What exactly is an appraisal gap guarantee?

Q: Some friends have submitted an offer to buy a home, an offer that includes an appraisal gap guarantee. What is this guarantee, and how does it help the buyer?

A: Home prices have moved remarkably higher during the past year. According to the National Association of Realtors (NAR), in July the median existing-home price was $359,900, up 17.8% from July 2020 ($305,600).

The July sale price, reported NAR, “marks 113 straight months of year-over-year gains.”

In a time of strong real estate demand, it follows that sellers want the best possible price and terms. If an owner has a property where home values have been quickly rising and are now priced at $525,000, it’s not unreasonable to think that it might be listed at $550,000. Buyers can then offer the listing price, or more, or less, as they see the market.

The strange thing is that in today’s market, with fiercely rising prices, a lot of homes are not selling for the asking price. They’re selling for more.

For instance, Redfin reported in mid-August that a survey of 400 metro areas found that “the average home sold for 1.8% above its asking price.”

In all-cash transactions, a bid above the asking price is not an issue, the buyer writes a larger check. However, in transactions that require financing, fastrising prices can be a problem because such sale prices may not appraise.

For instance, if one looks at recent sales, a new high price in the neighborhood may not compute. Recent past sales of like properties may justify a given value, say $525,000, but what about higher values? Sure, one buyer is willing to pay $535,000 but is that really a fair market value?

In fast-moving markets, it happens that appraised values sometimes come in low. If the owner does not reduce the price or the buyer won’t put up more cash, or both don’t compromise, such transactions can fall apart. For this reason, some sellers will not accept what they see as wildly high offers that require financing.

One workaround is for the buyer to make an offer that includes an “appraisal gap” guarantee. If the appraisal is low, the borrower promises to make up the difference — in cash.

In this situation, you have agreed in advance to pay extra cash if necessary, but you don’t know how much.

For instance, you offer $550,000 with 10% down for a property. The required down payment is $55,000. However, the appraisal comes in at $532,000. The lender will provide 90% of the sale price, or $478,800 in financing. Now you need $71,200 in down payment money plus cash for closing costs. Buyers can lose their deposit if they don’t have the required cash — and it can be a lot of cash.

For details and specifics, speak with a broker or attorney.