What is an Appraisal Gap Clause and How Does It Work?

An “appraisal gap” is the difference between the appraised value of a home and the purchase price in the sales contract. An “appraisal gap clause” is used in a sales contract to guarantee that the home buyer will cover the monetary gap between the appraisal and the sales contract if an appraisal gap becomes an issue. We'll explain how this works below.

This infographic explains an appraisal gap:

To fully understand an appraisal gap, we must discuss the basics of the appraisal.

What is an appraisal in real estate?

An appraisal is an opinion of value by a licensed real estate appraiser. Mortgage lenders hire appraisers for home purchase loans, refinancing, HELOC loans, and many other loan products.

Every sales contract between a buyer and a seller has a purchase price. The bank agrees to lend money to the buyer for the purchase of the home, assuming the property appraises at value.

Banks hire licensed appraisers to offer their professional opinion on what the home is worth. This process safeguards the mortgage company from lending too much money for an asset that may not worth the contract price.

Since appraisals are opinions, they have a margin for error. You may hire three separate appraisers for the same property and receive three different estimates of value.

How Does a Real Estate Appraiser Determine Value?

A real estate appraiser is an expert in determining the current market value of a property. When they conduct an appraisal, they provide a detailed report explaining their estimate.

Appraisers use recently sold properties (Realtors call them “comps” or “comparables”) to determine a home’s values. They break down aspects of each comparable sold property and use that data to calculate an estimate of value.

Once a home is under contract and passed the home inspection process, the mortgage lender will order an appraisal. The assigned appraiser will then visit the property to do a visual inspection and take photos of the home. Next, they will compare amenities and assets against recently sold properties within the same neighborhood and then prepare an appraisal report.

In a hyperinflated real estate market, appraisers are challenged to justify some of the crazy sales contracts that listing agents present. They have to protect the bank from over-lending while also protecting consumers from having their deals fall apart.

This tension is one of the most complex parts of the real estate transaction. Appraisers are responsible for helping lenders determine safe loan limits. This is a difficult task during extreme markets. 

What is An Appraisal Contingency?

Most real estate sales contracts will have an "appraisal contingency" written into the details. This clause allows the buyer and lender a way out of the contract if the home does not appraise at value.

In the example at the top of this post, the home appraised for $20k less than the contract sales price. In that scenario, the lending company may only lend up to the appraised value. This means that the buyer or seller would have to provide the money to fill the gap.

When a home does not appraise at the contract sales price, it can cause a deal to fall apart. This is a scenario that buyers and sellers have to understand before entering into a contract.

How Does An Appraisal Gap Guarantee Clause Work?

When a home does not appraise at value, the gap between the appraised value and the contract price must be resolved. The transaction cannot move forward without a resolution.

An appraisal gap clause states that the buyer will cover the gap between the contract price and the appraised value.

In the example used at the beginning of this post, the buyer may need to bring $20k to the closing table. However, if they added an appraisal gap guarantee clause for $20k (or more), it would automatically correct itself.

Appraisal gap coverage guarantees the seller that the buyer will cover the difference between the appraised value and the contract price.

When is an Appraisal Gap Clause Helpful?

A “seller’s market” describes a housing market where homes are in high demand and sell very fast. These real estate markets tend to create bidding wars, causing homebuyers to make high offers way over the original listing price.

In these scenarios, appraisers have difficulty determining actual market value. The sales data does not always support the crazy contract prices. This is when an appraisal gap in an offer contract is beneficial. It can be used to reduce or eliminate the risk of the seller losing money from a low appraisal.

When homebuyer demand pushes far past fair market value, home sellers may lose money during the appraisal process. Buyers who have extra cash to cover the gap tend to win bidding wars in multiple offer situations.

How Do You Write Appraisal Gap Coverage Into a Real Estate Contract?

There are many different ways to write appraisal gap coverage into a real estate sales contract. Your Realtor will be able to help you with this.

The main thing that needs to be noted is the monetary value of your appraisal gap guarantee. It’s not wise to state that you will cover an unlimited amount between the sales price and the appraised value. We recommend always putting in the maximum amount that you are willing to cover.

Here’s an example of an appraisal gap clause as written into a sales contract:

“If the property does not appraise for the purchase price, the buyer agrees to pay up to $20,000.00 above the appraised value, but not to exceed the purchase price.”

The phrasing above should cover the appraisal gap shown in the example at the top of this post. There are many different ways to word this clause. But, again, your real estate agent will structure your appraisal gap guarantee to best match your needs.

What other tactics are used to get a contract accepted?

Real estate agents have become very creative with their offer structures recently. Most real estate markets around the country are experiencing record low inventory, so sellers are kings right now. As a result, homes can receive over 50 offers in some cases.

Escalation clauses, short closing dates, and triple earnest money are all tactics being used right now. To better understand all these tricks, check out our blog post. It covers 22 ways to get your contracts accepted in a strong seller’s market.

Eventually, interest rates will rise, and new opportunities will create a balanced real estate market. But, in the meantime, home buyers will struggle to compete as demand for homes continues to break records in America.