Appraisal Contingency
An appraisal contingency is a clause in a real estate purchase agreement that allows the buyer to back out of the deal or renegotiate if the property's appraised value is less than the agreed-upon purchase price. It protects buyers from overpaying and ensures lenders do not finance more than a property is worth.
Key Takeaways
- An appraisal contingency protects buyers from overpaying and ensures lenders do not finance more than a property's market value.
- If the appraisal comes in below the purchase price, the buyer can renegotiate, cover the appraisal gap, or withdraw from the contract.
- Waving the appraisal contingency can make an offer more competitive but significantly increases the buyer's financial risk.
- Sellers should be prepared for potential appraisal gaps and consider strategies like price adjustments or offering credits to keep the deal alive.
- Understanding this clause is crucial for both buyers and sellers to navigate real estate transactions effectively and mitigate risks.
What is an Appraisal Contingency?
An appraisal contingency is a critical clause included in a real estate purchase agreement that protects the buyer. It stipulates that the sale of a property is contingent upon the property appraising for at least the agreed-upon purchase price. If the appraisal comes in lower than the contract price, this contingency provides the buyer with several options: they can renegotiate the purchase price with the seller, cover the difference between the appraised value and the purchase price out of pocket, or, in some cases, withdraw from the contract and receive their earnest money deposit back without penalty. This clause is fundamental for both buyers and lenders, ensuring that the property's value supports the loan amount and prevents buyers from overpaying for an asset.
How an Appraisal Contingency Works
The appraisal contingency is typically activated after a purchase agreement has been signed but before the closing date. It's a standard part of most financed real estate transactions because lenders require an appraisal to ensure the property serves as adequate collateral for the mortgage loan. The process generally unfolds in a series of steps:
- Offer Acceptance: The buyer and seller agree on a purchase price and sign a purchase agreement, which includes the appraisal contingency clause.
- Appraisal Order: The buyer's lender orders an independent appraisal of the property. A licensed appraiser evaluates the property's condition, features, and recent comparable sales (comps) in the area to determine its fair market value.
- Appraisal Report: The appraiser submits a detailed report to the lender and buyer, stating the property's estimated value.
- Outcome Determination: If the appraised value meets or exceeds the purchase price, the transaction proceeds as planned. If the appraised value is lower than the purchase price, an appraisal gap occurs, triggering the contingency.
- Negotiation or Withdrawal: In case of a low appraisal, the buyer can typically renegotiate the price, pay the difference, or, if the contingency allows, walk away from the deal and retain their earnest money deposit.
Key Components of the Contingency
- Appraisal Value: This is the independent expert's opinion of the property's market value, which directly influences the maximum loan amount a lender will provide. Lenders typically base their Loan-to-Value (LTV) ratio on the lesser of the purchase price or the appraised value.
- Loan Amount: The mortgage loan is tied to the appraised value. If the appraisal is low, the lender will only finance a percentage of the lower appraised value, not the higher purchase price.
- Negotiation Period: The contingency usually specifies a timeframe within which the appraisal must be completed and any resulting negotiations must occur. Missing this deadline can impact the buyer's ability to exercise their rights.
Navigating Appraisal Gaps: Strategies for Buyers and Sellers
An appraisal gap occurs when the property's appraised value is less than the agreed-upon purchase price. This situation can be a significant hurdle in a transaction, especially in competitive markets where buyers might offer above asking price. Both buyers and sellers need strategies to navigate this potential challenge.
Buyer Strategies
- Renegotiate the Price: The most common approach is to ask the seller to reduce the purchase price to match the appraised value.
- Cover the Gap: If the buyer is highly motivated and has additional cash reserves, they can choose to pay the difference between the appraised value and the purchase price out of pocket.
- Dispute the Appraisal: Buyers can request a review of the appraisal if they believe there are errors or if the appraiser overlooked key comparable sales or property features. This is often a long shot but can be attempted.
- Walk Away: If the appraisal gap is too large and no agreeable solution can be reached, the buyer can exercise the contingency and terminate the contract, recovering their earnest money.
- Waive the Contingency: In highly competitive markets, some buyers waive the appraisal contingency to make their offer more attractive. This is a high-risk strategy, as it commits the buyer to cover any appraisal gap, potentially requiring significant additional cash.
