If you’ve picked up any sort of newspaper, listened to the radio, or have simply been awake at all in the last year or so, you’ve heard all about the real estate market in Northern Michigan. It is HOT. Seriously, homes are selling for record prices, there are a major inventory shortage, and buyers are competing with huge offers with very favorable terms. Basically everything AND the kitchen sink.
But, there’s an achille’s heel to the Northern Michigan real estate market’s movement – something that could slow down this insane momentum and ultimately be the downfall of many a real estate transaction in the next year – an Appraisal Gap.
In this blog, we’ll talk you through what an appraisal gap is, why it’s a problem, and what you can do to avoid it submarining your transaction, regardless of whether you’re a buyer or a seller.
What is an Appraisal Gap?
An appraisal gap is the term for the situation that happens when a home’s agreed upon purchase price is more than what a bank’s independent appraisal says the home is worth.
If you’re not up to speed on the mortgage process and where the problem of appraisal gaps fall into them, here’s a quick lesson.
- When a buyer wants to purchase a home, nine times out of ten, they use a mortgage.
- When a buyer finds a home they like, they put in an offer on the home. If the seller likes that offer, it is accepted.
- After a home has an accepted offer, the bank goes to work conducting their due diligence on both the buyer and the home. They do this because they want to make sure the buyer is likely to make their payments, and they want to make sure the home is worth the amount of money the buyer has offered to pay for it.
- As a part of this due diligence, the bank orders an independent appraisal of the home to make sure that they aren’t lending money on a home that, in the event the buyer defaults on, is worth less than what they are paying for it.
The bank’s appraisal of the home is based on a lot of factors, but primarily, it’s based on the historical sales of the area, or as we call them in the real estate business, comps, and therein lies the problem.
The buyer is making an offer on a property based on the current market conditions, and the appraisal is happening based on (recent) historical market data points; mainly, what like-properties have sold for in the past. If the current market is accelerating, the comps often can’t keep up, and the appraised value of a home falls short of the purchase price; an appraisal gap.
Why is an Appraisal Gap Bad?
When you’re getting a mortgage, the bank is counting on you to make you mortgage payments every month. But, if you ever default on your loan, the end game to the foreclosure process is the bank repossessing your home.
Obviously, nobody wants that to happen, but statistically, it will to a certain number of borrowers every year, so when a bank issues a loan, they want to make sure they aren’t lending more money than the home is worth.
This means that if you make an offer on a home that is higher than what the bank says the home is worth, the bank won’t cover the entire purchase price. If the appraisal gap is a couple thousand dollars, many home buyers will be able to squeeze a little extra money from other places to make it work.
But, in the current market conditions, many appraisal gaps are closer to $20,000 or even $25,000; a cash shortage that the majority of buyers can’t cover, and is often the end of the real estate transaction.
How Buyers Can Protect Themselves From an Appraisal Gap
First and foremost, buyers need to listen to their agents. We here at Brick & Corbett have helped thousands of buyers (no, literally!) get homes under contract and closed. We’re carefully monitoring the market conditions, and while we don’t have a crystal ball, we have a pretty good idea of which offers are going to stick when it comes to your mortgage.
Secondly, do a little research for the neighborhood you’re buying in. If the prices the market is fetching are rising faster than 5% a year, your offer is in danger of suffering an appraisal gap, so set your expectations appropriately.
Finally, buyers should pad their budget a bit in the home inspection area. Remember, your home inspection occurs before your appraisal, meaning, if the appraisal gap is going to happen, it’s going to happen after you spend the money on an inspection. This means that if you have an appraisal issue that ultimately submarines your contract, you’ll need a budget for another inspection on the next house your offer on, so plan accordingly.
How Sellers Can Protect Themselves From an Appraisal Gap
While an appraisal gap is primarily an issue for buyers, it can be frustrating for sellers too. After all, you don’t want to sell your home for less than market value, however, if you’ve got a particular timeline you’re looking to meet when it comes to the sale of your home, an appraisal gap can throw that for a loop.
Sellers can protect themselves from appraisal gaps by considering alternative terms that add value to a transaction but not necessarily to the purchase price. For instance, say you’ve decided to sell your vacation home that you also use as a short-term vacation rental. As a part of the contract to sell the home, you can lower your sale price in exchange for interest in the rental income for a certain period of time or up to a certain amount.
Or, you could negotiate occupancy after the sale has closed for a period of time that is longer than typical in exchange for a lower sale price.
Both of these strategies need to be negotiated carefully, but are options for sellers who are concerned that their home’s sale price won’t meet appraisal requirements.
The Bottom Line
Appraisal gaps are happening, and they’re frustrating buyers and sellers all over Northern Michigan. The Brick & Corbett team is here, ready to help you clear this hurdle and take the next step in your home ownership journey. Please reach out to us today to find out how we, the #1 team in all of Grand Traverse County, can offer solutions to your real estate needs.