What is an Escalation Clause in Real Estate?

You’ve discovered your dream home, and you’ve decided to make an offer. Your real estate agent already has a real estate contract in the works. But does this mean you’re guaranteed to secure property? Unfortunately, that answer is not necessarily. So what happens next?

When dealing with a buyer’s market, house-hunters usually get a rapid response from sellers, and the negotiations are short-lived. However, if you’re attempting a purchase in a seller’s market, yours may be one of the multiple offers submitted for the same home. Strong competition can be overwhelming for many buyers with their hearts set on the perfect home.

By working with competent brokerage firms such as Ardor Homes Massachusetts, you can easily navigate a seller’s market by accessing solutions that will get you ahead of the competition, such as an escalation clause. If the term is unfamiliar to you, you aren’t alone. In simplest terms, an escalation clause will tell the seller that you are willing to increase your bid in a bidding war provided certain criteria are met.

In this article, we’re going to discuss escalation clauses, how they work, and why it’s best to enlist the help of professionals to get the most out of them and secure your ideal home!

A Competitive Real Estate Market Explained

Have you heard the term competitive real estate market? The term indicates that you currently face a seller’s real estate market. What does a seller’s market mean for you as a buyer? In the simplest terms, it means that the demand for real estate is greater than the supply of available homes.

When the market is saturated with buyers, the potential exists for multiple buyers to become interested in the same home. This disproportionality between buyers and houses can lead to a bidding war between buyers. So, how do you navigate a seller’s market and still find a house you want to call home?

Overcoming Multiple Offers in Real Estate

Your offer price needs to be better than any other buyer’s offer in a competitive market. You could offer the total asking price, but that doesn’t guarantee other buyers won’t push you into a bidding war. If you’re serious about purchasing your dream home, you will have to beat the competing offer… but how can you guarantee you are the highest bidder without going beyond what you are willing to pay?

When you learn there are other buyers interested in the house of your dreams, your real estate agent may suggest some tips for you to try to sway the seller’s agent into presenting your offer more favorably. One of those suggestions may be to incorporate an escalation clause into your initial offer. Before making a decision regarding escalation clauses, your agent might suggest you consult a real estate attorney to make sure you understand escalation clauses thoroughly before making your offer.

What Is a Real Estate Escalation Clause?

An escalation clause provides you with an opportunity to potentially win a bidding war with other buyers when the seller’s agent receives multiple offers for a piece of real estate. Real estate escalation clauses are written into the original contract and indicate the maximum amount you are willing to offer to guarantee your offer becomes the final sale price. Real estate agents dealing with hot real estate markets will sometimes suggest including an escalation clause in your contract.

Using an escalation clause can secure your dream home for you should other potential buyers outbid you. Escalation clauses come into play when the seller receives a higher bona fide offer than your original offer.

How Does an Escalation Clause Work?

An escalation clause gives prospective buyers a safety net when they are exhausted with house hunting or want to win a bidding war against another home buyer. Before incorporating an escalation clause into the purchase contract, buyers should know the maximum purchase price they are willing to pay for the property.

Their maximum amount will be added to the escalation clause as the cap price.

Basic Components of Escalation Clauses

The essential components of an escalation clause are:

• The original purchase price–the amount you offered the home seller before other interested buyers made an offer.
• How much more money above a competing bid that the home buyers feel comfortable paying to reach their cap price. (This is also called the escalation price.)
• The ceiling price is the absolute maximum amount a buyer is willing to pay for a property.

Original Purchase Price

The original price is the amount you offered before another prospective buyer made an offer. This is your base offer. If another buyer places a bid, your escalation price comes into play. The escalation clause will only kick in when the seller has a bona fide offer, and you can request that they provide proof of the offer.

Escalation Price

The escalation price is the amount above another offer you are willing to bid for the home. For example, you initially offered $300,000 for the house with an escalation clause that provided for a $10,000 escalation in price. The seller has received other offers, with the highest one outbidding you by $5,000. The escalation clause makes your price $315,000 (your original offer plus the additional amount offered by someone else plus your escalation price).

Ceiling Price

This is your absolute maximum bid. It’s calculated by adding your initial offer plus the difference between your price and the offer that outbid you. Then add your escalation price, and you’ve hit the ceiling. Two factors should help you determine your absolute top dollar: your real estate professional’s approximated valuation of the home and your pre-approval amount.

Pros and Cons of Escalation Clauses

As with any other decision, weighing the pros and causes of adding an escalation clause to real estate is a good idea. Consider whether the market is a buyer’s or a seller’s market before you even consider an escalation clause.

Pros:

Escalation clause pros include the following:

• Confident buying. Including an escalation clause in your offer gives you a sort of safety net if someone else outbids you. Your bid will automatically increase when a competing offer is submitted if you have included an escalation clause in your initial bid.
• Appealing to sellers. When a seller receives an offer with an escalation clause included, it’s possible they will take you more seriously. An escalation clause in real estate shows that you are willing to adjust your price to be competitive. Competing offers that only include a purchase offer may not be as appealing as yours with a willingness to pay more.
• Less likely to pay too much for the home. Because escalation clauses put a cap on the amount you’re willing to pay, you won’t get into an all-out bidding war that drives the price beyond your comfort zone.
• Competitive edge. An escalation clause could give you a competitive edge over other offers. Some sellers accept escalation clauses rather than entertain multiple bids. 

