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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.

1. 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.
2. The buyer does not have the opportunity to reconsider; whatever increment and cap you indicate on the escalation clause is binding.
3. Escalation clauses are almost exclusively used when the cap exceeds the list price.
4. 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 as 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.

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.

If you are relocating to the Philadelphia/Main Line area, please go to my blog page and search for posts using the relocation tag. Contact me to discuss your Philadelphia area relocation! jen@jenniferlebow.com/610 308-5973

What is an appraisal gap?

To understand what appraisal gap coverage is and how and why it’s used, you need to know what an appraisal gap is. An appraisal gap is the difference between what a buyer has agreed, through a contract, to pay for a house and the amount of the lender’s appraisal. How does the appraiser come up with a value?

How is appraisal value determined?

Appraisers use comparable sales, giving more weight to similar properties that are nearby and have sold most recently. They also look at properties currently available on the market and those that are under contract or pending settlement. An appraisal is a complex analysis of many characteristics, some of which are objective and have specific dollar amounts ascribed to them (like a garage or air conditioning or an additional full bathroom) while others are more subjective (like better condition or a less appealing view). The point is that the appraised value can differ from the amount a buyer and seller have agreed upon.

What if appraisal value and price don’t match?

What happens in this situation? Well, with no changes made to the standard language of an agreement of sale (at least in PA, where I work), the buyer reserves the right to terminate the transaction and receive all deposit monies back if the appraisal comes in below the purchase price. It can be a dollar below, $100,000 below–it doesn’t matter. The buyer is protected. The reason the contract is designed this way? Because the lender agrees to lend a percentage (often 80%) of the “value” but that is appraised value. That means, in the event of a low appraisal, the buyer would have to come up with extra cash to make up the difference. So the pre-written contract allows the buyer to terminate if the appraisal comes in below the purchase price.

Here’s an example:

A property goes under contract for $700,000. The buyer is getting 80% from the lender. That means the buyer is expecting the lender to provide $560,000 and to contribute $140,000 of his own cash toward the purchase price. However, if it appraises and $675,000, the bank’s 80% is now $540,000. So now, if the appraisal contingency that is built in to the contract is waived, in order to honor the contract, the buyer would have to find an additional $20,000.

How the seller views the appraisal

Now that you have a clear picture of how the appraisal works and how the agreement of sale allows a buyer to terminate with no penalty in the event of a low appraisal, consider how a seller feels about that, especially in a market where things are often going above list price.

1. List price is usually determined in large part by what the comparable sales suggest as a value for a house.
2. If the property sells for above list price, it’s likely that the house won’t appraise for that much (as the appraiser will be looking at the same comps the listing agent used to come up with the list price).
3. Sellers don’t want to enter into contracts that have a high probability of terminating, even when the original terms are appealing.

What is appraisal gap coverage?

Appraisal gap coverage is the answer, from the seller’s perspective, to the problem. (And note that sellers are much more concerned about appraisal gaps when their houses go under contract for prices that are likely not to appraise.) To prevent the buyer from being able to walk away from the transaction in the event of a low appraisal, the seller wants the buyer to give up the right to terminate due to a low appraisal. A buyer can offer appraisal gap coverage by guaranteeing to pay a certain amount above the low appraisal, not to exceed the purchase price. Sometimes, buyers waive the appraisal contingency altogether. That choice means that regardless of how low the appraisal is, the buyer will pay the full agreed-to price. This scenario is a seller’s dream.

More often, the buyer puts a cap on the amount of gap she will cover. For example, a buyer may add to her offer this language: “Buyer will provide appraisal gap coverage up to $15,000”.

Another example:

Buyer and seller have agreed to a $700,000 purchase price. The house appraises at $675,000. The buyer has guaranteed up to $15,000 of gap coverage. So she must pay the seller $690,000. That said, if the buyer is not willing to pay more than that, the seller doesn’t have to take any less than the $700,000 that was agreed to. Buyer and seller can renegotiate at this point if they both choose to. If, though, the seller is willing to take the $690,000, the buyer cannot terminate.

