Should You Use an Escalation Clause?
These sharp bids on purchase offers can backfire
Real estate agents really love including an escalation clause in a purchase offer. Buyer's agents in particular seem to be enthusiastic about the practice. But agents aren't to blame for the peaking interest in these clauses. It's often the homebuyers themselves who suggest that an escalation clause, also called a sharp bid, might be a good idea.
What Is an Escalation Clause?
An escalation clause is typically used in situations that could potentially result in multiple offers. It's intended to try to squeeze all competition out of a competitive bidding process. An escalation clause states that a buyer will pay X dollars ranging from $100 to hundreds of thousands above and beyond the highest offer received by the seller. It generally includes a ceiling cap.
An Example of an Escalation Clause
A typical escalation clause might read as follows:
Buyer agrees to pay $1,000 more than the highest offer received by the seller, not to exceed a sales price of $315,000.
A buyer might want to use this clause in a purchase offer if it appears that other potential buyers might make offers above the listed price. The property might be listed at $295,000. It has all the bells and whistles a buyer could possibly desire and it's located in a high-demand neighborhood on a quiet cul-de-sac.
Sometimes a listing agent will advise buyers that all offers will be presented on a certain day at a certain time. That might be your first clue that the seller expects to receive more than one offer on this plum property.
In a hot seller's market and with a gorgeous home listed at $295,000, a seller might receive offers of $290,000—because there's always somebody who believes that nobody else will bid—$295,000, $305,000, and $310,000. If the fourth buyer submits an offer with an escalation clause for an extra $1,000, he would be agreeing to pay the seller $311,000. Remember, his cap was $315,000.
The buyer is happy because the price is $4,000 under the maximum price he was actually willing to pay and the seller is happy because she gets the highest offer. It all seems well and good, but is it?
Drawbacks to an Escalation Clause
An escalation clause isn't always the best option for the seller. Accepting an offer with an escalation clause means she can no longer issue multiple counteroffers to the other parties, nor can she continue to negotiate. The buyer has taken money off the table. The buyer was actually willing to go even higher, so the seller lost that $4,000.
A seller who accepts a contract with an escalation clause will never know exactly how much higher the buyer might actually have bid.
It could be in the seller's best interest to issue a counteroffer instead. A seller can make a different counteroffer to each buyer in some states, or sometimes to just one or two buyers. The seller generally has more options available in a multiple-counteroffer situation. Each counteroffer might ideally be weighed and analyzed separately.
As an example, let's say that the seller decides that market demand is so strong for her home that she might elect not to take any of the purchase offers or to counter any of them. In this situation, the seller could change the sales price of the home to $315,000 and start the bidding process all over again.
Of course, the drawback to this scenario is that there might not be any immediate takers and the property might linger for more days on the market. That's always a risk when the seller raises her list price. It might still be a viable solution, however, and worth considering instead of accepting an escalation clause contract.
Why Buyers Gravitate Toward Escalation Clauses
Not every homebuyer enjoys the suspense and tension that come with negotiations to buy a home. Buyers are often worried about competing and some even refuse to submit an offer in multiple-offer situations. Introducing an escalation clause can increase the buyer's chance of offer acceptance and it sets particular parameters that define the buyer's comfort zone.
Whether an escalation clause is "legal" in every state depends on interpretation, but that doesn't stop agents from suggesting it or buyers from wanting to do it. For all practical purposes, however, it might be much easier for the buyer to simply make a highest and best offer and be done with it.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.