Appraisal Gap Explained

Jan 23, 2022

Definition of an appraisal: A real estate appraisal is an unbiased professional opinion of a home's value.The purpose of an appraisal is to help the lender/bank to determine the fair market value of a property to make sure the bank isn't lending on an overpriced property. Sometimes the lender will waive the appraisal for a low risk applicant especially if it's a primary residence with a large down payment amount but an appraisal is required for most traditional loan applicants. If the property appraises for lower than the sale price, then the bank will only lend based on the appraised value to minimize their risk so the buyer and seller must then negotiate on who covers the "gap".

Appraisal Gap refers to the difference ("gap") between the Appraised value and the Sale Price. In a highly competitive market where there are multiple offers, oftentimes signficantly higher than the asking price, the seller may be hesitant to accept such a high offer and worry that the property won't appraise for that high. In fact, the seller may accept a Cash offer or one with a higher down payment (e.g. Conventional loan at more than 25% down) even if those offers are not the highest. For a buyer trying to purchase a home with a low % down, offering an "appraisal gap" clause can be a very useful tool to compete with those Cash buyers.

An appraisal gap clause basically says that, "I am willing to put in extra money in addition to the down payment if the property does not appraise for the full sale price. For example, if the Sale price is $500k and it only appraises for $490k, then I'm willing to bring in the extra $10k so the seller still gets to sell the house at $500k"

Below is a flowchart that outlines the possible scenarios with an appraisal gap.

Scenario #1 with $10k appraisal gap: If the appraised value is $485k, the worst case scenario for the seller is to reduce the price to $485k, $15k below what the seller agreed to initially

Scenario #2 without the appraisal gap: If the appraised value is $485k, worst case scenario for the seller is to reduce the price to $495k, only $5k below what the seller agreed to initially.

As you can see, an offer with an appraisal gap is a stronger offer than one without because it gives the seller the comfort of knowing that the buyer is willing to come in with extra money if needed.

One thing that I omitted from this flowchart is that sometimes buyers can dispute the appraisal if they feel like the appraised value is too low if there are enough supporting facts. However, this can often be tricky if the property is very unique and there is not enough supporting evidence.

Sometimes buyers hesitate to use an appraisal gap or offer an appraisal gap that is too high because they are afraid that they will be overpaying for the house. What people sometimes fail to realize is that the appraisal is a subjective process since there are many different factors that go into an appraisal and oftentimes those factors are based upon the appraiser's best judgment. It is entirely possible that the appraised value is not an accurate reflection of how much the house is actually worth. At the end of the day, the appraised value is simply one person's opinion of what the house is worth based on the condition of the property and comparables (similar properties). Keep in mind that just because a property appraises for less than the sales price doesn't necessarily mean that you are overpaying for the house. Its true worth is the price that someone is willing to pay for it and no one can accurately predict that. Conversely, when a house appraises for more than the sale price, it also doesn't necessarily mean that you are gaining instant equity either. I tend to think of the appraisal just as a necessary step in the loan approval process and just an attempt at estimating the true worth of the property. I'll end this guide with a personal experience on the appraisal to further illustrate my point:

I purchased a property with a sale price of $227,500. This was a property that needed a lot of work - the roof was at its end of time, the furnaces were 35 years old, some parts of the siding had water damage, mold in the bathroom, shower tiles falling apart. So basically it needed a complete renovation. It was listed for over a year with multiple price reductions and at the time I got it under contract, the listing price was at $239,900 and it sat on the market at that price for a while before I offered. I had an appraisal done and the appraisal came back at $250,000. At that time, I actually thought the appraisal was an accurate reflection of the value of a property so I was almost at shock. How can the appraiser think the property is worth $250k when it wouldn't sell at $240k? I went through the appraisal report and did notice a couple of minor mistakes in the report so that might have influenced the appraisal a little bit. If the appraisal value is the true market value, then that means that I had gained over $20k of instant equity on the property which was definitely not true considering how much work it needed. In fact, I probably overpaid slightly for the property.

For more strategies on submitting offers in a highly competitive market, see the guide How to Win Offers.