How Does an Appraisal Gap Work?

You’re trying to buy a home and you’ve found one that checks all the boxes. You decide to make an offer that’s $30,000 above the list price. The market is competitive and you’ve been outbid a few times before. 

They accept your offer! Exciting times! Now your lender moves you onto the next stage of the journey: having an appraisal done. 

Unfortunately, the appraiser didn’t find the home as awesome as you did and returned with a low appraisal. The appraisal comes back the final figure is $20,000 below your offer. This difference is an appraisal gap, something that often happens in competitive markets.

An appraisal gap is the difference or gap between the offer price and the appraised value. The low appraisal serves as a red flag for the lender. This tells them that the property might not be worth what the buyer is willing to pay. 

The lender will only lend what the property appraises for. If the buyer still wants the property, they will need to come up with the cash to cover the appraisal gap. 

If, the appraisal comes in overvalue there is still a gap but it's to the buyer’s benefit. Since the buyer pays for and owns the appraisal the seller may never know. 

The type of real estate market you are in has a big impact on how appraisal gaps get resolved. There are three types of real estate markets. 

In a normal market, the parties usually work out the difference in an appraisal gap. Depending on factors like price and motivation, these differences are usually resolved. 

In a Buyers Market, the seller will most likely drop their price in order to accommodate the sale.

In both scenarios, the decision to deal with an appraisal gap is made after the appraisal is complete.

In an extreme seller’s market, we see what is known as an “Appraisal Gap Provision.” This provision occurs before the appraisal ever happens. The buyer waives the appraisal provision and commits to appraisal gap coverage. This coverage is in the form of cash for the difference between the appraisal and the purchase price. The appraisal gap provision is one of the tools homebuyers can use to survive in a strong seller's market.

The appraisal gap provision is also known as an appraisal gap clause. This is contract language that states the buyer is waiving the appraisal provision. This provision says that if the property doesn’t appraise, then the buyer will make up the gap. This gap is to be paid in cash, and a good listing agent will require proof of funds.

In a multiple-offer situation, this makes the offer more like a cash offer. One of the benefits of being a cash buyer is the lack of a loan and the need for an appraisal. 

If you have the cash to cover an appraisal gap it gives you a distinct advantage during negotiations. The appraisal gap provision is often the deciding factor for the best offer. 

It's easy to get caught up in the auction-like mentality of a bidding war. If buyers have limited funds, cash reserves for repairs or upgrades to the home can disappear. Stipulating a cap on the amount of cash you are willing to dedicate to the appraisal gap is a good idea.

A low inventory of single-family homes and a hot market create a sense of desperation. Many home buyers feel pressure to pay more than the appraised value of a home. The appraisal exists to protect homebuyers and their mortgage company from overpaying. 

Eliminating it is like buying without a safety net, you really need to understand what you are doing. It's important to work with a real estate agent who understands property values. A good agent will be able to advise you on reasonable and unreasonable gap amounts.

Not surprisingly, appraisal gap provisions are more common in hot real estate markets. In a strong seller's market, homebuyers need to be more competitive with their offers. This means making offers that are above the sale price. In some cases, buyers may also want to consider making an escalation clause to their offer.

Note: With an escalation clause, sometimes called an escalator, the buyer makes an offer and essentially says, “I will pay this much over the asking price for the home, but if the seller receives a better offer, I’ll increase my offer to x amount.”

Now, let's take a quick look at the appraisal process.

An appraisal is an expert’s assessment of a property’s market value. An appraisal can only be performed by a licensed appraiser. A real estate professional, your listing agent for example can only give a price opinion. The lender will require an appraisal, and they will order it.

While the lender orders the appraisal, the buyer pays for it. The cost is based on the square footage, the complexity of the appraisal, and location.

See Also: How to Ace Your Home Appraisal - Springs Homes

In any scenario, it is in the home sellers best interest to prepare for the appraisal. Showing the property in the best possible light, even for the appraiser helps. Prepare for the appraisal as though it were a showing. Make sure the home is cleaned, and in good repair so that nothing is marked as a negative during the appraisal. 

It also helps to provide access to documentation of recent renovations or improvements. Especially for any major upgrades, like a new roof, or upgrading the heating system in the home.

It's not uncommon for a home’s appraisal to come in below value, especially in a seller's market. A low appraisal is not the final word, the first thing to check is the accuracy of the data. If the appraisal contains incorrect or inaccurate information, you can request another appraisal.

The second appraisal would be done by a different licensed appraiser. You would also be responsible for an additional payment. Should that appraisal continue to show a large gap, you'll need to explore other options.

According to Housing Wire, appraisal gaps have become an issue in U.S. housing markets. When thrust into a bidding war, buyers often resort to making offers well above listing price. This competitive, auction-like mentality ends up driving home prices even higher. 

If you do have the cash and can use it to win a bidding war, you are rare, most cash buyers end up being investors. In a normal market, investors use cash to avoid financing issues. In a strong seller's market, they use cash to win the deal.

Actual home buyers are having a hard time competing with all-cash investors. This has led to buyers asking friends and family to help pay for their dream homes. We also see people borrowing from their retirement savings to say in the race for a home. 

The concern becomes sustainability. Will the real estate market be able to maintain this kind of appreciation? If appreciation continues, these buyers are fine. They can recoup their investment through equity gains. If this level of appreciation does not continue, they are in a tough situation. It's never a good idea to deplete your financial resources to buy a home.

We prefer to pursue more traditional methods when it comes to appraisal gaps.

If you can't negotiate your way around the appraisal gap, the next option would be to cover the difference.

There are some different ways that you can make up the difference to close the appraisal gap. These options are "last resort" and if the listing agents ask for "proof of funds" these might not work. 

Real Trends reports that it's become common for buyers to include an appraisal gap provision in their offer. This makes the offer more competitive in low-inventory, high-demand markets.

Pairing an appraisal gap with an escalation clause can amount to a lot of money. Many buyers are uncomfortable depleting their cash reserves to get into a house. It's important to understand your financial limitations in a bidding war. This is why it's wise to pre-determine your limits.  

You are able to stipulate a cap on the amount of gap you are able to pay. For example, if a home is listed at $200,000, you may choose to offer $220,000 with a $10,000 appraisal gap. If the home were to be appraised for only $200,000, they still get a $220,000 offer. If the home were to be appraised for $220,000, or more, you would be safe. The benefit of this is that the offer feels more like a cash offer to the seller. 

It’s up to a buyer to decide if the home is worth that risk because there is no guarantee the property will gain value after purchasing. If this is a route you choose when you present an offer, you need to ensure you are able to put your money where your mouth is. 

It becomes important to work with a Realtor who understands property values. A good agent will be able to advise you on reasonable and unreasonable gap amounts.

Finally, leaving the appraisal contingency in place is another option. You will lose the advantage if there are other offers with an appraisal gap provision in place. This is tough in a competitive market but at least you have the peace of mind knowing you didn't overpay. 

You can still submit a competitive offer and it might be the highest offer. The decision to accept or reject an offer comes down to the home seller's priorities. Because the buyer must live with the consequences of their offer, they should be comfortable with whatever they decide to do. Markets rise and fall, and at some point, the pattern will shift back to a "Buyers Market". At that point, those that bought during a very competitive housing market will find out if they made the right decisions. Until that point, all we can do is speculate.