What Is an Escalation Clause and Is It a Good Thing for Sellers or Buyers?
Feb 21, 2023
In seller markets, a popular house might have 50+ home showings/tours during the first weekend on the market. If 20% of those buyers decide to make an offer, the seller could potentially get 10 offers on their home.
In the competitive real estate market, it's not uncommon for buyers to face multiple competing offers on a property. When that happens, buyers need to find ways to stand out and make their offer more attractive to the seller. One strategy that has become increasingly popular is the use of an "escalation clause". In this article, we'll explore what an escalation clause is, how it works, and when it might make sense to use one.
How Does An Escalation Clause Work?
The main components of an escalation clause is the "cap" of the buyer's purchase price. The purchase cap is higher than the offer price. The purpose of the cap is to prevent the buyer from paying more than that specific amount when there are multiple offers.
For example, the actual offer amount from a buyer might be $300,000 but the purchase cap could be $325,000. We will explain further in an example below.
Generally, escalation clauses and offers are communicated in the purchase contract within the special stipulations section or in a contract addendum. The escalation clause is activated once sellers have shown they have evidence of a genuine, competing bona fide offer. In this scenario, the listing agent must provide evidence of the competing offer.
Escalation Clause Example
Here's how it works: let us say a buyer makes an offer of $300,000. When a buyer includes an escalation clause in their offer, they will typically specify the amount that their offer will increase over the other competing offers, as well as a cap on the maximum amount they are willing to pay for the property.
For example, a buyer might include an escalation clause that states that their offer will increase by $1,000 over any competing offer, up to a maximum of $325,000. If there is a competing offer of $310,000, the buyer with the escalation clause would automatically increase to $311,000.
However, if another offer is received for $330,000, the buyer's offer would not increase, as the competing offer has exceeded the maximum amount specified in the escalation clause. In this scenario, the competing offer would win the home.
When Should You Use an Escalation Clause?
An escalation clause can be a useful tool in a competitive real estate market, as it allows a buyer to increase their offer without having to continually submit new offers. However, it's important to carefully consider the terms of the escalation clause and whether it makes sense for your specific situation. Here are a few things to keep in mind:
Determine the Number of Competing Offers: Before including an escalation clause in your offer, it's important to understand the current state of the market and the level of competition. Your real estate agent should be able to get a gauge on how many other competing offers exist. Are there only 2-3 competing offers or are there more than 10?
If there are several buyers/offers and your market only has a few similar homes for sale, an escalation clause can help you stand out and win a bidding war. If there's only 1 other competing offer, you might not need an escalation clause.
Consider Your Escalation Cap: When using escalation clauses, it's important to set a cap on the maximum amount you are willing to pay for the property. Make sure that this amount fits within your budget and that you are comfortable paying that much for the property.
If your offer is signed and your maximum cap is enforced, you will go under contract at the maximum price. If this gives you a sense of dread, it might be a good idea to set a lower cap.
Escalation Clause Tips
As a buyer, the goal is to get your offer accepted without overpaying.
An escalation clause can be a powerful tool in the right circumstances, but it is important for buyers to carefully consider the potential risks and downsides before using one.
Tip #1: Don't forget to use an appraisal contingency.
If your escalation cap goes well over asking price, you may be at risk of the home not appraising. This can be de-risked by using an appraisal contingency, which protects the buyer from overpaying.
Tip #2: Make sure to optimize the other contract terms.
We've seen many scenarios where the person with the highest escalation clause actually loses the house. Although rare, this typically happens when they have weak terms, such as a long due diligence period or a low amount of earnest money.
Escalation Clause Contract Language
The Listing Agent May Not Understand Escalation Clauses
Despite being increasingly popular, some sellers still don't often notice escalation clauses. Although rare, even a novice listing agent might view your escalations clause and not fully understand it. For buyers, escalation clauses are a useful tool to make their offer stand out in a competitive market. For sellers, they can be a great way to lock in a higher sale price. However, they're not without risks and if you don't handle a competitive bidding war correctly. Here's an example of how to use an escalation clause in a real estate contract, but check with your agent before using or editing this language:
"All parties agree that the buyer shall pay $1,000 more than the next highest offer, up to a cap of $325,000. If no other competing offer exists, the purchase price shall remain $300,000 (or the same as the initial offer). If escalation clause is activated, the listing broker agrees to share any competing contract with the buyer for review."