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.
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.)
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.