Written by: Andrew Goodman
Q: What is an escalation clause and what is the purpose of it?
A: An escalation clause is a document that allows you to increase your offer in the event that another offer is submitted on the interested property. This clause comes in handy during bidding wars because it allows buyers to automatically increase their offer by and escalation factor up to an escalation cap amount.
An escalation factor is the amount of money a buyer is willing to increase their offer above the next highest net bid. In the event that the seller receives one or more offers to purchase a property, the escalation clause will automatically increase the proposed offer by the escalation factor, not to exceed the escalation cap. The escalation factor is based on the net proceeds to the seller, not just the sales price. Now, most buyers would assume that making the escalation factor $100 could work. However, I always recommend making the escalation factor at least $2500. When deciding on the escalation factor, you should ask yourself this question “how much money would it take the seller to choose my offer over a competing offer if the competing offer was “the perfect offer,” an all cash offer with no contingencies?” In other words, what amount of money would it take the seller to take on the risk of a contract with contingencies or one that needed to obtain a loan versus an all cash offer with no contingencies? Some sellers only care about the money, however if advised appropriately, the seller should see the potential risk involved. I am not saying that all loans are risky, nor saying that there could be issues accepting a contract with contingencies, but it is just a fact that an all cash offer is superior to an offer with a loan, assuming all other factors were the same. Now if you are submitting an all cash offer, your escalation factor is not as important since there is no risk to the seller, so your focus should be on what to make your escalation cap.
The escalation cap is the highest offer you are willing to increase your offer to before your escalation stops. So your escalation clause will be valid for any value under your cap, however once your cap is reached, your escalation clause is no longer valid. Choosing the right cap should be based on recent sales, trends, and market conditions. I always ask the question, “If another offer came in $1,000 higher than your cap, would you be upset losing the property?” If your answer is yes, then you should reconsider your cap. The cap should be the very top number that you are comfortable paying for the property and if someone were to pay $1,000 more, you would not be upset and instead comfortable walking away from the property.
Use this example:
Offer price: $500,000
Escalation Factor: $2500
Escalation Cap: $550,000
Offer Price: $510,000
Escalation Factor: $1,000
Escalation Cap: $560,000
Home Inspection Contingency
When analyzing these two offers you notice that the offer prices are different. The offer prices are starting points for their escalation. Since there are two offers, Offer #1 is automatically increased by it’s escalation clause because Offer #2 already starts off higher. Offer #1’s escalation cap is $550,00 so that offer capped out since Offer #2 doesn’t stop until $560,000. Offer #2’s offer is now $551,000 because the escalation factor of $1,000 is to be added to the next highest bid, which in this case is $550,000. Offer #2’s cap was never reached. However, if I were the agent representing the seller, I would advise him/her to accept Offer #1, even though it is a lower offer, the small $1,000 escalation factor only makes it a $1,000 difference between the two offers and I do not believe $1,000 is worth the risk of all of the potential issues that could arise with Option #2’s contingencies.
Once a bidding war has ended, the winning party is to receive proof indicating why their offer was escalated. Again, an escalation clause is not based on the highest sales price, but rather the highest net value. So make sure you receive not only the first page of the competing offer, but also the seller subsidy page identifying what the competing offer’s net was.
The escalation clause also allows you to automatically adjust your financing for the property as the price of the home is escalated. This is important because not everyone can pay the amount the contract has been escalated in cash, so you want to make sure that your loan is automatically increased as you wish as the price increases.
Please note that not all sellers/listing agents accept escalation clauses. In some cases, listing agents will advise their sellers not to entertain escalation clauses due to the risk that the appraisal could hinder or limit the escalation. If the home does not appraise and there is an appraisal issue, the escalation could be pointless if the buyer does not have the funds to make up the difference. Therefore requiring the seller to reduce the price from the escalation anyway.