Should I Include an Escalation Clause in My Real Estate Offer?
It can be devastating to lose a home you want to buy to someone who makes a higher offer. Consider including an escalation clause to minimize your chances of losing your dream home. Here’s why.
Q: I’m thinking about making an offer on a property. My real estate agent suggested that I should include an escalation clause. However, I’m confident I can buy this house because there are currently no other offers. Should I follow my agent’s advice or just make my offer? And what is an escalation clause, anyway?
A: As a home buyer, you may be placing too much confidence in your offer. Just because you don’t have any known competition doesn’t mean you will get the property. Even when you feel certain that you are going to win a property, there could be someone who makes a higher last-minute offer. This is why it might be a good idea to include a real estate escalation clause in your purchase agreement, so that you have the opportunity to outbid an offer higher than your initial offer but within the range you’re willing to pay.
Read on to learn more about what an escalation clause in real estate is and why you should consider including one in your offer.
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What is an escalation clause?
An escalation (or escalator) clause automatically starts the negotiation process on your offer to purchase a home should another buyer outbid you. In a standard transaction with no escalation clause, if you bid on a house and someone comes along and puts in a higher offer and the seller accepts the higher offer, you lose the opportunity to buy the house. But an escalation clause provides you with an opportunity to automatically sweeten your offer up to a predetermined figure.
An escalation clause typically contains three main components.
So how does an escalation clause work? Typically, your real estate agent will help you draw up a purchase agreement. They may also solicit the help of a real estate attorney to ensure the escalation clause is properly written. What the escalator offer will essentially say is that you are offering a particular amount for the property. But if another buyer offers the same amount or more than your offer, the escalation clause indicates you are willing to incrementally increase your offer by a set amount until you reach a specified cap. Below is an example of how this could be structured:
Original Offer: $450,000
Escalation Amount: $5,000
Maximum Price: $550,000
According to Freddie Mac, the escalation process goes like this: Once a seller receives a higher bid from another buyer, the seller must present to you solid proof of an offer higher than yours. Using the above amounts, if a competing buyer makes an offer of $460,000 on the property, your escalation clause will automatically beat that offer by countering at $465,000. This will go back and forth until your maximum price of $550,000 is reached.
In most cases, this will end long before reaching your maximum price, with you possibly winning the house. However, in a strong seller’s market, especially in a high-demand area, bids can go several hundred thousand dollars over a home’s asking price.
Escalation clauses can be beneficial in a seller’s market.
Should you consider including an escalation clause in a seller’s market? It would probably be a good idea to do so, considering the housing inventory may be low and the demand is high. Here are some reasons you should consider an escalation clause in a seller’s market.
- It can eliminate the cat-and-mouse game. In a hot seller’s market, the seller may have to go back and forth with numerous potential buyers. The benefit of having an escalation clause in a seller’s market is that it lets the seller know your lowest and your highest offer right away. This could make their decision easier.
- An escalation clause could speed up the process. Although the escalation clause could trigger negotiations and even a bidding war, there are times when it could also put other deals to rest. If your escalation amount happens to be several thousand above what any other buyers are willing to pay, you could win the property right away.
- In a hot seller’s market, an escalation clause may be the only option to remain in consideration. There will likely be plenty of high offers. Therefore, to avoid being outbid by making one offer, it might be a good idea to include an escalation clause. Be prepared to go as high over the asking price as your budget allows.
In most cases, a real estate agent will suggest including an escalation clause only if they are certain there is fierce competition over a given property. However, even when competition seems to be lacking, if the overall market strongly favors sellers, your safest option is to include an escalation clause in your offer. Such market conditions could bring several last-minute buyers that trigger a real estate bidding war, which could knock your offer right off the table. A seller may move on to the buyer with the better offer, especially if a last-minute buyer wants to buy the house with cash.
“It’s always worth putting an escalation clause into your contract if the competitive nature of a property calls for it,” says Stephen Michalakos, a real estate agent at Engel & Völkers in St. Petersburg, Florida. Michalakos adds that as the market changes with rising interest rates, it’s likely fewer homes will sell for hundreds of thousands over asking price, “but the escalation clause will still function as a tool even if only to beat one other competing offer.”
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There are drawbacks to escalation clauses.
Although escalations can be beneficial, especially in a seller’s market, there can be some disadvantages to including them in your offer. Here are a few.
- It may not look like an attractive offer to the seller. If a seller has multiple offers on the table and one with an escalation clause, they may prefer traditional offers in which buyers only present their best offers.
- Negotiations could delay the sale timeline. You aren’t the only one who is on a deadline to move. The seller may need to leave the property as quickly as possible for personal reasons. Adding an escalation clause could cause delays in the selling process and interfere with their timeline.
- You may not get the property after all. No matter how much money you are willing to put on a property, keep in mind that money isn’t the only factor that a seller may consider. An escalation clause doesn’t necessarily guarantee that you will get the house. For instance, if a lower bidder can close on the home sooner than you can, the seller may take that bid instead.
In some cases, an escalation clause may not be necessary and may even work against buyers. According to Megan Micco, Broker Associate at MeganMicco.com in Berkeley, California, “An experienced local real estate agent will have a strong understanding of pricing trends in their local market. They should be able to forecast the final selling price within a narrow range and advise their client accordingly,” she says. “Therefore, there should be no need to include an escalation clause.”
Micco further cautions that putting an escalation clause in a residential purchase agreement can be a red flag for a listing agent, explaining, “This is a sign that the buyer either is hoping to get a deal by underbidding the likely sale price, or that they are being represented by an inexperienced agent who is not advising their client on what it takes to win an offer in a competitive market.”
Consider adding an appraisal contingency.
An appraisal contingency allows you to break the home-purchase contract if an appraisal reveals that the value of the home is substantially less than the agreed-upon sales price.
Appraisals are fairly typical in real estate transactions and are often required by the buyer’s mortgage company, which wants to ensure the property is worth the amount it’s financing. If an appraisal comes back out of line with the purchase price, the bank may refuse to finance the full purchase price. This means the buyer will have to come up with additional cash to cover the difference between sale price and what the bank is willing to finance.
However, appraisal contingencies are another “red flag” that sellers may wish to avoid, especially if the contingency comes on top of an escalation clause, which sellers might also find to be an onerous complication.
“In a strong seller’s market, it is very difficult to prevail as a buyer with any type of contingency,” warns Micco.
However you present your offer, it’s important to carefully consider all the potential pitfalls. Per Michalakos, “If you’re purchasing a home via financing, including an appraisal contingency with your escalation clause will take a little bit of financial creativity from a good mortgage pro, and a great real estate advisor.
If you are paying cash for your new home, though, the game changes. “Many offers are all cash and don’t require any loan or appraisal at all,” says Micco. If you choose to forgo the appraisal, then an appraisal contingency is, of course, moot.
In the end, if you do choose to include a real estate escalation clause in your offer—with or without an appraisal contingency—Michalakos offers this advice: “Your escalation maximum should be regarded as your best, highest, and final offer. You should recognize that your escalation maximum may end up being beaten by other offers.”