What do you do when the appraisal comes in lower than the contract purchase price when you're buying a home? In the current real estate market, where supply is very low and demand is very high, multiple offers and bidding wars often push sales prices well beyond the price a home is listed for. As a result, the appraisal often comes in lower than the contract price presenting a potential challenge for both buyers and sellers. Watch the following video, or continue reading below, to learn what this means and what options you have to protect yourself while still remaining competitive with your offer.

When the supply of any product is low and demand is high, prices naturally rise. Housing inventory (supply) has been exceptionally low while demand, fueled by record-low mortgage rates, has been exceptionally high. This has caused home prices to appreciate at near-historic rates and caused challenges when it comes to home appraisals.

When the appraised value comes in lower than the contract purchase price the difference is known as an appraisal gap. This has become an increasing problem since February when home price appreciation really started to accelerate. Shawn Telford, Chief Appraiser for CoreLogic, explains it like this:

“Recently, we observed buyers paying prices above listing price and higher than the market data available to appraisers for support. This difference is known as the appraisal gap….”

Why do appraisal gaps happen?

When there is heightened demand for property, buyers are often having, and willing, to pay more than the asking price in order to secure a home. Homebuyers naturally start to become emotionally attached to a property as they start to picture themselves living in the home and neighborhood. That emotional attachment can sometimes lead to buyers bidding more in the moment. At other times, conditions of the local market mean that it’s necessary to pay 5%, 10% or more, over the asking price to be competitive.

Appraisers, on the other hand, are only looking at the home objectively and are focused on the facts and available market data. In many cases, when an appraisal takes place, the market data hasn’t yet caught up to current market conditions but is lagging behind. While the appraisal might indicate you paid above market value, your sale now helps set a new standard and within a couple of months, the market value will likely surpass the price you paid. Dustin Harris, Appraisal Coach, notes:

“It’s important for everyone to understand that the appraiser’s job in the end is to remain that unbiased third party, to truly tell the client what that home is worth in the current market, regardless of what decisions have been made of the price side of things.”

While I understand and appreciate the appraiser's perspective, we know that perspective isn't necessarily the reality of the market that we currently find ourselves in. The true market value of a home is whatever a qualified buyer is willing to pay for it, regardless of the list price. This can often create a challenge for the bank, which is why it’s important to understand your options when an appraisal gap does occur.

For example, let’s say a home is listed for $500,000 and you decide to write an offer for $530,000. There could be closed sales that support an appraised value of $520,000 or $525,000, but not quite $530,000. Yet another buyer might offer $540,000 or even $550,000, what's the house actually worth? In the eyes of the bank, it may be $525,000, but in the eyes of the other buyer it's $550,000, so what's one to do and how do you overcome the likely appraisal gap?

How to handle an appraisal gap

In the current market, it's honestly going to be based on what’s right for each individual on a case-by-case basis. The question homebuyers always have is “how much should we offer on this home?” My suggestion is always that we need to look at the market data to see where the most recent comparable sales are in order to determine where the appraisal is likely to come in and use that as a guide to determine how much the home is worth to you. Ultimately, that final number is going to be different for everyone.

In most cases, we’re seeing the appraisal come in somewhere between the list price and the contract price. If we go back to the example above and assume a list price of $500,000 and a contract price of $540,000 we can expect the appraised value to be approximately $520,000, a difference of $20,000. So what does this gap mean for you when buying a home?

Under normal market conditions, it would be expected that the listing agent, the agent working for the seller, would have presented the most recent market data to the seller and the property would have been listed at a price that they believed it could appraise for. Doesn't always happen, but that's what you would expect. Continuing with our example, let's say on the home listed for $500,000 you go under contract for $500,000, but the appraisal comes in at $490,000. Normally, the buyer would go back to the seller and ask to amend the contract to a purchase price of $490,000 based on appraised value. Sometimes the seller will agree and sometimes additional negotiations will take place and a new purchase price of $495,000 is agreed to.

In the current market that's not happening, because if you go back to the seller and say, "I need you to reduce your price," the seller is not going to agree because they most likely have 4, 5, 6….10 other offers behind you that would willing to come in and pay over the appraised value.

As a buyer, there are a couple of things to keep in mind. When you write an offer, my recommendation is that you always have some measure of protection to limit your exposure. The way you do that is through the use of an appraisal waiver. Every state will have a form of appraisal waiver that can be used. Here in Texas, you can partially or fully waive the appraisal. With a partial waiver, you are limiting the amount of exposure you have by capping the amount over the appraised value you are willing to pay. The other option is a full appraisal waiver which means you are guaranteeing the contract price regardless of the appraised value. That would mean, at closing, you would need to have enough cash to cover your down payment, closing costs, and the amount needed to make up the difference between the appraised value and contract price. It’s important for you to discuss appraisal waivers with your lender upfront so you know exactly how much cash you have available to still meet all loan qualification requirements.

Bottom Line

We are starting to see home price appreciation flatten out a little bit so the gap between appraised value and contract price is likely to shrink in the months ahead. It's important to stay informed and up to date on the latest trends and have a game plan going in to know what you can and can't do so you don't get stuck in an uncomfortable position. I hope this information helps. If you have any other questions whatsoever, please feel free to schedule a call with me as I’d be happy to discuss your situation in more detail.