Valuation Gaps in Real Estate: Are They a Decisive Factor?

When buying or selling a home, two numbers matter the most: the agreed-upon purchase price and the appraised value of the home. Sometimes these numbers don’t add up, which can be a problem when finalizing the sale. No seller wants to sell their home for significantly less than it is worth, and no lender will offer a buyer a mortgage amount that exceeds the home’s value.

So what does it mean when these two prices are significantly different from what was expected, and how might this affect the sale of the home? Here’s everything you need to know about the valuation gap.

What is a valuation difference?

When the sale price of a house is higher than its appraisal price, it creates what is called a valuation gap. Simply put, the spread is the difference between the agreed-upon purchase price and the price the home is worth, as appraised by a licensed professional appraiser.

“The purchase price is what the buyer and seller believe the home is worth, while an appraisal tells you what the value is, based on other homes sold that are similar,” says Esther Phillips, vice -Senior President and Director of Sales at Key Mortgage Services in Naperville, Illinois. “All standard mortgages use the appraised value to justify the loan.”

Here’s a quick example to help illustrate how the valuation spread works. Let’s say you’re an interested buyer of a house with an asking price of $350,000. You bid for the full amount and the seller accepts. But when your lender’s appraiser appraises the home, they determine the actual value is only $310,000. The result is an appraisal gap of $40,000, which means you are asking your mortgage agent to lend you $40,000 more than the appraised value of the house. This gap will have to be closed one way or another for the sale to continue.

How to handle a valuation gap

A valuation discrepancy can certainly disrupt the sales process, and in some cases, it can send both buyer and seller back to the drawing board. But that doesn’t necessarily tank the sale. In fact, there are several ways buyers can manage a valuation gap that will allow the sale to happen:

Pay the difference

The easiest way to close a valuation gap is for the buyer to pay the difference. It’s not always a financial option, of course – some payment methods are more realistic than others. If you have the funds available, you can simply pay the difference in cash. Or, if you’re comfortable with it, you may be able to cash out some investments or access retirement funds without penalty in order to pay the difference. You might even be able to take out a separate loan to cover the amount.

Plus, you may be able to show your lender that you can afford higher-than-expected monthly mortgage payments. Or they may allow you to make a smaller down payment, if that allows you to pay the higher monthly payments. In this scenario, Phillips notes, you may need to purchase private mortgage insurance, which provides additional protection for the lender in case you are unable to make your payments.

Renegotiate

Another option that may be available to buyers who encounter a valuation gap is to renegotiate the purchase price of the home. This option is particularly relevant if you have a valuation contingency in the contract (more on that in a moment).

You can ask the seller to lower the price to match the appraisal price, which they may be motivated to do, depending on their timeframe and their investment in the property. You can also ask them to split the difference or meet somewhere in the middle, reducing the gap to an acceptable level that you can afford.

Get new funding and a new valuation

It is possible to dispute an appraisal, although you will need substantial evidence to prove that the appraised value is incorrect, including showing that the appraiser misjudged the market and misjudged the property.

With successful litigation, you can seek new funding and get a new assessment. This may provide a valuation more in line with the sale price – although there is no guarantee on this. This process takes time and may not be something the seller is willing to go through, especially if they think other offers are available to them.

Hedging of valuation differences, contingencies and covenants

Although valuation discrepancies can interrupt the process of selling or buying a home, they are not exceptionally rare. In fact, most real estate contracts include some form of valuation gap hedging that addresses the possibility of this exact scenario.

“Appraisal gap coverage is an intermediate step you can take between having an appraisal contingency and giving up on it,” says Phillips. “A valuation variance coverage clause is custom wording in the purchase contract that states that you will pay the difference between the appraised value and the contract price, up to a certain amount.”

While valuation gap coverage binds a buyer to the purchase even if a valuation gap exists, valuation gap clauses, including a contingency clause, provide protection to the buyer. Certain clauses may allow the buyer to withdraw completely.

Phillips notes that valuation gap clauses often include specific dollar amounts, which indicate how liable a buyer may be, depending on the size of the gap. A valuation discrepancy contingency provides a legal way to withdraw from a sales contract, including recovering deposits. Without this eventuality, you may have to negotiate to cancel the contract and allow the seller to keep some of the deposit you have paid.

At the end of the line

Appraisal gaps can cause problems when it comes to finalizing the sale of a home, as they suggest that the real value of the property is lower than the agreed sale price. However, these deviations are relatively frequent. With a little preparation in the sales contract, both parties can protect themselves. In most cases, a valuation spread need not be a deciding factor.

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