Q: I’m trying to purchase a house in Nevada. The bid was accepted, but in the addendum it states that if the appraisal is lower than the offered price, the buyer will pay the difference at closing. Is that legal? Seems they should lower the price! –Joy
A: I often get questions asking whether thus and so is "legal," "allowed" or "standard" in the context of a real estate transaction, so your question creates a great opportunity to clarify. I define "legal" as allowed under the laws of the relevant jurisdiction, something that the courts would allow, if the matter were disputed in litigation.
In real estate, almost anything the buyer and seller agree to in the contract is legal. A contract term, closing-cost allocation or interpretation might be common or standard practice in a given state, but if the buyer and seller agree in the contract to a different arrangement, courts will almost always allow a written document that clearly expresses the mutual intentions of the parties to prevail.
In the situation you describe, it is true that a buyer might expect to be able to request a price reduction if the purchase price is not supported by the appraised price.
Fact is, most lenders will lend only the percentage they have agreed to lend of the appraised value of the home, if it is less than the purchase price. That is, if the lender has agreed to extend an 80 percent loan-to-value mortgage (i.e., a loan in which the buyer puts down 20 percent), that lender is actually only approving a loan for 80 percent of the appraised value of the home.
Until around 2006, it was common for the appraised value of a home to equal or even exceed the purchase price, so this issue was a rare one.
Once home values started to decline and appraisal and lending standards began to tighten, though, the situation you describe — in which the appraisal comes in below the purchase price that buyer and seller have negotiated — has become so common that in a recent survey of real estate brokers and agents, 40 percent said that a low appraisal or other appraisal-related glitch has caused the undoing of at least one of their recent transactions.
You wonder, well, why doesn’t the seller just drop the price? Many sellers are already so close to the bone on their sale price compared to what they owe on their mortgage and closing costs that they stand to recover nothing after the sale in the first place; reducing the price would doom them to either pay money to close the deal (which they may not have) or to turn the transaction into a short sale, which neither the buyer nor the seller wants, in most cases.
The other reason I’ve seen a major uptick in this sort of "buyer agrees to pay the difference in the event of a low appraisal" clause you describe is that many sellers — especially banks selling foreclosed homes — have been burned by getting multiple offers on the property, accepting a very high bid, then having that buyer just turn around and request a price reduction when the home doesn’t appraise.
In these cases, the bank fears it might have forgone a less extremely high offer from a buyer who would be willing to pay above the appraised value, or even from a cash buyer who didn’t even need to have the place appraised for lending purposes!
As a result, it is very common in multiple-offer situations on bank-owned properties for the seller to require the buyer to agree upfront to pay the difference that their lender won’t, if the place appraises low — especially if the offered price is above the asking price, which most banks set right at what they predict the property will appraise for.
So, even some smart individual homeowners who receive multiple offers will discourage buyers from bidding high just to win the war on the assumption they’ll be able to come back and get the price reduced when it doesn’t appraise by requiring them to sign such a clause.
And some savvy agents have adopted this sort of clause into their standard practices, especially if they work in areas where infrequent closed sales or a foreclosure-riddled market make good comparables hard to come by for appraisal purposes, or simply make low appraisal values quite common.
And yes, this is legal, as long as the buyer agrees.
If you’ve received such an addendum, it’s up to you to decide whether to sign off on it. Talk with your real estate broker or agent about how to manage your contingencies (rights to back out of the contract) vis-a-vis this addendum clause, before you sign.