Escalation clauses are becoming very popular again. Although controversial amongst those who work in the real estate field, they are not illegal nor prohibited. If you are a buyer or seller you should understand what they are and how they work…they could be a blessing or they could cost you in a big way.

An escalation clause allows a buyer presenting an offer to agree to pay a certain fixed amount higher than any other competing offers made on the property. Thus, the buyer has a huge advantage over other buyers. Usually there is a cap placed on the price overage.

Let’s look at an example. Say Mr. Seller puts his home on the market for $500,000. According to recent solds in the neighborhoods this is a fair price. He receives 3 offers, all for $500,000, and one with an escalation clause for $1,000 above any other bids, up to $510,000. Mr. Seller can either send out a multiple counter offer to all buyers, seeing if any of them will come up in price. If they do, the buyer with the escalation clause will still come in $1,000 higher, up to $510,000. If the comps do not support value over the $500,000 asking price, the only way any buyer getting a loan will be able to pay for this home is to agree to pay over appraised value, which many buyers will not or cannot do. Thus, the buyer with the escalation clause, who is presumptively willing to pay over appraised value, has an edge.

This sounds great for the buyer, who oftentimes cements his place as the winning bid in multiple offer situations. It also sounds great for the seller, who will undoubtedly sell his home over asking price. However, there are some major caveats when using these clauses, and you need to make sure you understand how they work in order to decide whether they are right for you.

Buyer Caveats

1. Place a limit on your bid. If you are going to utilize an escalation clause, it is important that you do put a cap on your price increase, for obvious reasons. Do not put yourself in a situation where you could be taken advantage of.

2. Understand possible consequences if your escalated offer is accepted. You need to make sure that you understand will happen if your offer is accepted. If you are obtaining a loan with 20% down, for example, you will have several options. You can include the higher contract price in your 80% loan amount, if possible. If not, you will need to be able to pay the cash difference. Similarly, if you do not include the increased price in your loan amount and the home doesn’t appraise, you will need to be able to pay the amount in cash over appraised value…unless you have a contingency in your contract giving you the right to cancel should the home not appraise – but this would make your escalated offer not very desirable to the seller and really defeats the purpose of an escalation clause.

3. Seller could use your offer to her advantage. Consider this: if you submit an offer with an escalation clause, it is possible the seller could use that to solicit higher offers, just by letting other potential buyers know there has been an offer presented with an escalation clause. This could be detrimental, so you have to decide whether you want to put yourself in that position. Also, how long does the seller have to contemplate your offer? You want to discuss this with your agent, and possibly limit the time the seller has to make a decision.

4. How do buyers really know there IS an escalation clause on a submitted offer? You need to be careful, because even if a listing agent informs you that there is an offer coming in with an escalation clause, you want to make sure any offer you present is one you can afford, and one that you can afford the increased price should the home not appraise at the price you are offering. In other words, if you know there is another offer with an escalation clause and thus decide to make your offer up to $10,000 over comparable market value, you have to be comfortable with the possibility that you will need to pay the $10,000 cash above appraisal value if the home does not appraise.

If you are a buyer who has been told there is an offer on the table with an escalation clause, you should have your agent obtain proof of this offer before presenting an offer. The listing agent can do so without disclosing the name of the other buyer or the price offered, by whiting out specific terms (name and price) and showing you the offer form.

5. Do not waive your contingencies. Make sure you keep your loan and inspection contingencies when using escalation clauses…you always want to make sure you know if there are any issues with the home that could cost you lots of money, and similarly you never want to waive your loan contingency (unless you happen to have enough cash to cover the purchase price in the event your loan does not go through.)

Seller Caveats

1. Escalation clauses may not be in the sellers’ best interests and could backfire. If you are a seller who has received an offer with an escalation clause, and other potential buyers know about this, it could ruin your chances of getting other offers. If the buyer with the escalation clause does not qualify or backs out for another reason, you could be left with accrued market time and no other offers.

