What Is an Appraisal Gap in Real Estate?

In real estate transactions, an appraisal provides an independent assessment of a property’s market value. This valuation helps ensure all parties, particularly lenders, understand the asset’s worth. In competitive housing markets, an “appraisal gap” can emerge, complicating closing. Understanding this concept is important for buyers and sellers.

Defining the Appraisal Gap

A real estate appraisal involves a professional estimate of a home’s value, conducted by a licensed appraiser. This process assesses factors such as property size, condition, location, amenities, and comparable sales data to determine the fair market value. Lenders typically require an appraisal to ensure they are not lending more money than a property is worth, protecting their investment. The appraisal provides an unbiased opinion of the property’s worth for all involved parties.

An appraisal gap occurs when the agreed-upon purchase price of a home exceeds the value determined by this professional appraisal. For instance, if a buyer agrees to pay $350,000 for a home, but the appraisal comes in at $310,000, a $40,000 appraisal gap exists. This often arises in competitive real estate markets where strong buyer demand and bidding wars drive offer prices above a property’s objective valuation. When home prices increase rapidly, recent comparable sales data used by appraisers may not fully reflect the current market pace, contributing to the appraisal gap.

Understanding the Financial Impact

An appraisal gap presents a financial challenge because mortgage lenders base the loan amount on the appraised value of the property or the purchase price, whichever is lower. If the appraisal value is less than the offer amount, the lender will not approve a loan for the full purchase price. This means the buyer’s mortgage loan amount will be reduced to align with the lower appraised value.

Consequently, the buyer faces a shortfall, as they must cover the difference between the lower loan amount and the agreed-upon purchase price. This additional sum typically needs to be paid out-of-pocket at closing, on top of the buyer’s planned down payment. For example, if a home is purchased for $300,000 but appraises at $290,000, and a loan requires a 3% down payment, the buyer would need to cover the $10,000 appraisal gap in cash, in addition to their down payment based on the appraised value. A low appraisal can even lead to a loan application being denied if the lender perceives the risk as too high due to the discrepancy.

Buyer Considerations

When an appraisal gap emerges, buyers have several options. A common approach is for the buyer to cover the difference in cash, bringing the additional funds to closing. This strategy is often necessary in a seller’s market where sellers may be unwilling to lower their price. Buyers might explore various sources for these funds, such as liquidating investments or using retirement savings. Consulting a financial advisor for such decisions is prudent.

Buyers can also attempt to renegotiate the purchase price with the seller to align it more closely with the appraised value. This might involve asking the seller to reduce the price to the appraised amount or to split the difference of the appraisal gap. The success of this approach often depends on the market conditions and the seller’s motivation to close the deal.

The appraisal contingency clause, typically included in the purchase agreement, is a safeguard for buyers. This clause allows the buyer to cancel the contract without losing their earnest money deposit if the property’s appraised value falls below the agreed-upon purchase price. If a buyer cannot cover the gap and renegotiation fails, this contingency provides a legal pathway to walk away from the deal. Without an appraisal contingency, a buyer who walks away due to a low appraisal might forfeit their earnest money deposit.

Seller Considerations

When a property appraises for less than the agreed-upon sale price, sellers also face important decisions. One option is to lower the sale price of the home to match the appraised value. This can help keep the deal on track, especially if the seller is eager to complete the sale quickly.

Alternatively, the seller may insist on the original purchase price, requiring the buyer to cover the appraisal gap out-of-pocket. This stance is more common in robust seller’s markets where there is high demand and multiple potential buyers. If the buyer is unable or unwilling to cover the difference, this choice could result in the deal falling through.

Sellers can also offer concessions to the buyer to bridge the appraisal gap without directly reducing the sale price. These concessions might include covering a portion of the buyer’s closing costs (typically 3% to 5% of the purchase price) or providing a credit for necessary repairs. While such concessions do not change the loan amount, they can ease the buyer’s financial burden and encourage them to proceed with the purchase. If no resolution can be reached and the deal falls through, the seller’s final option is to relist the property for sale.