If you are an active or previous home buyer, then maybe your agent has told you at one point or another that your offer wasn’t accepted because your competition used an escalation clause. If you are a former seller, maybe you hit the lottery and had the opportunity to accept an offer with an escalation clause. And maybe, just maybe, you have never heard about the escalation clause and you don’t know what the hell I’m talking about. This strategy in a real estate transaction can help you or hurt you, and In this article I’m going to:
- Define the escalation clause
- Show you how I apply it when working with home buyers
- Show you how I handle them as a listing agent
What Is The Escalation Clause?
In traditional business jargon, an escalation provision, or clause, is a contractual instrument that increases a price when certain conditions are met. In residential real estate, they are found in examples of a bidding war, defined as a situation in which two or more prospective buyers are competing for a property, driving up the market value in the process. For our own definition, we consider the escalation clause to be a clause written into the contract to purchase that indicates a buyer will pay a nominal amount over the highest current offer price. While not always the case, typically the escalation clause equates to an offer that is significantly higher than the asking price. Buyers often like the escalation clause because they want their offer to be competitive, but are afraid to outbid themselves. They look to this device to make their offer better than the next, but there are also significant pitfalls that a home buyer can run into.
Most importantly, A REALTOR® should never practice law (with the caveat they are in fact an attorney). It is written into the code of ethics specifically in Article 13 but can also be applicable to Article 11. Our purchase contracts are standardized for a reason, and the potential issue with the escalation clause is that an agent writing in contractual verbiage under the ‘Other Provisions’ section on an offer certainly toes that line, depending on what is actually written. When our team worked under another brokerage for many years, this language was provided to us by our Broker-Owners, and supplied by the company’s general counsel. There’s a reason for it. I have to preface the following demonstration and type of language found in an escalation clause with a disclaimer that I will not be providing the exact language I use here, and to check with an attorney about legal language. This is for informational purposes, only. And with that, I present to you the dumbed down version of the escalation clause:
“Buyer to pay $X above the highest offer price.”
That’s it? Well, kinda, sorta. You want the clause to indicate that you are paying $X more than the next buyer but there’s nuance to it as well. The clause I would use is expanded because I’m trying to accomplish two main goals: The first being that I want to clearly demonstrate My buyer’s offer is better than anyone else’s. So the language includes factors that support that. Secondly, One of My goals is to always have My buyer pay the lowest amount possible for their house, but it’s still a priority to put the house under agreement. The point is that the language I’m using, that My clients benefit from, establishes that they are serious home buyers, and this isn’t our first rodeo. It needs to exude confidence. Believe Me when I say I have seen offers that do the opposite, with the clause being vague enough that it could harm the seller. That really doesn’t help the home buyer get anywhere near an accepted offer.
Let’s run a quick scenario: Two home buyers are presenting offers on a single family home priced at $100,000 (damn, that house is cheap). Buyer 1, knowing there is competition, presents an offer at $110,000. 10% over asking, and a strong offer given the price point. Buyer 2 uses the escalation clause. They present an offer with the price at $100,000 and include the clause: “Buyer to pay $2,000 more than the next highest offer”. When the seller reviews both offers, they see Buyer 1’s offer at $110,000, and Buyer 2’s offer at $112,000. If all other aspects of the contracts are equal, the seller will likely choose Buyer 2’s offer.
In the above example, Buyer 2’s offer indicated that would pay $2,000 over the next highest offer. The nominal amount is extremely important. In the example, all other aspects of the offers were the same, but that’s not typically the case in the real world. One pre approval letter may demonstrate better financing terms and likelihood to obtain a mortgage. One could have no home inspection. Even closing dates could add value to a particular seller. This is why it’s extremely important that a homebuyer differentiates themselves from the next highest offer, because $2,000 may not be enough to be chosen over another buyer that has no home inspection. The nominal amount is going to be relative to the market you find yourself in, the price point, the house, and the other terms of your offer. So be advised, the nominal amount will play an important role.