Let’s understand this using the above example. Say buyer 1 presented the offer with the escalation clause; buyers 2 and 3 know this and also know it is highly unlikely the home will appraise beyond a certain number. Not knowing what buyer 1 offered, nor the terms of his escalation clause, they may simply decide it’s not worth it to present an offer at all under the circumstances. If you accept buyer 1′s offer and down the road the contract is canceled, you now have to start all over marketing your home, as you have no backup offers. You go back on the MLS with the accrued market time, potentially causing other buyers question why your home has not sold.

The important lesson here is to really understand how escalation clauses work, whether you are a buyer or a seller. Buyers need to be sure they can accept the terms should their escalated offer be selected. Buyers and sellers should talk to their agents and brokers to make sure using an escalation clause is in their best interests, and I also suggest consulting an attorney before doing so. Escalation clauses can be beneficial if you are careful.

Real estate contracts in most states are and have always been pro-buyer, especially here in California. Buyers usually have a contingency period, in which they can complete home inspections, get their loan approved and any other things that are important before contingencies must be removed and they risk losing their initial deposit. What most people don’t know is that a buyer needs to have a legitimate reason to cancel the contract, even during the contingency period.

The California Residential Purchase Contract (RPA) gives the buyer several “outs” that allow the buyer to cancel the contract without being penalized and losing the initial deposit.

1.  Loan contingency. This is one of the main reasons contracts cancel. The buyer’s lender uses the contingency period – standard is 17 days unless the agent wrote in a different number – to get the buyer’s loan approved. During this time period if the lender finds the buyer cannot qualify for a loan, the buyer can effectively cancel the contract.

2.  Appraisal contingency. Likewise, all loans rely on appraisals of the property involved. If the property does not appraise for the agreed purchase price the lender will not fund a loan. The buyer at this juncture can go to the seller and renegotiate the purchase price as per the appraisal. If the seller refuses to do so the buyer can cancel the contract. However, it is important to keep in mind that once a buyer hands the appraisal over to a seller, the seller is made aware of the appraised value of the property in respect to potential future buyers. If the seller’s property cannot appraise for the amount he desires, his only hope of getting that amount is to find an all cash buyer who does not mind paying more than appraised value – good luck with that one.

3.  Buyer’s right to accept the condition of and matters affecting the property. If during the contingency period the buyer discovers there are problems or issues with the property  that the buyer does not want to or cannot afford to deal with, the buyer has the option to cancel the contract. Some examples include where the buyer’s home inspector discovers a plumbing or electrical problem that will be costly or is dangerous, and the seller will not agree to take care of it;  a cracked slab, necessity for a new roof, additions not built to code, or if there is an easement on the property that could effect use and enjoyment of the property, or a myriad of other issues. The contract protects the buyer’s right to back out upon discovering issues that make the property less habitable or otherwise affect the condition.

4.  Breach of seller’s duties. If the seller does not provide certain documents to the buyer on time, such as property and statutory disclosures, it may be cause for cancellation of the contract. The buyer must wait until the expiration of the time period and then provide a written notice to perform to the seller. If the seller does not do so in the time period provided the buyer may cancel the contract. Time periods are specified in the contract.

The California Residential Purchase Contract is written with protection of the buyer as a high priority. No one wants to sell a home to a buyer who is unhappy about it (or, let me rephrase that – I certainly do not want to do that, and most agents feel similarly). Look at your contingency period as a time to gather all the information you will need, so that you understand any faults associated with the property.

Most sellers will work with buyers on repair requests, but keep in mind that ALL homes in California are sold as is – the seller has no obligation to make any repairs. Limit your requests to those items that are dangerous or alter the habitability or enjoyment of the property. Lastly, keep in mind that in short sale situations and most foreclosure cases, the lender will not agree to any requests for repairs.
Happy home hunting! Please let me know if you have any questions I can answer about the purchase contract or the purchase process. I will be happy to address them in a subsequent blog…just make your suggestions below.

I love to read Kenneth Harney columns. He is one of my favorite writers on the real estate market, and always poses poignant questions as he delves deep into real estate-related issues (some that the average journalist won’t tackle). Today he had a new column out discussing the “case of the walking homebuyers.” Apparently the numbers show that large numbers of signed real estate contracts cancelled last month across the country. Why is this, and will it continue?