Cons:

The cons of an escalation clause include, but may not be limited to:

• Negotiation power is removed. When you make your initial bid, your top-dollar offer is presented to the seller. The seller could decide to reject your initial offer and insist on you paying up to your cap. You might get a better deal on the property without including your escalated price in your contract.
• Potential loss of opportunity for the seller. Once a seller accepts an offer using an escalation clause, they lose the ability to counter any other bids. On the one hand, this can be an advantage to the buyer whose offer they accept, but they are losing the opportunity to entertain other offers that might have gone higher than your highest offer.
• Appraisal contingencies. Many real estate contracts are written with an appraisal contingency. Lending services use the appraisal to determine how much money to lend on a mortgage. Including an escalation clause could be detrimental to the appraisal contingency. The lender might not be willing to loan enough on the home to meet your purchase offer if the house doesn’t appraise high enough.
• If the parties involved don’t fully understand escalation clauses, it could cause confusion during the process. The listing agent is tasked with explaining an escalation clause to a seller, so it’s especially important that they understand these clauses.
• Potential offer refusal. Some sellers won’t accept offers with escalation clauses attached to them.

When Should You Use an Escalation Clause?

Typically, an escalation clause is used when a lucrative competing offer is expected to be submitted on the same property. The purpose of an escalation clause is to help keep your submission from being ignored in a sea of other offers. In a buyer-saturated market, it’s not unusual to use an escalation clause, but it should be done with caution. Be careful only to use an escalation clause on your dream home.

When Should You Avoid an Escalation Clause?

An escalation clause is for those times when you are confident there will be multiple offers on a property. If there’s not likely to be more than one offer, avoid using an escalation clause. Your agent should be able to learn if the seller is accepting offers with these clauses. Some sellers refuse to accept bids with an escalation clause attached.

What Happens if There Are Multiple Escalation Clauses

An inexperienced listing agent might panic in the event of multiple escalation clauses, but they are becoming more commonplace. More buyers are including escalation clauses with their purchase offers because hot real estate markets have them competing for prime real estate.

Which offer will a seller accept? Typically, sellers let the best (based on overall merit) offer stand. Depending on seller motivation, they may or may not be the ones with the highest escalation value.

Can You Pull Out of an Escalation Clause?

Homebuyers can’t pull out of an escalation clause just because they change their minds. However, if there are contingencies in the contract that the seller didn’t meet, you can pull out of an offer with an escalation clause. It’s best to ensure that the escalation clause states any and all contingencies clearly.

It’s wise as a buyer to place an appraisal contingency on any offer, but especially on an offer with an escalation clause. If you use an escalation clause, you could have an issue securing funding or be responsible for the difference between the money the lending services provided and the amount in your escalation clause if you don’t have a contingency based on appraisal in place.

Should I Consult a Real Estate Attorney?

A real estate attorney may be beneficial if you don’t understand portions of the process or the legalities of the contractual agreement you have entered into by submitting an offer on the house. If you’re wondering whether you should include an escalation clause, you might consider consulting a real estate attorney.

Tips for Successful Home Buying in a Competitive Market

Even in the most competitive home buying market, there are a few valuable things you can do to make your experience a positive one.

1. Get pre-approved. Securing a mortgage will be much simpler if you have taken the time to seek pre-approval. Keep in mind that pre-approval and pre-qualification are not the same things. Pre-qualification means you could be approved at a later time, while pre-approval means you have a mortgage waiting for you as long as your financial situation remains the same.
2. Be prepared with earnest money. Earnest money indicates to the seller that you are serious about your offer and that you have the funds to back the offer through the process. Earnest money will be deposited into an account for escrow and then either returned to you or applied to the balance of your mortgage.
3. Choose your must-have list and stick to it. When the housing market is competitive, and even when it isn’t, you are unlikely to find everything on your wishlist unless you contract with a builder for a custom-built home. Listing your priorities will help you to focus on your housing search.
4. Step out of your comfort zone. You could consider looking at houses in a different area. You may not find your perfect home in your dream area, but you might find your ideal home a few streets away in a new neighborhood.
5. Look past the superficial. Focussing on changeable things like rugs and paint colors can inhibit you from seeing the actual structure of the house.
6. Remember that money isn’t everything. Some sellers are interested in knowing the people behind the money. If the market is saturated with buyers but no home in sight, it might be time to think outside the proverbial house-sized box and get creative with your approach.

Buyers shouldn’t settle for a house due to fear. It can be frustrating to search for a home in a seller’s market, but if you are patient, you can find the home you’ve always dreamt of owning. Prioritize the essential things on your wishlist and focus on those to have a more successful home search.

Takeaway

The escalation clause in real estate is a tool that can be beneficial in a buyer-saturated market. Placing an escalation clause in your contract can let the seller know you are committed to purchasing the home. Be cautious about choosing to include an escalation clause.

A real estate escalation clause is beneficial if you feel certain that there will be multiple competing offers for the same house. However, there is likely no need for an escalation clause in a buyer’s market where there is more supply than demand.

All parties involved in the transaction need to understand the escalation clause if one is used. If there is confusion about how an escalation clause works or if there is a necessity for a clause like this, a real estate attorney should be consulted for clarification.

In a seller’s market, buyers should act quickly but not rashly. A bidding war for a house can send the price higher than the home is worth, causing the buyer to lose money in the long run. A buyer’s offer should clearly state any contingencies to protect their interests.

If you’re confused about escalation clauses or whether it’s appropriate to use one in your situation, contact Ardor Homes Massachusetts. They specialize in buying and selling homes, and they stand ready to assist you in securing your perfect home.

Steph Wilkinson

In her 25-year career, Steph Wilkinson has been involved in the acquisition, marketing and sales of over $3 Billion dollars of residential real estate. A number of years ago, Steph transitioned into Brokerage Leadership for National real estate brands and tech start-ups. She has served as a Business Strategist for real estate agents and brokerages alike and is also a real estate coach and trainer. In her new role with the Iconic Team, Steph will be responsible for the growth of the team and will be working with all of our agents to increase their productivity and bottom line.