Seller Strategies
- Lower the Price: To keep the deal alive, the seller may agree to reduce the purchase price to the appraised value.
- Offer a Credit: The seller might offer a credit to the buyer at closing to help cover some of the buyer's additional out-of-pocket costs, effectively reducing the buyer's cash requirement without lowering the sale price.
- Provide Additional Data: Sellers can provide the appraiser with a list of recent comparable sales or property improvements they believe were overlooked, though the appraiser is not obligated to revise their report.
- Re-list the Property: If no agreement can be reached, the seller may choose to terminate the contract and re-list the property, potentially at a lower price or seeking a cash buyer.
Real-World Example: A Residential Property Transaction
Consider an investor, Sarah, who makes an offer on a single-family rental property. The agreed-upon purchase price is $400,000, and Sarah plans to put 20% down, requiring a $320,000 mortgage loan. The purchase agreement includes an appraisal contingency.
- Purchase Price: $400,000
- Down Payment (20%): $80,000
- Loan Amount Needed: $320,000
Scenario 1: Appraisal Meets Price
The appraisal comes back at $400,000. Sarah's lender is willing to finance 80% of this value, which is $320,000. The transaction proceeds smoothly, as the appraised value supports the purchase price and the loan amount.
Scenario 2: Appraisal Gap
The appraisal comes back at $380,000, creating a $20,000 appraisal gap ($400,000 purchase price - $380,000 appraised value). The lender will now only finance 80% of $380,000, which is $304,000. Sarah still needs $320,000 for the purchase, but the lender will only provide $304,000. This leaves a $16,000 shortfall in financing ($320,000 - $304,000).
Sarah now has a few options due to the appraisal contingency:
- Renegotiate: Sarah asks the seller to reduce the price to $380,000. If the seller agrees, the deal proceeds with the original 20% down payment on the new price.
- Pay the Difference: Sarah could pay the $20,000 appraisal gap out of pocket, in addition to her original $80,000 down payment. This would mean bringing $100,000 to closing.
- Walk Away: If the seller refuses to lower the price and Sarah is unwilling or unable to cover the gap, she can invoke the appraisal contingency, terminate the contract, and get her earnest money deposit back.
This example highlights how the appraisal contingency provides crucial protection, allowing buyers to avoid overpaying for a property or being forced to bring significantly more cash to closing than anticipated.
Frequently Asked Questions
Can a buyer waive an appraisal contingency?
Yes, a buyer can waive an appraisal contingency. This is often done in highly competitive markets to make an offer more attractive to sellers. However, waiving this contingency means the buyer agrees to cover any appraisal gap out of pocket if the property appraises for less than the purchase price. If they cannot cover the gap, they risk losing their earnest money deposit if they cannot close the deal.
What happens if the appraisal is lower than the purchase price?
If the appraisal comes in lower than the purchase price, it creates an appraisal gap. The buyer typically has three main options: 1) renegotiate the purchase price with the seller to match the appraised value, 2) pay the difference between the appraised value and the purchase price in cash, or 3) if the contingency allows, terminate the contract and receive their earnest money deposit back.
Who pays for the appraisal?
The buyer typically pays for the appraisal. The cost is usually included in the closing costs and is paid upfront or at the time of closing. The appraisal is ordered by the lender to protect their interest, but the cost is passed on to the borrower.
Can an appraisal be disputed or challenged?
While challenging, it is possible to dispute an appraisal. The buyer or their real estate agent can submit a formal request to the lender, highlighting specific errors in the report, providing additional comparable sales data, or pointing out property improvements that may have been overlooked. The lender will then review the request and may ask the appraiser to reconsider or order a second appraisal, though this is not guaranteed.
Is an appraisal contingency the same as a financing contingency?
Yes, an appraisal contingency is distinct from a financing contingency. A financing contingency allows the buyer to withdraw if they cannot secure a mortgage loan, regardless of the appraisal value. An appraisal contingency specifically addresses the property's valuation relative to the purchase price. While often related, as a low appraisal can impact financing, they are separate clauses with different triggers and protections.