When purchasing a home and using financing through a mortgage loan, the lender of that loan will require an appraisal. This is typically performed following the seller accepting the buyers contract. The lender orders and schedules the Appraisal and the cost is typically paid for by the Buyer in their closing costs. The appraisal ensures that the lender is not writing a loan for an amount greater than what the home is worth. An appraisal gap occurs when the appraised value of the home is different than the purchase price offered on the property.
For example, a single family home is listed for $440,000, and there is likely a multiple offer situation. The Buyers really love the home and so write an offer offer of $450,000. The Seller accepts their offer, and then the appraisal comes in at $440,000. The $10,000 difference between the appraised value and the Buyer’s offer price is the appraisal gap.
There is an appraisal gap, what does this mean?
As stated above, the Buyers lender will typically not write a loan for any amount over the appraised value of the home. So now the Buyers in the above example only will get a loan for $440,000, but are under contract for $450,000. If nothing is written in the contract, the Sellers can now terminate the offer if the Buyers do not agree to bring an extra $10,000 in cash (on top of closing costs and down payment) to closing to cover the “gap” between the appraised price of the home and the offer amount they agreed to pay in the contract, or if the Seller does not agree to lower the purchase price.
However, to avoid this situation I often will insert language into my contracts that will only obligate my Buyer to a specific amount, if any, that they are willing to pay over the appraised amount.
Using the example above, the Buyer and I spoke before we submitted the offer, and they agreed that they are willing and able to pay $5,000 over the appraised value in cash as appraisal gap coverage, if needed. I then wrote language in the contract that states the Buyer is “offering $450,000 for the home with a $5,000 appraisal gap, not to exceed $450,000“. Using this language, if the appraisal comes in lower than $450,000, the Buyer will only pay up to $5000 over the appraised value, up to a maximum of $450,000. Which will essentially put a cap on the out of pocket expenses my Buyer will owe.
Now, lets say the appraised value came in at $440,000 as mentioned above. My Buyers would then be paying $445,000 for the home and must bring the extra $5,000 to closing to cover the appraisal gap. They would ONLY pay the full $450,000 offer price IF the appraisal came back at $445,000 or higher, but they would never be responsible to pay more than $450,000.
Let’s alter the appraised value a couple more times to give you other scenarios. Say the the appraisal came back at $448,000. If the same contractual language is used, my Buyers would only owe $2,000 extra at closing to cover the appraisal gap (Remember, they will only owe a MAXIMUM of the purchase price agreed upon of $450,000). So then this also means if the home were to have come back with an appraised value of $450,000, or higher, my buyers would then not owe anything for the appraisal gap since they lender has already qualified them for a loan up to $450,000.
How can Appraisal Gap language affect a buyers offer?
In the current strong sellers market, appraisal gap language is often used to strengthen a Buyer’s offer. The appraisal gap coverage gives further assurance to the Seller that they will get what the Buyer offered in the contract, at closing, and without concern the Buyer will back out if it does not appraise for the offer price. And in today’s market, if a Buyer is going to submit an offer that is over the list price, it is almost necessary that it includes an appraisal gap. Even if an offer beats all others on price, the Sellers may not accept it if there is no appraisal gap language, as then there is more risk to the Sellers that the deal may not close.
Can a buyer win an offer without covering the appraisal gap?
Absolutely! Including appraisal gap language in a contract is not mandatory and I am obligated to write and submit any offer you would like. And there are instances where either the home is priced right and the Sellers just simply want the asking price, or they Sellers are willing to negotiate the purchase price with the Buyer if there actually is an appraisal gap.
There are also several other points in a real estate contract where the Buyer can strengthen their offer. In this sellers market, it may be difficult for the Seller to find and purchase a home, so one of their top concerns may be a closing date that will accommodate the time needed for them to buy another home. So in this case, you may see the Seller request a Post-Closing Occupancy Agreement (PCOA) from the Buyer.
Also called “rent back”, this essentially means that upon closing, the Buyer will instantly be come the landlord and rent the property back to the Seller to allow them to remain in the property for a time period, not typically to exceed 60 days if financing is being used in the purchase. This establishes a landlord and tenant situation following closing, where the Buyer then will collect a security deposit and monthly rent which is negotiated between both parties. In order to make an even offer stronger, the Buyer can give the sellers a very low rent, or or charge them completely nothing during the rent back period. Once the Seller finds a replacement home, the rent back can terminate and the Buyers can take possession. However, this does have it’s risks as you are now a landlord, and there are many ways in which your new tenants can cause you undo stress.
Other ways for Buyers to win offers in this market are discussed on my page: Writing A Strong Offer in Today’s Sellers Market