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Real estate markets across the country have been bursting with appreciation for the past year. Exploding would be a good word to describe it. Inventory is low, and demand is high. The current environment has been ripe for home pricing to go through the roof.
Appreciation of home values has continued to skyrocket. In many areas, bidding wars are commonplace. Sellers, buyers and real estate agents are experiencing a market they have never witnessed before.
With prices going up so quickly, it is not uncommon for real estate comps not to have caught up to the current market conditions. Something that sold three to six months ago is now worth a lot more money.
Given this, there are issues with appraisals coming in at the agreed-upon purchase price. There ends up being an appraisal gap. For sellers, appraisal gaps can be a nightmare. It can stop a sale dead in its tracks.
The fear of a home not appraising has caused many homeowners to forgo higher offers and accept a cash buyer instead. Even though the cash offer is lower, the owner has less risk.
Is there a way around this common appraisal problem? There sure is, and it’s known as an appraisal gap guarantee.
What is a home appraisal?
When buying a house with a mortgage, the lender will usually have the house appraised by a licensed appraiser. There are times when an appraisal does not happen, such as when there is a significant down payment.
If there is substantial equity in the home, the lender could waive the appraisal process. Sometimes lenders will also use an AVM appraisal model.
How does an appraiser arrive at the market value?
An appraiser will do market research by finding comparable sales. The “comps” are properties that have sold close to the subject property and share many similar characteristics.
Similar features include the square footage of the property, the age, amenities, the number of bedrooms and baths and the location. They visit the subject property and take notes and pictures to be able to compare to the comparable sales data.
Appraisers will make adjustments up and down based on the noted strengths and weaknesses of the property. An appraisal is nothing more than a qualified opinion like a comparative market analysis that a real estate agent completes.
Unfortunately, lenders look at a real estate appraisal as gospel. It is hard to challenge the appraiser and win even though they are human like the rest of us. They do make mistakes.
What is an appraisal gap?
An appraisal gap is a difference between the agreed-upon sales price of the home and what the appraiser believes is the fair market value.
For example, if you purchase a home for $575,000 and the appraisal comes in at $550,000, there would be an appraisal gap of $25,000.
The lender in this circumstance might not want to provide financing if the borrower was putting less than 20 percent down. They may reject the loan.
As you might imagine, this would not make anyone involved in the real estate transaction happy. The seller, without a doubt, would be the most upset as they would have wasted time with a buyer who is potentially backing out of the sale.
What is an appraisal gap guarantee?
As you might imagine, many sellers love cash offers because they don’t have to worry about financial surprises like this. It takes many of their worries off the table.
Is there something that takes away a seller’s worry and makes a non-cash offer more appealing? Yes, there is, and it’s called an appraisal gap guarantee.
To make their offer less risky to a seller, a buyer will insert language into the offer that says they will agree to make up any appraisal gap. It’s called an appraisal gap coverage clause.
So, in the above scenario, a buyer would increase their down payment amount so that the lender was satisfied there was enough equity in the home to make them whole.
Appraisal gap guarantee clauses have become far more common today, with many homes selling way over the asking price.
What is the downside to a buyer with an appraisal gap clause?
The drawback of an appraisal gap clause is you could be paying more than a home is worth. You can no longer use the appraisal clause to escape the contract when you offer this clause.
In a traditional offer with no appraisal waiver, you could use the mortgage contingency to escape the sale and get your earnest money deposit returned. With the appraisal gap language, you will need to proceed.
The upside is that you’ll be able to purchase the home you want. The appraisal gap clause could be a significant reason why you were able to win the bidding war.
Final thoughts
In the current real estate market, buyers need to think outside the box to get a house they love. Many buyers are doing everything necessary to land the home of their dreams. An appraisal gap coverage clause is just one tool to accomplish that goal.
More and more real estate offers have appraisal gap clauses included. They strengthen an offer considerably when a buyer offers well above the asking price.
If you have lost out when offering on other homes, adding an appraisal gap guarantee clause could be worth it. It can help level the playing field with other buyers who are doing so.
Before proceeding with an offer on a home, make sure you understand any language inserted into a standard contract. Your real estate agent should be able to answer any questions to your satisfaction.
If they cannot do that, consult with a real estate attorney.
Bill Gassett is a nationally recognized real estate leader who has been helping people buy and sell homes for the past 33-plus years. He has been a top agent with RE/MAX Executive Realty, which serves many towns across the state of Massachusetts. Check out his blog.
