In real estate, an escalation clause is a tool buyers use to outbid competitors on a coveted home. An example will make the concept clearer.
Say you find the home of your dreams at a crowded open house. You know the next day’s offer deadline will likely have multiple bidders. Your agent tells you a generous-but-fair offer would be $200,000. You don’t want to miss out, but you also don’t want to overpay. You could spend up to $215,000 if you had to, though.
Here’s where the escalation clause comes in. You submit an offer of $200,000, but you stipulate that if anyone beats your offer, you’ll raise your offer so that it’s $1,000 more than the highest offer, with a cap of $215,000. That way, if someone bids $210,000, you’ve already promised the seller that you’d go up to $211,000. You’re auto-escalating your bid to exceed competitors and (hopefully) get the home.
As you might guess, the technique is primarily used in real estate markets that are highly competitive. For example, I work in Omaha where we’ve have a very tight market this spring, due to an inventory shortage. We’re seeing bidding wars and, for the first time, escalation clauses. They’ve been a very useful tool, and it’s helped several of my clients win homes.
Should you use an escalation clause? It depends on your situation, your market and the seller. If you think it fits, talk with your real estate agent. Here are some things to consider:
How Competitive Is It, Really? You should only use an escalation clause if you’re told specifically that you’re going against multiple offers. While it’s easy to feel like someone might swoop in and outbid you, make sure that’s actually a possibility. Otherwise, you’ll put yourself in an awkward situation.
Are Escalation Clauses Common in Your Market? In some markets, they’re not done – or, they’re out of favor. Make sure you won’t be committing a faux pas by submitting an escalation clause. Also, some sellers flat-out won’t accept them.
How Much More Should You Pay than Your Competitors? In some markets, an escalation of only $500 or $1,000 will do the trick. In other markets, where you’re bidding on a home that will sell for over $600,000, for example, you may need to beat competing offers by $3,000 or even $5,000. Talk with your agent about what’s appropriate.
Are You Really Willing to Go That High? Make doubly sure you’re willing to go to the absolute tippy-top of your escalation. The very fact that you’re submitting with an escalation clause says you’ll likely have to raise your price over your initial offer.
How Will the Seller and Seller’s Agent View It? One of the primary objections to using an escalation clause is that the seller can see how much you can actually pay. And they might ask why they’d accept anything lower. Or, they might feel you’re low-balling them if you’re willing to escalate quite a bit over your initial offer.
How Will it Affect Your Loan? A technical detail to think through, remember that if you do escalate, you’ll need to put more down to stay at 20% (or whatever threshold you’ve decided on), or your loan terms will change. Also, check that you don’t escalate outside your pre-approval zone.
What About the Appraisal? If you need a loan to buy the home, what you’re willing to pay might not match the price at which the bank appraises the property. Anticipate this issue by having an appraisal contingency as part of your offer.
Make Sure You Ask for Proof. If you do win the home based on your escalation, make sure you ask for proof of the competing offer. You don’t want to be escalating against thin air.
Also, remember that just because you use an escalation clause, there’s no guarantee your bid will be chosen – and it’s not the only tool at your disposal. After all, price isn’t the only term in the contract. Closing date, earnest money and contingencies are also important. When appropriate, everything from offering all-cash, waiving certain contingencies, writing a cover letter, or offering a rent-back can be used to make your offer stand out.
An escalation clause is just one tool to use, but it’s one that buyers in competitive markets should know about.