What is an Escalation Clause in Real Estate? 7 PROs and CONs
If you are buying or selling a home in a hot real estate market you might hear the term escalation clause mentioned, but what exactly is it and how will it affect you? While a hot real estate market can be great for sellers it can be extremely difficult for home buyers. This is where an escalation clause can come into play.
An escalation clause is used by buyers when sellers are receiving multiple offers on their homes. It could give buyers a much-needed advantage in a competitive multiple offer situation and ultimately help win the home they want.
But before buyers jump at the opportunity a clause like this offers, they need to understand how it works. Making an offer on a home is legally binding, so they need to understand the ramifications and possible outcomes before taking this route.
What is an Escalation Clause?
An escalation clause is a clause added to a buyer’s offer. It states if the seller receives a higher offer the buyer’s offer price will automatically increase to beat the highest offer by a stated amount. There will also be a maximum offer amount in the clause to prevent the buyer from going higher than they want to pay.
So, a buyer could add an escalation clause to their offer stating if they are outbid they will increase their offer by $10,000. If the offer was for $350,000, and someone else bids $360,000, the clause would automatically offer $370,000.
The buyer could have a maximum offer amount, or cap price, of $385,000. So if the other buyer comes back with a counteroffer above $375,000, the escalation clause will no longer trigger. But if there isn’t another offer above the automatic bid, the buyer with the clause will win the bidding.
However, just because a buyer has the highest price and “wins” in a multiple offer situation with an escalation clause it doesn’t mean the seller will accept their offer nor are they required to. There are so many terms to an offer besides price. What if the “winning” bid has to sell their home in order to buy? Maybe they have a mortgage pre-approval, but still have a mortgage contingency and the other offers don’t have a mortgage contingency because they are paying cash. There are many other factors that sellers consider besides price, which needs to be kept in mind when submitting an offer.If you are buying or selling a home in a hot real estate market you might hear the term escalation clause mentioned, but what exactly is it?
The Pros of Escalation Clauses
As previously mentioned, using this clause could give the buyer a better chance of getting the home they want against the competition. But it also offers some other benefits:
Reduces the Buyer’s Stress
It allows a buyer to put in their offer, without having to worry as much about whether it is high enough. It also saves some of the back and forth of negotiations, thanks to the automatic bid increases.
Limits the Buyer’s Offer
Since the clause puts in writing how much the buyer is willing to go to, it stops the buyer from paying more. Though it will increase the offer when necessary, when the other bidder stops, the buyer won’t pay anymore.
The Cons of Using Escalation Clauses
There are some negatives that need to be considered before including a clause like this with an offer.
The Appraisal Price
If the buyer’s escalation clause increases the price to exceed comparable sales there can be an issue if the buyer is obtaining a mortgage and the home must appraise. Appraisal shortfalls are something a majority of sellers want addressed upfront, not after accepting an offer. They want reassurance the buyer is going to put their money where their mouth is. Sure a buyer can throw out a ridiculously high offer but it means nothing if the buyer is able to wiggle out of the contract and get their money back if the home doesn’t appraise.
Annoying and Confusing the Seller
When a buyer brings an offer to the seller with this clause attached, it could produce a negative reaction. They could be annoyed that the buyer isn’t submitting their best offer and making the process more complicated.
It will take more work from the seller and their agent to keep up with the offers, particularly if there are a lot of offers on the table. The situation could lead to the seller preferring to only deal with traditional offers, and they could refuse any offers with clauses.
Revealing the Maximum Bid
When a buyer uses this clause, they give the seller details of the maximum they are willing to pay for the home. This puts the seller in a position of power in the negotiations. This could lead to the seller rejecting the offer and telling the buyer to offer their maximum price instead.
The details of the buyer’s top amount could be disclosed to the other buyers, which can increase their prices too.
Creating a Fraud Risk
When a buyer puts the seller in a position where they know how much their top offer is, they could potentially get a friend to make an offer that pushes you to your maximum bid. While this probably happens very rarely, it is a risk that will see you spending more than you needed to on the home.
Price Isn’t Everything
While it is easy to imagine that an escalation clause will make a buyer’s chances of getting the home very strong, not every seller is solely focused on the price. The seller could be more concerned about other factors in the sale, like the terms of their offer; escrow amount, contingencies, and the closing date.
Perhaps they need the sale to move more quickly with fewer problems getting in the way, like a home sale contingency that could hold things up.
If a buyer’s escalation bid only goes up in increments of $1,000, the seller is more likely to put other factors ahead of the extra cash and could choose another buyer. Though if the buyer is willing to go up in higher amounts, it is more likely they may sway the seller’s decision their way.
If you are buying a home in a seller’s market, an escalation clause could be a way to improve your chance of securing the home you want. Though it isn’t without its problems that could backfire on you.
This is where help from your real estate agent can guide you to the best choice for the situation you are in. Your buyer’s agent should understand the market situation, as well as whether this approach is likely to succeed.
When you are buying a home, you need to be clear on how much you are willing to spend, along with how much your lender will loan to you. Whatever happens, knowing your limit and sticking to it can avoid problems and regret later on.
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About the Author
Top Wellington Realtor, Michelle Gibson, wrote: “What is an Escalation Clause in Real Estate? 7 PROs and CONs”
Michelle has been specializing in residential real estate since 2001 throughout Wellington Florida and the surrounding area. Whether you’re looking to buy, sell, or rent she will guide you through the entire real estate transaction. If you’re ready to put Michelle’s knowledge and expertise to work for you call or e-mail her today.
Areas of service include Wellington, Lake Worth, Royal Palm Beach, Boynton Beach, West Palm Beach, Loxahatchee, Greenacres, and more.