Definition of an escalation clause
An escalation clause is a rider, or addendum to an agreement of sale (purchase contract). It specifies the dollar increment (let’s say $5,000) the buyer will increase her offer by over the current highest offer made by another buyer. It also indicates the maximum purchase price the buyer will pay (let’s say $650,000). We will use these numbers in our example later.
How does an escalation clause work?
There are a few important things to understand about escalation clauses.
- The seller can only invoke a buyer’s escalation clause if there are other offers, in writing, that are higher than the buyer’s offer.
- The buyer does not have the opportunity to reconsider; whatever increment and cap you indicate on the escalation clause is binding.
- Escalation clauses are almost exclusively used when the cap exceeds the list price.
- It is vital that you understand how the use of an escalation clause may affect your financing (both as far as appraised value and loan amount).
There must be other offers in writing
If there are no offers that currently exceed your offer in price, the seller cannot “escalate” you. The seller can counter your offer, but you are not required to pay even a penny more than your offer price. Remember, the escalation clause is NOT the offer or the offer price. It’s an addendum which can only be used if there’s another, higher offer. (As an aside, people often ask me how they will know that there’s a higher offer. Your agent can ask the listing agent to provide the competing offer with the buyers’ names and other info, aside from the price, redacted).
The escalation clause is binding
You don’t get to negotiate when the listing agent notifies your agent that there was a higher offer and the escalation clause on your offer is now in play. Whatever the terms of the increment and cap are, you are required to honor them.
Escalation clauses are only used to exceed list price
If, even with an escalation clause in play, an offer is still below the asking price, the seller may just counter the offer. The idea behind escalation clauses is that they are used in multiple bid situations when the price has exceeded the list price (because in that situation, the seller will already receive more than he even listed for, so he is going to take the best offer of the bunch).
Financing is affected by an escalation clause
The escalation clause is actually a form with places to fill in the increment over the next highest offer you will go as well as the cap on your offer. There are also boxes to check regarding how your financing is affected. One option is that you will pay in cash whatever the difference is between your original offer and whatever the escalation takes you to (not always your cap, but we will get to that in our example in a bit). Another choice is that the loan percentage (i.e. 80%) will remain unchanged. That means that you need to be sure your lender is willing to loan you that percentage of the highest price you’ll pay as per the escalation clause (this is the “cap” I have mentioned).
While, if you are getting financing, you always need to be prepared for what happens in the event of a low appraisal, you are more likely to encounter a low appraisal as you escalate and pay more above the listing price. When a lender approves you for an 80% loan, they are promising to lend you 80% of the property’s VALUE as defined by an independent appraiser. Since appraisal values are mostly derived from what similar homes have sold for, the more you pay above list price (which is usually a close reflection of those similar homes’ sold prices), the more likely the house will appraise for less than you’re offering to pay for it. When that happens, the boilerplate language in an agreement of sale (at least in PA) allows the buyer to terminate and get deposit monies returned (or buyer and seller can choose to see if they can come to some other agreement about the price).
As a result, sellers who accept escalation clauses often want to see an accompanying guarantee of how/whether you will cover any gap between the appraised value and the purchase price you are offering. Appraisal gap coverage is its own topic; click here for a full explanation.
Example of an escalation clause
Let’s say a house is listed for $600,000. Your agent reports that the listing agent has multiple offers. You decide to write an offer for $600,000 with an escalation up to $650,000 with an increment of $5,000 above the next highest bid. Most people understand how people arrive at their cap–it’s the highest you’d be willing to pay. But what about the increment? How do you choose that number? You don’t want to make it too large for two reasons. The first is that you have to consider the relationship between your increment and your cap. If the increment is too large, it could prevent you from being able to outbid the next highest bid if that increment puts your offer above your cap. So if you were considering an increment of $15,000 and your cap is $650,000, if the next highest bid is $640,000, your top bid, according to the escalation clause, is $635,000. The second reason you don’t want that increment to be too big is that you don’t want to pay, say, $15,000 more than the next highest bid if you don’t have to in order to get the house. In theory, you’d like it to be $1 more, right? So why shouldn’t the increment be $1?
If the increment is too small, you run the risk of losing it to a slightly lower bidder whose terms may be better. Let’s say the competing offer has a settlement date the seller likes better than the one in your offer. If your increment is very small, like $800, the seller may decide she’d rather forgo the additional $800 and get the preferred settlement date. So, you see, a good deal of strategy is involved in choosing your increment.
(When I realized I had never written a post about escalation clauses, I wondered why. At this point in the post, I’ve figured it out: it’s a very complex topic that requires a lot of explanation which creates a very long blog post–I wonder if anyone will even get this far into it, but I’m almost done and will try to make it worthwhile to finish, so stick with me here!)
So let’s say you decide on $5,000 for your increment. The seller receives four other bids and the highest one of those, aside from yours, is $640,000. You would get the house for $645,000. However, if the next highest bid were $645,250, that bidder would get the house as your increment would put your over your cap.
Why use an escalation clause?
What’s the advantage of using an escalation clause vs. just putting in an offer at your cap? Depending on what someone else offers, you might not need to go as high as you’d be willing to go in order to get the house (like in our example above where you’d get the house for $645,000). For this reason, escalation clauses generally favor buyers. For the same reason, agents and sellers who understand how they work often won’t accept them. Additionally, choosing between offers can get very confusing if several of them have escalation clauses, which is another reason many agents advise their sellers to disallow them.
In most cases, it’s beneficial to buyers to use escalation clauses if they are permitted. That said, there are scenarios in which sellers will take a slightly lower offer that is a “straight” offer (with no escalation clause) vs. one with a clause that might be a few dollars more. Why? It’s psychological. Some sellers feel that the “straight” offer reflects a more direct approach and demonstrates that that buyer wasn’t trying to get it for less, but, rather, was willing to commit to an above-asking offer from the start. It’s nearly impossible to predict what type of person the seller is and how he will interpret the intent of any offer. And, of course, you won’t know what any competing offers are going to look like. So I advise my buyers to try not to guess about either of those things, but to just put together the offer that they believe will be most compelling within their own boundaries.