No, it’s not a physical chasm, but it is real.
Mortgage lenders require a current property appraisal as part of the loan process. Normally, that is protection for both the lender and the purchaser. However, in a hot real estate market — which is today’s reality in most of the nation — the appraisal can be lower than the amount actually offered by a buyer.
Appraisals are based on many factors. Home characteristics, including square footage, number of bedrooms and baths, general condition, lot size and landscaping, amenities, location and zoning can be verified by onsite inspection and research. General quality of construction and property condition, although somewhat subjective, are typically not an issue. But appraisers also must use verified past sales prices of comparable properties, as well as tax assessments, to assign a dollar valuation to the property.
Because those numbers are obtained from completed transactions, appraisal figures can lag behind actual property values, particularly in rapidly-appreciating areas. Such gaps are not uncommon where demand is high and supply is low, when multiple offers are common and often above the asking price. Sometimes the seller is as surprised at the discrepancy as the buyer.
If an appraisal is lower than the offered sales price, a buyer is obligated to make up the difference in cash, because a signed contract is legally binding. Including a clause in the offer that places a limit on the additional funds a buyer is willing to pay to close the deal is one way to deal with an appraisal gap. Such a clause gives a buyer an “out” if the appraisal is not at least as high as the offer.
Sellers and buyers alike should discuss with their real estate brokers in advance all options that exist for dealing with a low appraisal. Both should understand the potential problems and be familiar with the specific legal language that can be included in the offer. Both should also understand that any additional funds to cover an appraisal gap are in addition to the agreed-upon down payment a buyer must make to the lender.
In some cases, additional solutions might be available, such as requesting a second appraisal, but this is an area where the stakes are high, and neither seller nor buyer wants to be surprised.