If you’re searching for drama, don’t limit yourself to Netflix. Instead, tune in to the real estate market, where the competition among buyers has never been fiercer. And with homes selling for record highs,¹ the appraisal gap and the appraisal process— a normal part of a home purchase—is receiving more attention than ever. That’s because some sellers are finding out the hard way that a strong offer can fizzle quickly when an appraisal comes in below the sales price. Thus, many sellers favour buyers who can guarantee their full offer price—even if the property appraises for less. For the buyer, that can mean a large down payment or extra cash on hand to cover the gap. Whether you’re a buyer or a seller, it’s never been more important to understand the appraisal process. A quickly rising and highly competitive housing market can easily create an appraisal gap. That’s why it’s crucial to work with a skilled real estate agent. He or she can guide you to a successful closing. If you’re a buyer you don’t want to overpay. If you’re a seller you don’t want to sell for less than is “fair”. Find out how appraisals work—and in some cases, don’t work—in today’s unique real estate market.

APPRAISAL REQUIREMENTS

An appraisal is an assessment of a property’s market value. It is done by a licensed appraiser. Mortgage lenders use appraisals to lower their risk of loss in the event a buyer defaults on their loan. It shows that the home’s value equals or is greater than the mortgage. In certain cases, you can avoid an appraisal. For example, when a buyer purchases mortgage insurance because they have a down payment of less than 20%. In that instance, the mortgage insurance would cover the lender’s loss in a case of default. Or, if a buyer makes a large down payment, a lender may waive their right of appraisal.² Sometimes a lender will use an automated valuation model (AVM) to estimate a property’s value. According to the Appraisal Institute of Canada, “AVMs are computer programs that provide real estate market analysis and estimates of value.” If the sales price falls comfortably within the AVM’s range of value, a lender may skip the formal appraisal.³ However, in the event a formal appraisal is required, it will need to be conducted by a licensed appraiser. In most cases, the appraiser will analyze the property’s condition and review the value of comparable properties that have recently sold. Using this information, they will determine the home’s current market value. Buyers are usually pay the cost of an appraisal.²

APPRAISALS IN A RAPIDLY SHIFTING MARKET

Problems can arise when the appraisal gap occurs and the appraisal comes in lower than the sales price. And while low appraisals are not common, they are more likely to happen in a rapidly increasing market, like the current one.⁴ That’s because appraisers use comparable sales (referred to as comps) to determine a property’s value. These could include homes that went under contract weeks or even months ago. With home prices rising so quickly, today’s comps may be lagging behind the market’s current reality. Thus, the appraiser may be basing their assessment on stale data, resulting in a low valuation.⁵ However, I try to avoid this by offering the appraiser a list of properties that are fair comps and reflect the buyers valuation. According to Kevin Lonsdale, Executive Director of the Canadian National Association of Real Estate Appraisers, the best valuations should be based on “data, not emotion. This emotional process where people are outbidding each other creates a disconnect and that then becomes a comparable six months down the road. It’s very difficult to value properties based on what the market wants to pay for them.”⁶ The appraisal gap is virtually inevitable.

HOW ARE BUYERS AND SELLERS IMPACTED BY THE APPRAISAL GAP?

A financing condition is a standard inclusion in a home purchase offer. It enables the buyer to make the purchase dependent on their ability to get a mortgage. And in many cases, the loan depends on an appraisal, where the value of the property is at or near the purchase price. But in today’s market, sellers often hold the upper hand because the current demand for homes exceeds the available supply. That’s why many buyers are choosing to exclude the financing condition as a way to sweeten their offer.⁵ However, this approach can leave a buyer vulnerable if the appraisal comes back lower than expected. Without a financing condition, the buyer must come up with enough cash to bridge the gap between the contract price and the appraised value—or walking away from the transaction and potentially losing their deposit. It may seem, then, that a buyer carries the sole risk of a low appraisal. However, the sellers will have wasted time and money with little to show for it. And they run the risk that the market may have cooled or interest in their home may have gone down by the time they relist. Sellers should keep this in mind when evaluating offers. The offer price should never be the sole consideration. We weigh a range of factors when advising our clients, including a buyer’s conditions, mortgage qualifications, financial resources, and deposit size, among others. According to Lonsdale, overheated blind bidding in Canadian real estate means that there is additional pressure on everyone involved in the transaction. With a tight timeline, there’s not always enough time for proper due diligence, putting stress on the transaction and on the buyer and seller involved.⁶

MITIGATE YOUR RISK OF THE APPRAISAL GAP WITH THE BEST REPRESENTATION

There’s never been a market quite like this one before. That’s why you need a master negotiator on your side who has the skills, instincts, and experience to complete your deal …no matter what surprises may pop up along the way. If you’re a buyer, I can help you in this unusual market—without getting steamrolled. And if you’re a seller, I know how to get top dollar for your home with little hassle and stress. Contact me today to book a free meeting.  

Sources:

1. Financial Post – https://financialpost.com/real-estate/canadian-home-sales-prices-surge-to-new-record-in-march
2. Mortgages.ca – https://mortgages.ca/what-you-should-know-about-home-appraisals
3. Appraisal Institute of Canada – https://professional.sauder.ubc.ca/re_creditprogram/course_resources/courses/content/452/AVMPositionPaper.pdf
4. Teranet–National Bank House Price Index™ – https://housepriceindex.ca/#maps=c11
5. The Globe and Mail – https://www.theglobeandmail.com/business/article-rapid-increase-in-home-prices-puts-buyers-in-bind-when-appraisals-dont/
6. Personal Interview: Kevin Lonsdale, Executive Director, Canadian National Association of Real Estate Appraisers. 4 Jun 2021