How I Use It, And When to Use It
The obvious use case for the escalation clause is a highly competitive market. We haven’t seen a buyer’s market since the 2009–2012 years immediately following the recession, so should we be using it all the time? Of course not. I recommend the use of this tool under special circumstances, and with many caveats. When buyers find themselves losing out over and over again, it means that either I am not preparing them properly for the competition they are facing, they are not ready or willing to compete in the price point, or they are just extremely unlucky because all of their lost offers were great, and they were edged out. I’ll typically recommend this as the nuclear option for the latter case, or, a case in which clients need to secure housing quickly. I’ve written before on what happens when a home buyer “chases” the market, and sometimes the escalation clause can help stop that bleeding.
No Cap
Many clients have asked Me if they can include a cap to their escalation clause. After all, they might still be restrained by a budget and otherwise do not want to outbid themselves out of affordability. I have explained to them that essentially they are telling the seller exactly what they are willing to pay, and it defeats the purpose of the escalation, it’s easily countered. I’m going to go into more detail about that in just a moment when I explain the listing perspective. Otherwise, putting a cap on your escalation clause is not an effective means of negotiation. GenZ is known for the phrase “no cap” to imply there’s not a ceiling of truth when it comes to a certain topic. I’m too old to talk like that so I’ll state for the record that the term used here specifically applies to escalation clauses only.
The Listing Side Perspective
It’s always great to see one of My Team Member’s smiles after they inform our colleagues about receiving an escalation clause. Again, we know the house was priced right and their sellers are thrilled. Our job on the listing side after all, is to net the greatest return for our clients, and humble brag: We’re damn good at it. We love to see escalation clauses for two reasons, the first being that if we did our job and the stars align, we have done everything right to maximize the offer price for that house. Secondly, there’s really no negotiation unless there are inspection issues. I won’t delve into our secret sauce to explain how we effectively counsel our sellers, but the goal is to increase the leverage from the seller’s perspective to ensure the best possible terms are presented. This is the counterargument to using the escalation clause. Even in competitive offer situations, a strong offer still carries clout that may make it a better choice for a seller to accept. Escalation clauses may hurt your own leverage by indicating you are willing to pay more with a lower initial offer price. Starting from a more competitive offer price is often more powerful. I have seen some buyers start their base offer price at asking or below, but all that says to me as a listing agent is that it’s not a strong offer, relatively speaking. Starting at the higher price point indicates that the buying party has already ran the numbers, and presents that offer with a lot more confidence. If the escalation is written with an incredibly strong offer on its own, it’s a different conversation
The one concern on the selling side, and definitely on the buying side, is the question of appraisal. If an appraiser cannot justify the value you are offering for a home, the bank may be unwilling to deliver the needed loan to purchase the property. It means a buyer either needs to increase the downpayment and reduce the loan amount, or potentially back out from the deal. Escalations without backing of the mortgage lender for a financed purchase can mean very little to the listing agent, and it is another example of an escalation clause potentially holding the buyer back.
Is It Recommended To Use An Escalation Clause?
I have presented a lot of information here, and you still may wonder whether or not it’s right to use one. That’s completely okay. The escalation clause is another tool in the negotiation tool box, but it’s probably best described as that obscure tool that you don’t reach for very often. Have you lost out on many houses with competitive offers? Are you on a time-crunch? Are you willing to accept the risk of paying a higher price on the high range or even above market value? The answer to these questions should be a solid “yes” before thinking about using it. Even then, each situation should be evaluated individually prior to the decision to use it. In Massachusetts, I have seen these used frequently, however in other states they are actually prohibited. Think about that for a second. The fact that a practicing agent couldn’t use this device for their client in another state speaks volumes to the risk involved. But for that select situation, this strategy can also land your dream home. For more information and legal questions, do talk to your real estate attorney.