Ask Brian: What is an Escalation Clause?

Ask Brian is a weekly column by Real Estate Expert Brian Kline. If you have questions on real estate investing, DIY, home buying/selling, or other housing inquiries please email your questions to askbrian@realtybiznews.com.

Question from Melony in CA: Hello Brian, I’ve been house hunting for more than eight months. Sad to say, but I’ve lost three bidding wars on houses that I really wanted. I did increase my offer on all three but so did other buyers. In one situation, I learned that my second offer was only $1,200 less than the offer that was accepted. If I had known that at the time, I would have increased my offer again. I talked to my agent about this. She says that the next time I make an offer, I should anticipate multiple offers being made and have a strategy to stay in the bidding as long as I can afford to. She’s suggesting that I include an escalation clause in the offer. This sounds risky to me. What should I know before including an escalation clause and is it a good idea?

Answer: Hello Melony. Escalation clauses have become a popular tool in competitive markets. A couple of years ago, people started including a letter to the seller explaining why the house was a great fit for them and telling the seller how much TLC they would give to the house. These letters were intended to appeal to the emotional side of sellers. Turns out that the letters didn’t have much effect when bidding wars broke out. That’s when the market saw an increase in the use of escalation clauses.

First, let's look at what an escalation clause is. At its simplest, it is an offer that automatically increases the purchase price by a specific dollar amount above any competing offers. Two key features that go into an escalation clause are how much your increase will be above other offers and what your upper limit will be.

A minimum of three elements need to go into an escalation clause.

1. Proof that another good-faith offer has been made. You don’t want a seller to be able to trigger an escalation clause just by saying that they received a higher offer. They need to show proof of the other offer.

2. Your escalation amount. This is the amount that your offer will automatically increase above the amount offered by another buyer. For instance, if the other offer is $325,000, your escalation amount might be $5,000, which brings your new offer up to $330,000. The amount of the increase can be more important than you might think at first glance. In a deal worth hundreds of thousands, only increasing your offer by $1,000 might not be enough to overcome other factors in a competing offer, such as waving some contingency clauses or a faster closing date.

3. Your maximum offer. If you will be taking out a mortgage, you probably have at least two caps to the highest amount that you can offer. The maximum mortgage you can qualify for and the amount that the house will appraise for. If your offer exceeds these amounts, you must be prepared to pay the difference in cash.

We know that sellers have an advantage in competitive markets. Escalation clauses do have a place in these markets, but an escalation clause is not a foolproof way of making the best offer. There are limits to escalation clauses. Cash is still king. Most buyers must limit the escalation to not go above what the mortgage will be approved for. An all-cash offer is not limited by this constraint. A higher all-cash offer still trumps an escalation clause.

You want to see other good-faith offers. This is especially true if you are making an offer below the asking price. A shady seller may reject an offer below the asking price just to see if the buyer has an escalation clause. Without revealing a good faith offer, the seller can just say they have a full-price offer and wait to see if an escalation clause kicks in. If an escalation clause doesn’t kick in, the seller can always come back saying the better offer fell through and accept your lower offer. This might be unethical, but it does happen.

You should only include an escalation clause if you are reasonably confident there will be competing bids. Once the seller sees your escalation clause, all of your cards are on the table. You lose your ability to negotiate. If you submit an escalation clause and there are no other immediate offers, the seller may hold out accepting or rejecting your offer in the hopes that another offer will be made that triggers your escalation clause. If two or more offers are made with escalation clauses, it automatically starts a bidding war until the second-highest cap is reached.

Melony, here are a few tips for using an escalation clause effectively. In today’s market, a good strategy is looking at houses below the top end of your budget. That allows you to make a high opening offer and include an escalation clause. The key is that your budget must have room to go higher even if it goes slightly above the current market analysis. An escalation clause says you’ll pay a certain dollar amount above any offer up to your budget limit. A first offer at the full asking price of $250,000 with an escalation clause might say that you’ll outbid any competing offers by $2,000 up to $272,000. But you should be prepared to pay that escalation in cash. If the appraisal doesn’t support the higher offer, you can probably still get the mortgage you are preapproved for, but you’ll need to pay cash for the difference between the appraised value and what you offered above the appraised value. That is added cash in addition to your down payment to qualify for the mortgage.

Also, try some psychology with your upper limit. Set the top limit at something like $272,000 so that you exceed the psychological limit of $270,000 that another buyer might have. You should also be sure that you and your agent are on the same page when writing the escalation clause. You want the seller to understand upfront that you and your agent know exactly what you are doing when you include an escalation clause. These are legal and binding contracts. If you don’t completely understand what you agree to with an escalation clause, consult a real estate attorney.

This is not the definitive strategy for using an escalation clause. What can you add with a comment?

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