s one very important factor that’s often overlooked in these transactions – when the closing date comes, the buyer has to come up with the money. We’re not playing Monopoly here. And when there are no comparable sales to support a price, the property may not appraise. And when a property doesn’t appraise, the bank won’t lend as much money as a buyer may need. And when a buyer doesn’t get the money from the bank, what can happen? No closing. Panicked buyers. Angry sellers. Lawsuits. But let’s not get ahead of ourselves. Let’s take a step back to see how this all works.

We suggest to all our clients that they get pre-approved for their mortgages before they start looking at homes. That way they know how much they can afford and don’t overspend. Some people are under the impression that these pre-approvals mean the bank will loan them up to the pre-approved amount, but that’s not the case. They mean that the bank will loan them up to the pre-approved amount only if the property they seek to buy appraises. Now what does that mean?

Let’s say you have $250,000 of your own money to spend and get pre-approved by the bank for a $1,000,000 mortgage. You think that means you can spend $1,250,000 on your new home. You find a home you love, make an offer for $1,250,000 and beat out the other 4 buyers who offered on the home. You didn’t include any conditions so the deal is done. It’s firm and there’s no way out. You’re feeling pretty happy.

You tell your mortgage broker or banker and they arrange for an appraiser. The appraiser examines all the comparable sales and reports to the bank that the property is worth only $1,000,000. You’re not concerned at first because you think you’ve been approved for a mortgage of $1,000,000 and a price of $1,250,000, but then your banker or mortgage broker explains to you that your pre-approval was conditional on the property appraising and, as is typical, the bank is only willing to loan you 80% of the appraised value of the property, which in the case of a $1,000,000 property is $800,000. This means you’ll have $1,050,000, but you need $1,250,000 to close the deal. So what do you do?

First, you take some deep breaths. Second, you call your Realtor and ask if he or she can find some comparable sales to support the price you paid so these can be sent to the appraiser who will hopefully increase the appraised value which will allow the bank to loan you the money you need. (A good Realtor will have done this before you made your offer so you’d have advance notice of this potential problem and also so you’d know if you were paying too much.)

Assuming there are no comparable sales to support the price, you’re in a bit of a tight spot. You can try to get out of the deal, but that may result in you losing all or part of your deposit. Your failure to close may also produce a domino effect on other transactions. The buyers of your current home expect you to move out and the sellers need your money to buy their new home. Failing to close may put you at the centre of several lawsuits. That’s somewhere you’d rather not be.

You can also look at a second mortgage for the extra money you’ll need, but be prepared for a much higher interest rate. Other options would be a loan secured by another asset you own such as a recreational property or a stock portfolio, an unsecured line of credit if your financial position is very strong or a loan from family or friends. But at the end of the day, you don’t really want to have to go down any of these roads.

This isn’t to say that all buyers paying these unsupportable prices will find themselves in this position come closing. Hopefully, they will all have looked at the comparable sales before making their offers, be aware of the possibility of the property not appraising and know they have access to the additional cash they’ll need to make up for the shortfall from the bank because the property didn’t appraise.

As with every step of a real estate transaction, it doesn’t matter if you’re buying or selling – preparation is key. The last thing you want is a nasty surprise on closing day. When you’re buying, make sure you understand the financial situation your offer will put you in. Look at the comparable sales. Check with your banker or mortgage broker in advance. Unfortunately, offers conditional on financing have very little chance of success in this market which is causing some buyers to take unadvisedly large risks. When you’re selling, try to find out what you can about the buyers’ finances. Unfortunately, this is very hard to do because of our privacy laws, but if you think your sale price is unsupportable by the comparables, try your best.

Big risks come with big rewards for both buyers and sellers, but if they don’t pay off, they’re worthless. A deal for $1,000,000 that closes is worth a lot more than a deal for $1,250,000 that doesn’t.

As always, if you know anyone who’s interested in learning how the market works and who’d like to receive the kind of help that involves honest answers, straightforward advice, no pressure and being treated like family, please let me know the best way for me to connect with them because I’d like to offer them this kind of help. And as always, don’t be shy if you have any questions or comments about this post! Thanks for reading.