If the appraised value were $685,000, the buyer would have to pay all of the $15,000 gap coverage and the seller would get the full $700,000. If the property appraised at $690,000, the buyer would still have to pay the full purchase price of $700,000–but NOT any more. The gap coverage only extends to a maximum of the original purchase price ($700,000 in our example).

Understand your financial obligations and options

Obviously, you need to be prepared to come up with the maximum amount of gap coverage that you offer, for the worst case scenario. Don’t promise more than you are willing to supplement with cash. There is a potential work-around to having to come up with all the cash you’ve promised though. Try to stay with me here:

Let’s say your original plan was to get an 80% loan from the bank for a property you are offering to buy for $700,000. That means you were relying on the bank to loan you $560,000. If the appraisal comes in at, say, $67500, the bank won’t give you $560,000; they will give you 80% of $675,000 ($540,000). So if you’ve offered to cover the appraisal gap, you have to make up the $20,000 difference in cash.

Or do you? Here’s what I mean:

If you still want the bank to loan you closer to $560,000 of the $700,000, you’d could ask for an 82% loan. 82% of the appraised value of $675,000 would be $553,500.  So now instead of having to find an additional $20,000, you would only need to find another $6,500 (the difference between the original $560,000 and the $553,000). Your only additional out of pocket expense would be mortage insurance (which banks charge for any amount of the loan above 80%). Note that once you pay down enough principal to have 20% equity in the house (you’d start with 18% in this scenario), that mortgage insurance disappears.

So you’d have to consider whether it’s more palatable to come up with the additional $20,000 all at once in order to close on the property vs. paying mortgage insurance. PMI is determined by the current rates, and the loan amount. In this case, it might take about three years to pay down enough principal to get to 20% equity. If you’re paying $325 a month in PMI for three years, that’s $11,700. Not only is that less than the $20,000 difference in cash you’d have to pay at closing if you kept your loan at 80%, but it also is not due all at once; it’s spread out over three years. So asking the bank for a slightly larger percentage loan (not a larger dollar amount) might make sense. Be sure to inquire with the lender for the specific fees and how many payments it would take to have the PMI removed.

Psychology of appraisal gap coverage

Is the seller a gambler, or more risk-averse?

I hope you can see now why sellers whose properties are likely to sell above what they are appraised for strongly prefer offers with gap coverage. In our example, a seller who receives an offer for $725,000 that does NOT have any gap coverage probably won’t take that offer–because remember, with no appraisal gap language added, the way the contract reads, even if the property were to magically appraise for, say, $720,000, the buyer would not have to complete the transaction. She could get her deposit back and go on her merry way. Might she be willing to negotiate and pay some gap? Sure. She might. But the seller has no guarantee she’d pay any at all.

How and when should you use gap coverage?

This explanation should help clarify why the strategy behind writing an offer is so complicated: it has to account for the risk/reward profile of both the buyer (who knows his own parameters) AND the seller (whose thoughts are usually a mystery to the buyer). Some sellers might be willing to gamble that the $725,000 buyer would be willing to cover some level of gap in the event of a low appraisal. (And there’s no way to know, beyond an educated guess based on the comps, what the appraisal will be.) Other, more risk-averse sellers, would rather forgo the possibilty of getting more for the guarantee of getting up to $15,000 above the appraised value that the first buyer offered.

I hope you have a better understanding of what appraisal gap coverage is now. While it’s not exactly simple, it is concrete. If you “get it”, you will be better positioned to determine if, when and how you’d want to consider adding it to any offer you might make.

If you are relocating to the Philadelphia/Main Line area, please go to my blog page and search for posts using the relocation tag. Contact me to discuss your Philadelphia area relocation! jen@jenniferlebow.com/610 308-5973