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In today's real estate market, with inventory at a premium in many areas of the country, buyers are finding that they need to do whatever they can to help themselves stand out from the crowd. One strategy they're using to make their offers more attractive is including an escalation clause in their purchase agreements.
If you're wondering "What is an escalation clause?" you're in luck. Below is an explanation of what this clause is, how it works, and why some buyers include it in their real estate contracts. In addition, you'll find a summation of the advantages and disadvantages to using this clause, as well as some tips on how to make it as effective as possible.
What is an escalation clause in a real estate contract?
An escalation clause is sometimes included in real estate purchase agreements, particularly in situations where there is a lot of interest in the property. As the name suggests, it's a clause that allows buyers the opportunity to escalate, or increase, their offer on the home in order to beat out the competition.
Sometimes also known as an escalator clause, this stipulation gets triggered when the seller receives a higher offer than the one the buyers in question originally submitted. It states that the buyers are willing and able to outbid the higher offer, at least up to a certain point.
If the higher offer is less than the maximum amount listed in the escalation clause, the buyers in question could win the home at the escalated purchase price.
Why would you use an escalation clause when you bid on a home?
Put simply, every time you make an offer on a home, you're taking a gamble. If your offer piques the sellers' interest, they might be willing to negotiate with you. However, if the sellers feel that your offer is too low, or otherwise unrealistic, they might choose to simply not respond at all. In other words, there's no guarantee that you'll get to negotiate with the sellers, especially when you're in a situation where you're competing against multiple offers.
In that respect, using an escalation clause gives you a little bit of a safety net. It provides some extra reassurance that your offer will be considered by the sellers because it shows them that you're serious about buying the home -- so serious, in fact, that you're willing to outbid the competition for the chance to be the winning buyer.
With that in mind, escalation clauses are best reserved for situations where you know there is a lot of interest in the property and where you have your heart set on your offer being selected. In truth, there is a bit more uncertainty involved in submitting an offer with an escalation clause because, when you send in the offer, you don't know how much you'll ultimately be expected to pay. You have to truly want to own the home, even if that means having to pay the maximum amount outlined in the clause.
How does an escalation clause work?
Typically, there are three distinct parts to any escalation clause that's included in a real estate contract. Read them over to ensure that your real estate agent has included them all in your purchase agreement:
- Proof of a bona fide offer: You can rest easy knowing that sellers can't just use an escalation clause as an excuse to make you pay a higher sale price. When the contract asks for "proof of a bona fide offer," it means that the listing agent must be able to prove that another offer came in with a purchase price higher than your original suggestion. Typically, the listing agent will send over a copy of the page from the other buyer's purchase agreement that shows the higher price. However, any identifying information for the other buyer will be redacted.
- An escalation amount: The escalation clause should also include an amount by which you'd like to outbid any higher offers. For example, if the highest offer that the sellers receive is worth $300,000 and your escalation amount is $5,000, the escalation clause would automatically increase your offer to a total of $305,000.
- A price cap: The price cap represents the maximum amount you're willing to pay for the property, or how high you're willing to allow your offer to go. If an offer is submitted that is higher than this amount, be aware that your offer may be taken out of the running.
In essence, an escalation clause works by taking the middleman out of price negotiations. In most real estate transactions, if the sellers are presented with two similarly competitive offers, the listing agent will call both parties and ask them to submit their highest and best offer. Then, once both buyers have given their responses, the sellers can decide how to move forward.
By using an escalation clause, you've more or less eliminated the need for all of that back-and-forth. In this case, your position is spelled out on paper, including how high you're willing to allow your offer to go. Here, you're more likely to simply hear whether or not your offer has been accepted than to be asked if you're willing to negotiate on the purchase price.
Using an escalation clause: Three concrete examples
If you're still having some trouble wrapping your head around how an escalation clause works, it may be helpful to look at a few examples. Below are three different scenarios for how using an escalation clause could play out.
In each scenario, let's say that there are multiple offers on the table and that you've submitted the following offer, which includes an escalation clause:
- Property list price: $250,000.
- Initial amount offered: $250,000.
- Escalation amount: $2,000.
- Price cap: $260,000.
Scenario #1: You submit the highest offer
In this case, even though you submitted an offer with an escalation clause, there's no need for it to go into effect. Provided that the sellers are mainly focused on netting the highest possible dollar amount for their asset, you would win the bidding war and only have to pay the amount that you initially offered, which is $250,000.
Scenario #2: Another offer is slightly higher
Now, suppose another offer came in that was worth $255,000. Normally, since the sellers are focused on getting a high sale price, your offer of $250,000 would simply be passed over. However, here, your escalation clause would go into effect. The clause would automatically increase your offer to a purchase price of $257,000 and you would be able to buy the home.
Again, though, in order for you to be legally bound to pay the full amount of $257,000, the listing agent would have to provide proof that the sellers actually did receive an offer worth $255,000.
Scenario #3: Another offer is much higher
Finally, let's say an offer came in that was much higher than yours at $265,000. In this case, even though the escalation clause is present, it would not be enough to help you win the home. Since you set a price cap of $260,000, your offer will only increase to that amount, meaning that the other offer is still worth $5,000 more than yours.
