Have you heard of an appraisal gap? It’s not very common, but in today’s quickly appreciating market, the appraisal gap isn’t such a rarity. Whether you’re a buyer, seller, or lender, I want to give you the facts about what can happen during the appraisal process and how the results can affect you.
But first, let’s cover some of the basics.
What is a property appraisal?
When someone is buying a property, they’ll typically take out a mortgage to pay for it. Because the property serves as collateral for this mortgage loan, the mortgage lender wants to make sure that they don’t lend more money than the property is worth. This is where the appraisal comes in.
A property appraisal is essentially a valuation of the property performed by a professional third party. This third party looks at many different factors, including the property’s location and its condition, to determine the property’s financial value. However, an appraisal is not the same thing as a home inspection; an appraisal is performed to protect the lender’s interests, whereas an inspection is performed to protect the buyer’s interests (such as ensuring necessary repairs are completed before finalizing the purchase).
What is the appraisal process?
Once the buyer and seller agree on a price for the property, the lender orders the appraisal. Here is a quick rundown of the appraisal process:
- The lender selects an appraiser, who then contacts the seller to set up an appraisal date
- The buyer typically pays the appraisal fee, which usually costs several hundred dollars
- On the appraisal date, the appraiser reviews the exterior and interior of the property
- The appraisal report is sent to the lender, seller, and buyer at least three days before closing
Appraisers also perform research and decide which valuation approach is best. For more details, read about how home appraisals work.
The appraisal gap
The appraisal gap is when the property appraises for a value that’s significantly less than the price agreed upon by the buyer and seller. This normally reopens the negotiation table. The buyer may exercise the appraisal contingency written into the contract, or they may be able to show how serious they are about purchasing by adding appraisal gap coverage to their contract. Here’s a breakdown of these two protections:
- An appraisal contingency is written into a purchase contract, and basically states that the buyer can back out of the deal if the property appraises for a value that’s less than what they offered.
- Appraisal gap coverage is insurance written into a purchase contract, which states that the buyer will pay a certain amount of the potential difference between the appraised value and the purchase price. For example, if the purchase price is $325,000, and the appraised value is $315,000, the buyer may have $10,000 in gap coverage, bringing their total purchase price to $325,000.
Mortgage lenders typically will only finance up to the appraised value of a property. So in short, an appraisal contingency gives the buyer a way out of the deal, while appraisal gap coverage helps them appeal more to the seller since they’re willing to spend more than the appraised value.
The appraisal gap in typical market conditions
Let’s go over what the appraisal gap means in regular market conditions, and examine it from the perspective of the buyer and seller. In general, this usually can reopen the negotiation table for the buyer and seller to work through the deal, or call it off.
- The buyer can ask the seller to match the appraisal price. If the seller disagrees, the buyer can simply walk away from the deal and keep their earnest money, so long as they have an appraisal contingency clause in their contract. However if they want to show the seller that they really want to purchase the property, they can write in an appraisal gap coverage clause to up the ante (so long as they have the financial means to cover the difference).
- The seller can gauge how serious the buyer is based on whether the buyer is willing to cover some or all of the difference. However if the seller’s property hasn’t been very competitive or has been listed for a prolonged period of time, the appraisal gap might signal that the seller needs to lower their asking price.
The appraisal gap in a seller’s market
As of this writing (December 2021), real estate is a seller’s market. That simply means that there are lots of buyers compared to sellers, which often leads to bidding wars. The appraisal gap that typically can serve as a renegotiation tool now works in favor of the seller. Here’s a breakdown of the appraisal gap from the perspective of the buyer and seller.
- In a seller’s market, the buyer loses a lot of leverage because buyers are plentiful. They may waive the contingency clause and risk losing their earnest money if forced to walk away from the transaction. They may also increase their appraisal gap coverage amount to remain competitive and outbid other buyers.
- The seller has the luxury of letting buyers outbid each other until a savory, top-dollar offer comes in. If there’s an appraisal gap, high bidders are likely to have the funds to cover the difference, or they may have already solidified their offer by waiving their contingency. In any case, the appraisal gap makes it easy for the seller to see which high bidders are willing and able to give them the most for their property.
For lenders, a seller’s market can make appraisal gaps more likely. That’s because appraisers have to rely on rapidly changing data when making their assessments. Data for comparable sales can literally change on a day-to-day basis, and sellers may opt to go ahead with the reconsideration of value process. No matter the case, now is the time for lenders to be on their toes to properly vet buyers as well as maintain updated data for their appraisers.
Don’t bridge the appraisal gap alone
Get help reaching your homeownership goals, even in today’s seller’s market. Get in touch with me to discuss how much home you can afford, and let’s build a plan that gets you into the property of your dreams.