One of the reasons cited for contracts falling a part is the good old economy. Uncertainty about what is going on with the deficit, unemployment and the housing market may be causing many folks to rethink home purchases. Ironically enough now is the time to buy a home if you are in the position to do so, as prices are low, rates are low, inventory is ripe for negotiations and it is a buyer’s market. Call it a Catch-22, but the savvy buyers (like investors, who have no emotions in the game) are purchasing some great deals.

Short sales are also cited as one of the culprits for purchase contract cancellations. As you are aware, these sales can be long processes and often buyers decide not to wait the process through. I even had one cancel after the lender had approved the short sale, because the lender decided to sell the property at auction…but this is a rare case. For the most part though, my short sales have not had a problem closing (only the annoying time burdens). Most short sale buyers, if counseled correctly by their agents, will understand going into the process that it could be timely.

Lender issues are another potential roadblock with purchase contract cancellations. Often buyers have a hard time obtaining funding for a loan, and this process has become even more difficult due to the possibility of loan limits reductions (see my previous blogs on this topic). For the most part, if buyers are pre-approved and the agents follow up with the lenders on this prior to writing an offer, and then during the contingency period, the majority of the loans go through. The key is communication with the mortgage broker/bank representative, so that they get all the paperwork needed from the buyer(s).

Appraisal issues are also pointed out in the article. Appraisers have been known to blow a sale here and there by valuing properties too low. As Mr. Harney pointed out, if an appraisal comes in too low the buyers may opt to back out if the price is not reduced. But for the most part I have not personally had any appraiser issues (only one a few years back, and he was right on – so the sellers had to reduce the price for my buyer and, although they were unhappy, they would have had to do so for other buyers as well). Oftentimes though the appraisals can be the subject of errors, which can be remedied should the buyer and seller take their agents’ advice and submit an appeal.

No matter what forces may compel buyers to abstain from home purchases, if you are in the position to buy, are qualified, and are working with an agent who is both smart and savvy, there really is no better time. I know I say this often, but that is because it is the truth. If you need more proof just look at all the investors out there buying right now…that says a lot.

Many people who purchase real estate have little understanding of the way the law effects your purchase, yet it is important to learn because your purchase is a legal transaction.

In California, according to the Statute of Frauds all contracts for the sale of real property must be in writing to be legally enforceable. When you sign your name to a contract it is assumed that you have read and understood the language therein, and you are bound by that language. While there are exceptions to the Statute unfortunately naivety is not one of them; the point is to read and understand the entire contract.

Unlike other states where an attorney represents buyers and sellers in real estate transactions, we have to be more vigilant here. If you do not understand something you need to consult with your Realtor. If he or she cannot explain it to you then they need to involve their broker or speak with your attorney. But the bottom line is that you need to understand what you are signing.

What can make a real estate contract voidable (able to be canceled by either party), void (rendered nonexistent) or unenforceable (allowing for a legal remedy)? Without going into elaborate detail here are the exceptions that may enable the contract to fall under one of these categories:. 1. Age/minor–you must be over the age of 18 or have a legal guardian who can sign in your capacity. 2. Insanity–if it can be proven that the signer was not of sound mind when s/he signed the contract. 3. Misrepresentation–if a party can prove that they signed the contract as a result of the misrepresentation of the other party. There are two types of misrepresentation so you need to speak with your attorney to apply specific facts and to see what types of remedies may be available. 4. Fraud. If you entered into a contract because of fraud on behalf of the other party the contract could be void or voidable, with legal remedies available.

Fraud has become a buzz word lately due to the numerous lawsuits filed by homeowners against lenders in foreclosure cases. If you are purchasing a lender-owned property please consult with your Realtor and make certain that the lender acquired the home legally. Title companies are stepping up to make it more difficult to get these properties insured, so that will make it easier on the buyers because clean title cannot pass if the lender acquired title to the property in a fraudulent manner. Keep in mind that it also may make title insurance policies a lot more expensive with regard to these types of properties.

The bottom line is to make sure you understand the contract you are signing, and make sure to have your Realtor do some extra investigating in cases of lender-owned properties.