By Neil Goradia

House prices are skyrocketing! (YES, we already know that—old news.)

Winning a bid can be tough and you need the “secret sauce,” right? (We’ve heard that before, too.)

But have you put thought into how to address appraisal gaps for your clients?

Appraisal Gaps Are on the Rise

I’m seeing an increasing number of houses fall out of contract because of an appraisal gap.

This is, of course, due to the meteoric rise in home prices. With another summer of house price mayhem expected, I anticipate the situation getting worse before it gets better.

So, what can we do about this as real estate professionals?

In order to figure out what to do about appraisal gaps, we first need to know what they are, why they happen, and where they happen. It’s important to also know where root cause lies and how to prep buyers and sellers on how to deal with a gap.

Appraisal Gaps 101

An appraisal gap is the difference between market value (per the appraiser) and the price of the home agreed upon on the signed purchase agreement. The value difference only becomes an “appraisal gap” when the offer is higher than the appraisal.

So why is this an issue?

It comes down to the banks. If the bank thinks the house is worth less than the offer, they may not lend money on it. In this case, buyer financing can—and usually will—fall through. What’s happening out in the marketplace?

Appraisal Gaps in Real Time

I polled a couple of agents in different parts of the country to find out what this issue looks like in their market right now.

Joseph K., Tampa Bay, FL: When it comes to appreciating house prices, Tampa Bay is no exception, with some research showing a 29.7% jump in house prices over the past 12 months. Another 19% is predicted by Zillow this summer. Because of this, I am absolutely seeing appraisal gap issues. Comps almost caught up by the end of summer 2021, but it’s a concern when trying to close the deal for a client.

Bryan W., Columbus, OH: According to Norada, houses appreciated 17% in Columbus in 2021. I certainly felt the heat. Homes are selling fast, and way over asking. The net result was homes were not appraising, and unless the buyer had cash to bring to the table, I saw more deals falling through.

My personal experience: Being an authority on the real estate market in Denver, house prices went up more than 20% over the last 12 months. I don’t see it slowing down anytime soon as the fundamentals remain the same: Low inventory, relatively low interest rates, and buyers getting more and more desperate. It’s almost making for the perfect appreciation storm.

Who’s to Blame for the Appraisal Gaps?

As with many complicated issues, there’s no one group to blame here.

If you talk to my dad, he’ll say it’s the last two administrations and all the cheap money they have been printing. And I can’t say he’s completely wrong. I can’t say he’s wrong because I don’t 100% understand economics as he does.

However, I know that basically more money does create a chance of inflation, and inflation means prices go up.

Maybe we can blame builders and lack of building over the past several years. (Build more houses gosh darn it!) But it’s not quite that simple—inflation, lack of workforce, and supply chain issues have all contributed to the problem. I have friends in new construction, and I know that they are definitely trying.

Of course, there would be no gap if the appraisers just appraised for the contract price, right?

Then there’s the other side of the coin. If you submit an offer $50,000 over on a $300,000 dollar house, guess what? Yep, there will most likely be an appraisal gap.

And we must look at ourselves, too. If we tell a client to list a house for sale at an uncomfortably high price, then we know it might not appraise.

So maybe we should blame ourselves.

Ultimately, it’s the Real Estate Cycle. We shouldn’t be trying to blame anyone. Instead, we should be trying to help our clients and ourselves through this period.

At the end of the day, we see appraisal gaps every time we have accelerated increases in house prices. The last 12 months at an average 20% increase is one of these times. So, despite who you might like to blame, the truth is the greater market is at play.

How to Prep Sellers for a Potential Appraisal Gap

So how can we help people who are selling their homes and facing an appraisal gap?

Prepare them for it.

How exactly do we do that? Education and information.

It’s important to let your client know what the current real estate market means for them—appraisals included. They’ve likely heard a lot already from friends, family, and acquaintances who have been involved in the market. They might think they have all the information they need. But have they thought about how it can affect the buyer getting financing?

You can use this situation as a learning opportunity, which also gives you a chance to prove yourself as an authority in real estate.

Provide Expert Advice to Your Seller

It’s important to front-load your client with information, and you can also reiterate the specifics about appraisal gaps during the selling process.

“When we get an offer that is well over comps, I always mention the chance of an appraisal gap,” says Jenn S., an agent for home buyers and sellers in Denver’s scorching housing market. “And I like to suggest that we include an appraisal gap clause. This isn’t rocket science, and of course, there is no way to force the home buyer to bring more money, but I think it’s better to address it at the start of the contract—not three weeks in when (the) financing is due.”

How to Prep Buyers for a Housing Appraisal Gap

What do you say to your buyers (especially those buyers who have lost seven bidding wars on houses over the past nine months)? The current market is fast-moving and can be disappointing for many buyers, especially when they are super anxious to buy a house.

Start by letting them know the realities of their options. Say your client wants to put in a really competitive offer—maybe one 50% over the list price, for example—in order to secure the contract. Start by explaining:

“Yes, (insert client name) we could submit an offer that is 50% over the list price, and I understand your desire to do that. I am pretty confident we would be the highest. But here’s the problem…”

At this point, explain your concerns about an appraisal gap and how that would affect their financing. As an agent, I would do everything to ensure they understand their options. It’s important to relay to a buyer that they can put in an offer over asking, but an appraisal gap is possible, which could affect their financing. If it doesn’t affect their financing, then they need to be sure they’re willing to pay over the appraised value.

I like to make sure my buyer fully understands this and is willing—and able—to pay if needed.

As an agent, I like to tell the buyer that we can bid whatever he, she, or they want. However, I’m sincere, and I let them know that if they bid really high, they will be expected to bring cash to close if the home doesn’t appraise.

Responsibility as an Agent

We must fully inform our clients. Additionally, I think it’s fair to the entire process if we explain these issues up front, because there is already so much pressure on the market and I think we should keep the “silly sausages” (as my mom would say) out of the equation.

Final Thoughts

What’s going to happen next? Will house prices keep going up? Will more and more deals fall through due to financing and appraisal gaps?

Or…

Will the banks put enormous pressure on appraisers? Will rising interest rates push prices back down?

Feel free to add your 2 cents in the comments below so that we’re more fully informed by sharing our market experience, allowing us to better advise our clients.