What is an Escalation Clause | 5 Critical Things to Know

You might have heard about escalation clauses, but what are they? You need to know!!

When you are ready to make an offer on a home, including this type of clause, could help you get the home you want in a competitive market or in a bidding war. Let’s take a closer look at escalation clauses.

What is an Escalation Clause?

escalation clauseAn escalation clause is an addition to a real estate contract that allows the buyer to increase their offer price automatically over the initial offer. If the buyer makes a new offer, but the seller receives another and better offer, the escalator clause allows the first home buyer to increase their offer. In this competitive market, the buyer should make the highest and best offer.

Though the principle of this type of clause is fairly straightforward, there can be a few details that complicate matters.

How do Escalation Clauses Work in Practice?escalation clause

The exact details of an escalation clause can vary greatly, but there are a few common factors. The clause will state the original offer price as well as the maximum amount that buyer is willing to offer for the sales price. The clause will also set out how much the buyer is willing to increase their purchase price when the clause is triggered.

For example, if a purchaser has made an offer on a home for $200,000 and they include an escalation clause, they might increase their offer by $5,000 in the event of a higher offer.

They can set a limit to their offer, and the escalation clause will increase their offer until it gets that maximum or their offer is accepted. By limiting the amount of the escalation clause, can protect the buyer with the final sales price. Using an escalation clause will create a higher amount over the initial offer to create a final offer which is hopefully high enough to get the deal done.

This can be a very effective tool when making an offer on a home, as it ensures the buyer’s offer is going up in value. This is a method of ensuring that the offer will be considered by the home seller. It shows that the home buyer has serious consideration with the home purchase agreement.

When Should an Escalation Clause be Used?

These types of clauses are only going to be required when you can be fairly confident that the seller will get multiple offers. This type of clause does show the seller what the maximum offer the buyer is willing to make, and so it hands over a lot of negotiating power to the seller. A listing agent will discuss all the offers on a property with the seller.

Also, some sellers will not accept an offer with an escalation clause. Instead, preferring that every buyer submits their highest and best offer. This can potentially lead to buyers offering higher offers initially so that they beat other potential purchasers.

Are There Going to be Multiple Rounds of Offers?

escalation clauseIf the real estate agent has indicated that there will be multiple rounds or offer review processes, this can be a great time to use an escalation clause. These will normally happen in a hot seller’s market where using this clause can give you an advantage. Your buyer’s agent should be providing you guidance on how to prepare the most competitive offer to have a shot at having your offer accepted.

The seller’s agent may collect offers from buyers and then respond to the best bids by a certain date. If you are using this clause, it will mean that you can avoid much of the back and forth process the other buyers will participate in. An offer with an escalation clause may end up being a higher price than any of the other offers.

Though this can put you at a disadvantage too. If there is going to be a second round of counteroffers, the seller will know your maximum bid will be. This amount can be revealed to other potential buyers. This can happen to increase the offers from other interested buyers and means the prospective buyer with the clause is disadvantaged. In this competitive market, buyers are waiving all kinds of contingencies that can be very risky. Many buyers are not including an appraisal contingency which could put the prospective buyer at risk if the property does not appraise.

Treating Every Situation Differentlyescalation clause

When you are making an offer on a home, using escalation clauses might not be the right approach for every situation. There are steps to buying a home, and an escalation clause may not be the right way to go.

Help from your buyer’s agent should go a long way to show you whether using this type of clause will increase your chances of getting the home you want or not. You will want to have your home buying process planned out in advance and know what you need to offer in order to have your offer considered in this hot market.

A lot will depend on the market conditions, and the research carried out by your real estate agent can also show how the seller reviews the offers they receive. It is likely that the seller will receive a competing bid on the property.

Real Estate Market

I am sure you are aware of the very competitive real estate market that we are experiencing right now. You need to be prepared with having your preapproval in place and your lender ready to proceed in the event you have your purchase offer accepted. It is common to see homes that are priced well to sell well over listed price with multiple offers in hand.  It is unlikely that you will receive a counteroffer, so it is ideal to submit your highest and best offer. The real estate market can be very frustrating for a buyer, however, listen to your buyer’s agent and understand if you do not win the offer, then move on to the next property.

Legal Advice

You may want to consult with a real estate attorney and seek legal advice if you are going to be utilizing an escalation clause. Most buyers are being quite aggressive with their offers by waiving contingencies and using escalation clauses. Be sure you fully understand the ramifications of what you are offering to create a winning offer. Due to the very low housing inventory, buyers are creating very competitive offers including waiving a home inspection, which is not something I would recommend. Keep in mind that you may be paying an inflated price for a particular property that may really have a lower value. Everyone wants to find the perfect home, but not at the risk of putting yourself in harm’s way which can ultimately be very expensive. Consulting with a real estate attorney may be something that you choose to do. At the end of the day, you want to feel comfortable with what you are offering and have peace of mind.

Final Thoughts

The idea of using real estate escalation clauses can be an added stress for home buyers, but the process of creating a clause like this isn’t complicated and shouldn’t be feared. You want to avoid making mistakes in a multiple offer situation because if you do, you will likely lose the home you are making an offer on. Whenever you are entering into a bidding process for a home, the situation is going to be stressful enough, so, understandably, you don’t want more complications.

When you make a purchase offer in competitive housing markets, it is important to be realistic about how much you have to spend and the home that will buy you. When you are competing against other buyers, there is pressure to increase your offer to win. But if you give into this, you could find yourself in financial problems later on that could lead to foreclosure.

It is easy to think that the seller will only entertain the highest bidder, however generally speaking the seller will look at all the terms of the purchase offer. Although in a bidding war, it can go either way as well. If the buyers are not persuing homes as aggressively as they need to in order to get the home they want. Because the market is so competitive right now, sellers are generally not concerned with selling a home quickly in a seller’s market. A buyer’s agent needs to prepare the buyer for what they can expect with the home buying process. If the property is at a good market value, and interest rates are low, stretching your finances that little bit further could be beneficial long-term. Overpricing a home, even in this competitive market is not a good idea.

About the Author

Top Newport Beach Real Estate Agent Sharon Paxson has written the real estate article “What is an Escalation Clause | 5 Critical Things to Know”. With experience since 2005 representing sellers, buyers, and landlords with their real estate transactions, we welcome the opportunity to share our knowledge and expertise and guide you through the home buying or selling process.

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Sharon Paxson is a full-time REALTOR® with Compass and has been specializing in residential real estate throughout the Newport Beach area since 2005 assisting Buyer’s, Seller’s, Landlords and Tenants with their real estate needs.

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