Duane Duggan, Realtor and Author RE/MAX of Boulder

“Appraisal gap” is the current buzzy catchphrase in today’s hot housing market. An appraisal gap is the difference between what a home buyer is willing to offer and what the bank’s appraiser says the property is worth, based on the most recent sales of similar homes. Appraisers use sales that have closed in the past to create an estimate of the home’s value. However, when a market is accelerating rapidly, buyers are often willing to pay more than what past data says the house is worth.

An appraisal gap is not a new issue; it is an issue in any accelerating market. Today home values are much higher, so this concern receives more attention than it did in the past. For example, when I bought my first Martin Acres home in 1980, it was a hot market in Boulder. I offered $59,000, but the home only appraised for $55,000. Oh no! It was an FHA loan so that meant I needed to come up with $4,000 more than the $2,065 down payment on the FHA program at the time to close on the home. This $4,000 is known as the appraisal gap. 41 years ago, that was a huge amount of money.

Now in 2021, real estate has been appreciating rapidly in Colorado and across the country. The demand for real estate has been soaring. There are a variety of reasons demand is surging, but one of the main reasons is that since the beginning of the recession in 2007, the U.S. has not built enough homes to keep up with population growth. This has created a situation where many homes coming on the market receive multiple offers. This creates bidding wars and a contract price over what the appraiser can justify based on past data. The difference compared to 1980 is that the appraisal gaps are much bigger — sometimes over $100,000.

Let’s back up a bit and talk about the purpose of the property appraisal. If you are obtaining a new loan to purchase a property, the lender will almost always require an appraisal. An appraisal is an independent opinion of the market value of the property. The appraiser is actually hired by the lender, therefore, the lender is the client of the appraiser, not the purchaser. The appraisal is done to ensure that the property has enough value to cover the loan amount in the event the borrower defaults and the lender must foreclose. The less the buyer puts down, the more concerned the lender is about the property appraising for the purchase price. A $4,000 low appraisal on an FHA or VA contract can possibly kill the transaction. However, a $4,000 low appraisal on a 20% conventional loan will rarely kill the transaction. In an FHA or VA transaction, if the property appraises $4,000 low, the home buyer will have to bring that amount to closing in the form of additional down payment, according to the FHA/VA provisions of the contract. On a 95% conventional loan, the lender will make the loan on 95% of appraised value OR purchase price, whichever is less. The buyer would then need to bring the difference in the form of additional down payment.

Appraising is not an exact science, but it is an opinion of market value based on recently sold comparable properties. Usually, the appraisal will come in at contract price, unless the justifiable value of the property is significantly different. If you have three appraisals done on a property, each one will usually be slightly different. If the appraisals are reasonably accurate, they should all be within about 5% of each other. In the typical transaction, only one appraisal is done.

If the appraisal comes in at the contract price or higher, the transaction proceeds without a hitch. If the appraisal comes in low, which has become common in an accelerating market, there are a few options.

If the contract was conditional upon the property appraising for contract price, the buyer has the option of terminating the contract by the appraisal objection deadline.

2. Review the appraisal to see if there are any other comparable sales that were not used that might indicate a higher value.

3. Get another appraisal by an appraiser approved by the lender.

4. Proceed with the transaction, paying the required extra amount (known as the appraisal gap) of down payment in cash/cashier’s check at closing. (The lender may need to be consulted about acceptable sources of cash for the additional down payment.)

When making an offer on a property, the buyer has the option as to whether or not to make the offer conditional upon the property appraising for the purchase price or greater. In most cases this is the prudent thing for a buyer to do. However, in a hot market where there likely will be competing offers, a buyer may choose to waive the appraisal condition, in order to make the offer more attractive to the seller. The biggest risk to the buyer at this stage of the transaction, is that the size of the appraisal gap is unknown. The buyer needs to be sure they can cover it and the seller will want to be assured they can, too.

Before waiving the appraisal condition or agreeing to cover the appraisal gap, it is prudent to conduct a detailed analysis of the risks involved. Your REALTOR®, mortgage lender, and attorney will be able to help and guide you.

By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career. He has been awarded two of the highest honors bestowed by RE/MAX International: The Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail DuaneDuggan@boulderco.com, call 303.441.5611 or visit boulderco.com.