Writing an offer that really stands out amongst the competition can be tough in a seller’s market. Sure there are escalation clauses that allow you to pay more than the next highest offer — up to a certain amount, of course. But is that enough? After all, what happens when the seller accepts a high offer, but the appraisal doesn’t agree with that offer? Enter the appraisal gap — a strategic way for a buyer to stand out amongst the competition in a bidding war.
Before we explain how an appraisal gap works, let’s review what the appraisal process entails and provide tips on what you can do to avoid this predicament in the first place. After all, we’re in a seller’s market (at the time of this article), it’s very unlikely the seller will budge on price to help you.
Explaining the appraisal process
Appraisals are done by an appraiser that’s hired by the buyer’s lender. This certified professional will determine the current market value of the home that’s up for sale. They look at square footage, bedroom and bathroom numbers, plus neighborhood value or recent sales that have taken place within the area. Doing this helps the mortgage company understand whether or not you’re paying a fair value for the property.
If the appraised value matches or exceeds the listing price, all is well. If not, you may encounter a few problems — especially if you’re financing the home.
You see, lenders (usually) only approve loans up to 80% of a home’s assessed value. So if the appraisal is less than that amount, the lender uses the lower appraised amount to determine how much loan money they approve.
For example, say a home lists for $450,000, but it only appraises for $435,000. The remaining $15,000 of the home listing price is considered an appraisal gap, and it needs to be covered by the buyer or seller.
If the seller is eager to move, you may be ok. But, the likelihood of a seller settling for a lower amount than the asking price is not very likely, especially in a seller’s market. This is where an appraisal gap may be an advantageous strategy for both parties. Otherwise, as the buyer, you may have to come up with a stronger down payment.
How accurate are home appraisals?
Home appraisals are only as good as the data that’s available to appraisers. For the most part, you’re looking at an opinion of an ever-changing real estate market. If a property in your desired (or current) neighborhood sells far below or well over the asking price, your appraisal could tilt either of those ways.
Here a few reasons why your home (or the home you want to buy) may be at risk of being overpriced.
Significant home improvements
If the listed home has recently undergone a renovation or two, it’s often considered a worthy investment. However, if that home is located in a neighborhood where the home comps are significantly lower, the appraiser may look right past your new pool or finished basement. After all, appraisals look mostly at neighborhood comps and square footage. They don’t often consider your decor or the newness of a living room space or kitchen.
Though, if you added a bedroom or bathroom, that may be to your advantage. You just need to be sure your expectations aren’t too high. For example, if you spent $100,000 on a renovation expecting your value to increase by $35,000, but the appraiser believes the final project to be closer to a $20,000 upgrade — you could be looking at too high of a listing price, which may result in a low appraisal value.
Bidding wars on the home
Bidding wars cause a spike in home offers. As expected, they tend to inflate the home price. The fewer homes that are available, the more you can expect to pay. Similarly, an oversupply of housing will bring home prices down.
Let’s consider an example. Say you list your property at $475,000. If you live in a highly sought-after area, you may find yourself receiving offers for over asking price at no fault of your own. It doesn’t happen all the time, but it could as many home buyers think offering more money is the best way to compete.
No matter how nice that extra money sounds to the seller, it’s not advantageous for either party. After all, if the appraiser deems the home to have a lower value, then someone has to make up the extra money to cover the appraisal gap because the mortgage lender is not going to do that.
What is an appraisal gap?
Now that we’ve explained why it’s not worth offering too much over the listing price, let’s talk more about an appraisal gap, which can also be known as an appraisal gap guarantee clause or appraisal gap coverage.
The bottom line: an appraisal gap is when you agree to cover any shortage between the offer price and the appraised value. It’s written into your offer and often includes a specific number of how high you will go. Its purpose: to show the seller you are serious about the home and are willing to pay more. You, like the current homeowner, believe the home is worth more than the appraised value and you’re able to offer additional funds (a predetermined amount) to help sweeten the deal.
Let’s consider another example. Say you write an appraisal gap guarantee clause to pay up to $5,000 over the appraised value. If the appraiser says it’s worth less than the listing price, plan on coming to the closing table with an extra $5,000 in cash. If the appraisal comes in on target or above, you get to keep your $5,000 — no loss.
How does an appraisal gap differ from an appraisal contingency?
An appraisal contingency is a condition that’s in place so buyers can walk away from a deal — with their earnest money — if the appraisal comes back low. They still have to pay the $600 or so for the appraisal, but that’s much less than what they have to cover in earnest money.
Now, let’s again consider we are in a seller’s market. As the buyer, you can waive this contingency or waive the appraisal and simply agree to pay the asking price. But as we mentioned earlier, you can only borrow a certain amount from a mortgage lender (amount is dependent on the loan program). So if you are financing your home purchase, this is extremely risky.
The bottom line: waiving the appraisal contingency is a strategy that should only be considered by an all-cash buyer or by someone who can make a sizable down payment (because a large down payment means the bank has a much lower loan amount to finance).
If this is not you, then maybe it’s time to learn about appraisal gaps and other strategic ways to make your Denver home offer more competitive. Our experienced agents are ready to help. Give us a call today to learn more: (303) 695-5900.