The home buying process ranks as one of the most stressful events in most people's lives. Seriously! When Alexander and I first consult with first-time homebuyers, they often express that everything feels like an entirely new language. I get it. There are SO MANY specifics: escrow, earnest money deposit, down payment, inspection, contingency...and of course, the dreaded 'appraisal gap', which is what I'll focus on today.
There are several reasons why an appraisal gap can occur within a real estate transaction. First and foremost, it is important to define the situation where an appraisal is necessary: when a buyer is seeking a mortgage loan to fund a portion of the purchase. In an all-cash situation, an appraisal will not be ordered. During the loan process, the lender will put in an 'order' for an appraisal to be completed on the property. An appraiser serves as a third-party, neutral candidate to define the value of the property. This is necessary from the lender's side, as you can imagine, to ensure that they will receive enough collateral back if the buyer defaults on the loan payments and therefore the bank repossesses the property.
The housing market is currently a strong seller's market. This means that the inventory available for buyers is low, and therefore the seller commands most power within the transaction. As fewer homes are available, but a certain percentage of buyers still need homes, higher purchase prices are occurring. An excellent realtor will always run comparable sales as a data point for the market, but it is important to remember that the true market value of a home is whatever a buyer is willing to pay. Therefore, this can lead to gaps within the value a neutral, third-party assigns (the appraiser) for the land, physical structure, etc. versus the purchase price a buyer offers due to necessity or emotional connection to a home.
How do I handle an appraisal gap?
There are a few options when an appraisal gap occurs within a transaction. While it is not the desired outcome, there are alternatives to prevent the home purchase from falling through.
One option is for the buyer to take the brunt, and put more money down for the purchase to make up any gap. If a buyer puts 20% or more down initially, there is a significantly reduced chance for the appraisal to come back low enough for them to have to add any more funds. Another option is for the buyer to negotiate the difference and ask for the seller to split the gap, 50/50 with them. This is not likely to hold up in a strong seller's market, however, in certain scenarios, the seller would be more inclined to take a slightly reduced price during the escrow period in order for the transaction to go through and prevent the hassle of putting the property back on the active market. If you feel that the appraisal came back unfairly low and the appraiser overlooked some important home features or recent comparable sales, there is always an option to request a second appraisal. Keep in mind, however, if this appraisal comes back at a similar value, you will be in the same boat as before.
It is important to note that there is something to protect a buyer from the appraisal gap, called an appraisal contingency. This is a clause within the offer (purchase contract) that allows for the buyer to rescind their offer and receive their entire earnest money deposit back if the appraisal comes back lower than the purchase price. This can be an important leveraging power for a buyer but sometimes is more difficult to get the offer accepted, especially within a seller's market.