An Alternative Approach to Appraisal Gap Coverage

[Liam Hanlon]

An Alternative Approach to Appraisal Gap Coverage

Current State of the Residential Market

After the financial crisis of ’08, the eligibility criteria to buy a home in the United States became more difficult to adhere to, while the astronomical rise of student debt and the cost of healthcare acted as catalysts in the continuously mounting wealth disparity in our country. This led to trends, such as putting off marriage, waiting to have children/having fewer children, and renting instead of buying.

However, in 2020, the combination of low-interest rates and the institution of work from home policies has caused unprecedented competition and market saturation in the suburbs of major metropolitan areas. This competition leads to bidding wars that inspire emotions amongst buyers, that lead to irrational decision making. Many buyers believe that the only way to differentiate themselves from their competition is to increase the price they are willing to pay for the home. However, there are ways to sweeten a deal and stand-out, without having to escalate the purchase price of an offer. A method that I have found success using in the past is the addition of Appraisal Gap Coverage (AGC) to an offer.

Before you can use AGC, you’ll need to be familiar with what an appraisal is. At a high-level, an appraisal is an unbiased professional opinion of a home’s value. Ordering an appraisal is almost always a step within the transaction process of buying/selling a home, and is non-negotiable when using bank/lender backed financing. Your lender will rely on the appraisal to evaluate the true value of the home. If the appraised value of a home is below the purchase price the lender will not finance the deal, because it means that the collateral (the home) is worth less than what they are lending. AGC is an addendum that you (or your buyer’s agent) can add to an offer that states that you are willing to cover the difference, or a portion of the difference, between what the agreed-upon sales price of the home is and what it is appraised at. A flat fee of $3,000-$10,000, depending on what the buyer is comfortable with paying in cash, is most commonly used as the dollar amount promised in the addendum (example below).

“In the event, the appraised value comes in below Purchase Price, the Buyer agrees to pay up to $6,000.00* over appraised value not to exceed the purchase price. Any such cash differential shall be applied to Buyers` Cash at Closing.”

Let me give you a simple example of a situation where the appraised value is less than the sales price and how AGC can be applied to save a deal…

Now that we have seen an example of how AGC can be applied, let’s analyze its strengths and weakness…

Pros	Cons
Acts as an insurance policy to the seller against a low appraisal	Often results in the buyer paying more money for less equity in the home
Allows a buyer to improve and offer without raising the purchase price	It is not financed through the bank/lender (paid in full by the buyer)
Allows the buyer and seller to transact outside of a lender’s domain	Is binding upon acceptance of the offer

To demonstrate the negative effects of AGC let’s take the same example from before and compare a few scenarios…

	Appraised at 100k	Appraised at 90k (w/ AGC)
Original Sales Price	$100,000	$100,000
Appraisal Gap Coverage	-	$5,000
Appraised Value	$100,000	$90,000
New Sales Price	$100,000	$90,000
Seller Gets	$100,000	$95,000
Buyer Pays	$20,000	$23,000

Alternative Approach

It is clear from the example above, that AGC has the potential to force the buyer to pay substantially more for a home that has a lower expected value than originally anticipated. Paying more for less equity can be detrimental to the long-term value of an investment and needs to be considered when instituting such addendums. However, there is an alternative approach that can be used to mitigate downside risk and still capture the positive effects of AGC.

Instead of agreeing to pay a flat fee of AGC, a buyer is able to institute dynamic contingencies that alter the AGC owed to the seller based on the scenario. Personally, I use a simple mathematical equation that allows me to improve an offer without increasing my projected down payment. The method I use is an agreement to pay (1-LTV)*(Sales Price – Appraised Value).

“In the event, the appraised value comes in below Purchase Price, the Buyer agrees to pay up to 20% of the difference between the appraised value and Purchase price not to exceed $50,000.00.”

	Appraised at 100k – No AGC	Appraised at 90k – Using Traditional AGC	Appraised at 90k – Using Alternative AGC
Original Sales Price	$100,000	$100,000	$100,000
Appraisal Gap Coverage	-	$5,000	20% (SP-AV)
Appraised Value	$100,000	$90,000	$90,000
New Sales Price	$100,000	$90,000	$90,000
Seller Gets	$100,000	$95,000	$92,000
Buyer Pays	$20,000	$23,000	$20,000

The first scenario, in the example above, is appraised at the agreed-upon purchase price. Therefore the buyer simply has to pay for the 20% down payment ($20,000). The second scenario was appraised at $90,000 and had a $5,000 AGC included in the offer. So the buyer ended up paying 20% of the appraised value (20%*($90,000) = $18,000), and $5,000 in AGC, for a total of $23,000. The third scenario was also appraised at $90,000, with an AGC addendum that stated the buyer would pay 20% of the difference between the appraised value and the original purchase price. Meaning the buyer ended up paying 20%*($90,000) = $18,000, and 20%*($100,000-$90,000), for a total of $20,000.

Through this example, we see that the first and third scenarios have the exact same total down payment of $20,000, while the second scenario has a down payment of $23,000. Using the simple mathematical equation previously outlined, you can be confident about your closing costs regardless of the appraised value and still provide insurance to the seller.

Impact on Investment Metrics

This alternative approach to AGC is applicable for purchasing single-family homes or residential multi-family (2-4 family). If you are using this method when purchasing a multifamily property, it is important to analyze the impact it will have on your investment statistics.

The alternative method almost always results in a smaller down payment than its flat fee counterpart and an identical mortgage. With all else equal (rental income, expenses, etc.) the alternative approach would lead to a more favorable cape rate, cash-on-cash return, ROI, and much more.