What are the pros of an escalation clause in a real estate contract?
In truth, there are quite a few reasons why you might consider using an escalation clause in a real estate contract. When utilized correctly, this clause can be an effective tool to help you stand out from the crowd and, ultimately, help you land the home of your dreams.
To that end, we've laid out a few of its biggest advantages below. Take a closer look to can gain a better sense of how including this clause in your real estate contract might work to your benefit.
It helps to keep you relevant
Typically, when sellers have multiple offers on hand, they go through them one by one. However, as they do so, they have a tendency to quickly focus in on their priorities, which allows them to narrow down the field until they've zeroed in on the top one or two offers that best meet their needs. When using this method, it soon becomes easy to pass over an offer that doesn't catch their eye.
It almost goes without saying that an escalation clause will serve as that eye-catching detail. If your initial purchase price is not high enough on its own, the escalation clause will help keep your offer in consideration.
It shows that you really want the home
Selling a home can be an emotional process as well as a monetary one. Typically, sellers have created memories in their home over the years, and when they go to sell, it can be hard to separate from them. As a result, when it comes time to decide who will live in the home next, many sellers find that they want their property to go to someone who will cherish their home in the same way that they have.
Including an escalation clause in your offer indicates to the sellers that you're truly invested in buying the property. It shows that you're willing to go above and beyond what's required in order to become the home's new owner. For sellers who have that emotional connection to their home, taking that extra step to show that your heart's invested in the property may be enough to put your offer on top.
It cuts down on the negotiating
Some buyers love the idea of negotiating; others don't. If you fall into the latter group, including an escalation clause in your offer might be a smart idea. Since it gives the seller a solid idea of your positioning upfront, it cuts down on the back-and-forth that needs to happen between you and the sellers.
What are the cons of an escalation clause in a real estate contract?
That said, like anything in life, this clause isn't perfect. It does have its disadvantages, which you will need to carefully weigh before deciding whether to include one in your offer. Below are a few potential pitfalls to keep in mind.
It only considers sale price
While this clause can be an effective way for you to ensure that you're the one offering the sellers the most money, be aware that the purchase price is only one facet of an offer. Not only that, but in some situations, money may not be the sellers' top priority.
For example, some sellers may have school-age children and may prioritize a settlement date that allows them to move before the start of the new school year. Other sellers may not feel that they are up to the task of doing repairs to the property and may look for an offer that has waived inspections.
It "tips your hand" to the sellers
Another downside of this clause is that it essentially forces you to lay all your cards on the table. By providing a price cap for your escalation clause, you're essentially telling the sellers how much you are willing to pay for the home, and there's nothing to stop them from simply presenting you with a counteroffer at that price.
If you use this strategy, be aware that, in exchange for a better chance at being the winning offer, you're giving up some of your bargaining room.
Should you include an escalation clause in your offer?
Now that you know more about escalation clauses, the next step is to decide whether to include one in your offer. Ultimately, only you know which decision is right for you. If you're still unsure, ask yourself the following questions to help you zero in on whether including this clause in your contract makes sense:
- Are you sure there are multiple offers on the table?
- How badly do you want the home? Badly enough that you're willing to pay more for it?
- If you knew you lost out on the home because your purchase price was too low, would you be upset?
If you answered "yes" to all three questions, odds are good that you're ready to use an escalation clause to better your chances of submitting the winning offer. If not, think twice before you include it in your contract.
Tips for writing an effective escalation clause
All that said, if you do decide you would like to move forward with including an escalation clause in your offer, here are a few things you can do to make sure it is as effective as possible:
Make your escalation amount count
Truthfully, in an escalation clause, the escalation amount is what lets the sellers know how badly you want the home because it shows how far you're willing to go to edge out the competition. With that in mind, make it count. Be sure to choose an escalation amount that is large enough to make the sellers feel as though they will really benefit from choosing to go with your offer.
Do the math on your maximum
The last thing you want is to be unhappy that you got the house because you feel you paid too much. Before you choose a price cap for your escalation clause, take the time to do the math. Ask your agent to work up figures on what your monthly payment and closing costs will be at that sale price, and make sure you feel comfortable paying that amount.
If you find it's too much for you, it's OK to make adjustments to your price cap accordingly.
Have your agent mention that you're also willing to negotiate other aspects
Lastly, though it won't be included in the written contract, be sure to have your agent mention that you're willing and able to negotiate on other areas of the contract in addition to the sale price. This will help cover your bases in the event that the sale price is of secondary importance to the sellers, and it will put you in a better light because it will show that you're willing to accommodate the sellers' needs.
The bottom line
Ultimately, the decision of whether to include an escalation clause in an offer is a personal one. When writing up an offer, you need to feel comfortable with all the terms outlined in the contract, and an escalation clause is no exception. By learning more about how this clause works as well as learning about some of the advantages and disadvantages associated with it, you can be better prepared to decide whether using one is the right choice for you.
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