The Potential Impact of Appraisal Gap Clauses

By Mike Armentrout

Despite a worldwide pandemic and uncertain economic conditions, the market frenzy continues to push real estate markets to new highs.  With supply and demand being so far out of balance, we are seeing some dynamics that are somewhat unprecedented for the Central Ohio market.

Many will say that “a property is worth what someone is willing to pay” but this can only be true in a predominantly cash market.  Since approximately 90% of properties are financed, then the market will become subject to the risk tolerances of the lenders.

With some buyers willing to pay more than market highs of sales and listings, they seem to be abandoning the principle of substitution which states that a buyer will not pay more than the price of an equivalent competing property.  This presents a major issue for real estate appraisers but more importantly, lenders.

If buyers are boiling a purchase down to a payment over 15 or 30 years without regards to current value, this will tend to create a market bubble.  That is a concern for lenders who may get burned when the market cools and loan to value ratios are high.  They simply don’t want a repeat of the 2008-2011 financial crash.

Many appraisals are yielding values that are under a contract price and that creates a lot of reaction from buyers, sellers, agents, and lenders.  One of the responses to this has been the use of “appraisal gap” clauses within contracts.  A buyer bringing cash to close a gap between the appraised value and the contract price allows the bank to lend within their guidelines and it assures sellers that a deal is less likely to fall apart. 

Appraisers must make every attempt to understand these nuances as they collect data.  To illustrate, a realtor provided a breakdown (See Table 1) on a recent property our firm completed.  The property was offered at $274,900 and had 26 immediate offers.  Obviously, the sellers accepted the offer of $351,000 with an appraisal gap clause that covered any amount.  Our final report yielded $300,000 which leaves the buyer bringing a $51,000 check to closing, not including closing costs and down payment.

Upon the theoretical closing of this transaction, how should appraisers and market participants view this sale?  Even among 26 offers, the $351,000 was 8% higher than the next highest offer.  The average offer was $297,673 and the median offer was $300,000.  Based on Table 1, the final offer of $351,000 is not representative of the predominant buyer. It is in fact an anomaly that has the potential to skew the market data.  Use of this sale for subsequent pricing and valuation of other properties is misleading and artificially inflates the market trend.

Once this scenario plays out multiple times in a market, the net impact may be a falsely inflated sales pool that is not indicative of typical buyers.  An eventual drop in demand or increase in supply will likely result in a longer period of recovery to correct that imbalance.

      

Table 1

Original List Price $274,900

	Offer	Appraisal Gap	Escalation Clause	Home Sale Contingent
1	$265,000	$5,000		N
2	$274,900	$8,500	By 1K to $303,501	N
3	$275,000	$5,000	By 1K to $285,000	N
4	$280,000	$5,000		N
5	$280,000	None	By 1K to $295,000	N
6	$282,500	None	By 1K to $290,000	N
7	$285,000	$2,500	By 1K to $295,600	N
8	$287,000	$12,100		N
9	$288,100	$8,100		N
10	$289,000	$8,000		N
11	$289,500	Full Amount		N
12	$291,000	Full Amount	$302,000	N
13	$300,000	$15,000		Y
14	$300,000	$7,500		N
15	$300,000	$10,000		N
16	$300,000	$20,000	By 1K to $350,000	N
17	$302,500	$10,000		N
18	$305,000		By 2K to $312,000	Y
19	$305,500	$15,000		N
20	$307,500	None		N
21	$311,000	Full Amount		N
22	$315,000	$5,000		N
23	$315,000	$25,000		Y
24	$315,000	$10,000		N
25	$325,000	$25,000		Y
26	$351,000	Full Amount		N