In competitive housing markets, buyers need to have more than great finances. Even ideal clients who know what they want and are ready to act quickly should have a trick or two up their sleeves to secure their dream home. Oftentimes, this means making an offer that is higher than the property’s purchase price.
What is appraisal gap coverage?
To get an offer accepted, buyers may have to go over the asking price. But when offering above the asking price on a property, there is a chance that it may be more than what the bank appraises the home for.
Here is an example: Say a home is listed for $100,000 and it goes under contract for a sale price $110,000. However, the appraisal comes in at only $105,000. Your mortgage lender won’t cover the gap for you. In this scenario, the buyer would have to either fork over an additional $5,000 cash to make the deal happen or convince the seller to accept a new purchase price of $105,000—or walk away from the deal.
Sellers are afraid of the latter option, so if the appraisal comes in short, they like to see a guarantee of an offer over the asking price. Sellers want to be sure that the buyer will come up with some money to cover the difference between the appraisal and the offer.
That is called appraisal gap coverage. It is insurance for the seller that the buyer pays an additional amount over the home’s appraised value if the appraisal comes in less than the agreed-upon purchase price.
To modify the previous example, let’s say the house is listed at $100,000, the buyer offers $110,000 with $1,000 in appraisal gap coverage, and the home appraises for $105,000. The appraisal gap coverage now kicks in, the buyer comes up with $1,000 cash, and the new purchase price is $106,000. The buyer has to pay the seller $1,000 in cash because the lender will not include the appraisal gap coverage in the home loan.
If a seller is looking at two equal offers and one offer has appraisal gap coverage, but the other offer doesn’t, they will go with the offer with the appraisal gap coverage. Plus, in this scenario, the buyer gets the house for less than they initially planned on purchasing it for, so it is a win-win!
The home appraisal process
A home appraisal is an unbiased professional opinion of a home’s value based on recently sold properties nearby. It is conducted by an appraiser who is an independent third party contracted (often by a lender) to establish a value on a property. This provides another set of eyes on a property and opinion of condition. The appraisal can establish an “as-is” value and a “subject-to” value in the case of a rehab.
What are the steps of going through the appraisal process?
1. Third-party appraisal service
As soon as a property is put under contract, the lender will immediately collect payment for the appraisal and order the appraisal through a third-party appraisal service. The lender doesn’t get to decide who the appraiser will be.
2. Nearby comps
Once the appraisal is scheduled, the seller should be notified when the appraisal will happen to prepare and put their best foot forward to help achieve a high appraisal value.
The appraiser should also be given a list of three to five “as-is” comps that sold in the area in the last six months. If it is a “subject-to” appraisal, include the proposed construction budget and three to five “subject-to” comps that have sold in the last months. The appraiser may or may not use the information. However, this could help if they are unfamiliar with the area or help them better understand the level of rehab the buyer is looking to do.
3. Contact the lender
Once the appraisal is complete, the buyer has to contact their lender to find out when the report will be back. If an appraisal objection deadline extension is needed, the buyer should ask their realtor to get a signed amend and extend agreement so the buyer can protect their earnest money.
4. Review with a Realtor
Once the appraisal report comes back, the buyer needs to review it with their real estate agent.
More about appraisals from BiggerPockets
When is appraisal gap coverage necessary?
In a competitive housing market, people can get really crazy with their offers. This is a problem for a seller because they might take the best offer, only to have the property appraisal come back way under the sales price.
If that happens, the buyer and the seller have to agree on what the home price will be and/or who will pay for the difference between the offer price and the appraisal. So, an appraisal gap guarantee clause in the contract helps the seller feel better about taking the highest offer even if they are worried the appraisal won’t support it.
How does gap coverage work with an offer?
Appraisal gap coverage makes a buyer’s offer stronger in any market. That said, it is almost always used in a high demand market, where the buyer needs to incentivize the seller to take their offer.
For example, let’s say a couple is considering buying a two-bedroom condo in downtown Denver, Colorado, listed for $385,000 with offers pouring in from all sides. They know they need to come in strong with a serious offer. They decide to put in an offer for $415,000 with appraisal gap coverage of $5,000. Hypothetically, let’s say the place appraised at $400,000.
An offer for $415,000 (without appraisal gap coverage) would mean that the lender would only secure the loan for $400,000. There is now a $15,000 difference between what the seller thought they could get and the loan. Now everyone is required to re-negotiate: Will they split the $15,000? Will they lose the contract? No one wants this because buying/selling a house requires paperwork, so sellers really do not want to be in this position.
An offer for $415,000 on a house that appraises for $400,000 with $5,000 in appraisal gap coverage means that the buyer is securing appraisal + $5,000. So, in this case, if the buyer offered $415,000 and it came back at $400,000, they are guaranteeing they will pay at least $405,000. The offer is stronger because the seller knows they will get the appraisal + $5,000, even if the market doesn’t support this price.
First, a bank loan will not support this, so the buyer needs to make sure they have the cash to cover it. If they offered a $5,000 appraisal gap coverage and the appraiser says the property is worth less, the buyer has to come to the closing table with the $5,000 in cash.
This is a great tool to help an offer stand out in a competitive market, but it should not be confused with an appraisal contingency.
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Appraisal gap coverage vs. appraisal contingency
A contingency clause in the contract defines a condition or action that must be met for the sales contract to become binding. Both parties—the buyer and the seller—must agree to the terms and sign the sales contract, contingencies included, to become binding.
These added clauses enable the investor to acquire property on their terms and provide a way out of the contract if things go south. However, since a real estate contract is binding, buyers must understand how they are used and how to remain competitive when making offers.
An appraisal contingency clause ensures that the purchase depends on the findings of an appraisal. Typically, the buyer is simply making sure the property is worth what the seller says it is or, hopefully, worth more.
The contingency basically says either:
- The appraisal on the property is at least as high as the purchase price; otherwise, the buyer can back out of the deal; or
- If the appraisal on the property is lower than the purchase price, the buyer can ask the seller to drop the price, and if the seller refuses, the buyer can back out of the deal.
The appraisal contingency often goes hand in hand with the financing contingency, as the lender will not fund the loan above the appraised price.
Appraisal gap coverage is a great way for buyers to stand out, and it doubles as a safeguard from potentially overpaying for a property. Either way, it will help increase the likelihood of an offer being accepted and should always be considered when making a real estate purchase.