What is an Appraisal Gap?

What is an Appraisal Gap?

By: D. Keith Dunnagan, Esq. and Trey Van Dyke (2L)

August 10, 2021

In competitive housing markets like the one we currently find ourselves in, home prices can quickly soar beyond the value that a home will actually appraise for. This is due to a fundamental difference in the means by which the value is calculated. Appraisers typically use one of three types of valuation methods: sales comparison, cost approach and income approach. For the residential resale market they almost exclusively use the sales approach, where appraisers value a property based on the recent selling prices of similar properties in the same neighborhood. In a fast-moving market with so many multiple offers, the auction-like environment can move the purchase price up faster than the value would appear from just looking at the most recent sales. This difference is what’s commonly known as the appraisal gap.

Section 3I of the Residential Purchase Agreement (RPA) details the Appraisal Contingency and Removal. Here, after acceptance of an offer a buyer can (or cannot, if that option is checked) use this protection within the contract to cancel the agreement and receive their deposit back in accordance with section 14H of the RPA. This section also specifies when this contingency must be removed by the buyer so the transaction may proceed and is changeable by the buyer or their agent. This protection only makes the agreement contingent on “a written appraisal of the Property by a licensed or certified appraiser at no less than the purchase price” (RPA §3I). Thus, a buyer cannot use the appraisal contingency to cancel the contract if the licensed or certified appraiser writes a report where the appraised value comes in at or above the purchase price; the buyer must then release the contingency within the timeframe agreed-upon in the same paragraph.

If the buyer selects the checkbox in section 14C of the RPA, and attaches a C.A.R. Form CR, or contingency release indicating removal of the appraisal contingency, then they are waiving this protection with the offer that protects them from an appraised value lower than the purchase price. “If buyer removes any contingency without an adequate understanding of the Property’s condition or buyer’s ability to purchase, buyer is acting against the advice of Broker” (RPA §14C, emphasis added). The first part of this warning relates to the inspection contingency and the second relates to the loan contingency. This second part is critical because the RPA specifically says that once the appraisal contingency has been waived or removed, the buyer cannot use the loan contingency to cancel the agreement and regain the deposit if the “buyer is otherwise qualified for the specified loan” (RPA §3J(2)).

This comes into play in this current market, where many buyers are waiving their appraisal contingencies in an effort to make their offers stand-out to the seller. Absent any other agreement between the buyer and seller to address it, this effectively places all liability for obtaining financing, including coverage of the appraisal gap, solely on the buyer. This is emphasized in the Contingency Removal form where “buyer shall conclusively be deemed to have… assumed all liability, responsibility, and expense, if any, …for the ability to obtain financing” (CR §I1(iii)). In effect, this acknowledges buyer will cover the entire appraisal gap.

It is critical that buyers understand that by waiving the appraisal contingency they may also be covering the gap themselves. Upon receipt of the lower appraised value, lenders will re-work the numbers of the loan to correspond to the appraised value, not the purchase price. Let’s look at an example. Suppose a buyer agreed to purchase a home at $400,000 (20% down payment) and waived the appraisal contingency with the offer without any appraisal gap language or other agreement. The home appraises for $350,000. Now the lender reworks the numbers. The down payment dropped by $10,000 (happy buyer) but now the buyer is responsible for $120,000 cash instead of $80,000 (possibly a very unhappy buyer). This consists of a $70,000 down payment plus the $50,000 appraisal gap. Because of the language in the RPA in section 3J(2), the buyer cannot use the loan contingency to cancel:

If there is no appraisal contingency or the appraisal contingency has been waived or removed, then failure of the Property to appraise at the purchase price does not entitle Buyer to exercise the cancellation right pursuant to the loan contingency if buyer is otherwise qualified for the specified loan. Buyer’s contractual obligations regarding deposit, balance of down payment and closing costs are not contingencies of this Agreement.

Buyers and their agents can (and probably should!) add some clarification to this situation by adding language in the RPA in section 6 that specifies who or how an appraisal gap would be covered. This can be a term of art and many agents and attorneys have their own way of establishing this, but some examples could include; the buyer and seller shall split any difference in appraised value and purchase price 50/50, the buyer shall cover any gap in appraised value and purchase price, or buyer shall cover any gap in appraised value and purchase price up to $50,000. If the buyer is willing to cover some of the appraisal gap in order to facilitate acceptance, it is recommended that limiting language is added that the buyer is comfortable with paying out of pocket.

One final note for Veterans and any first-time home buyers using an FHA loan. There is extra U.S. government protection in place for home buyers using one of these government-backed loans. The VA and FHA require that an FHA/VA Amendatory Clause (C.A.R. Form FVAC) be completed by the veteran or qualified first-time home buyer. “Purchaser shall not be obligated to complete the purchase of the property… or incur any penalty by forfeiture of earnest money deposit unless the purchaser has been given [a written acknowledgement of]… the appraised value of the property of not less than $____” (FVAC §1). Although this language does say “notwithstanding any other provision” it’s regarded as an extra protection for these buyers, despite waiver or removal of the appraisal contingency. Veterans and first-time home buyers can still continue on with the purchase if they choose to, but this amendatory clause is added protection that they have the option of exercising to receive their full deposit back in the event they do not want to go forward after a lower appraisal. This amendatory clause is an added protection for Veterans and first-time home buyers, but clear understanding in the offer negotiations upfront and knowing what appraisal gap a buyer might be comfortable with paying for can clear this up before it becomes an issue later in the transaction. Do not let the use of a VA or FHA loan be a basis for choosing another potential buyer. Any discrimination against a Veteran or first-time home buyer can be cause for discipline.

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.

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