Today’s greatest investors are well aware of the escalation clause real estate deals have the potential to exercise; it’s perhaps one of the most advantageous contract clauses known to real estate entrepreneurs, but did you even know it existed? Are you aware that a few key phrases can make a contract more attractive to homeowners looking to sell their property?
If you answered yes, I commend you, as you are ahead of the game. If, however, you are racking your brain for a simple explanation, you are not alone. Through no fault of their own, far too many new investors are unaware of what an escalation clause is, let alone what it can do for them. At the very least, a properly executed escalation clause may serve as a tool to strengthen an offer. At its pinnacle, an escalation clause can be the single most important factor in separating your offer from the rest of the competition. Let me explain.
What Is An Escalation Clause?
A real estate escalation clause is a condition contained within a contract that allows respective parties to escalate their existing offers. Otherwise known as an escalator clause, these clauses are commonly found in the underwriting of offers, indicating that the buyer is willing and able to increase their original offer if subsequent higher offers are submitted. In other words, escalation clauses offer prospective buyers a safety net if another party outbids them.
More often than not, escalation clauses will convey two critical messages: that the offer is serious and just how far they are willing to go. That’s an important distinction to make, as these clauses typically include a cap—exactly how high the potential buyer is willing to go. Perhaps even more specifically, a good escalation clause will indicate how much they are willing to beat subsequent offers by—up to a point, of course.
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How Does An Escalation Clause Work?
Real estate escalation clauses can vary significantly; however, they generally provide the same basic components. Here are the primary questions an escalation clause will answer:
What is the original purchase price?
How much will that price be escalated above other competitive bids?
What is the maximum purchase price in case of multiple offers?
Escalation clauses are relatively simple to understand; they essentially allow prospective buyers to offer slightly more than any additional offer submitted after their initial offering. Bram Jansen from vpnAlert suggests that “In real estate, an escalation clause is essentially a price increase clause that is included in an official real estate offer. It informs the seller that you will automatically outbid any other offers they receive, specifying how you will do so. This gives you a greater degree of control over obtaining the property you desire. Otherwise, sellers will frequently reject your offer in favor of a more attractive one”.
If, for example, an investor submits an offer of $400,000, they could supplement their offer with a clause that specifically states they are willing to beat any additional offers by a specified amount, up to the maximum amount they are willing to spend. Therefore, if a $405,000 offer is submitted after their initial offer, an escalation clause will make it possible to beat the competing offer by a predetermined amount. As a result, the investor needs to clarify how much they are willing to beat subsequent offers by, and up to a maximum price point. That way, the clause will incrementally beat out any subsequent offers up to a designated price point.
Escalation Clause Example
Now that we have learned the concept of an escalation clause, let’s put it into practice with an example that highlights this useful real estate contract addition:
Let’s say, for example, Molly finds the perfect home for her next investment deal and proceeds to offer the owner $100,000. However, in addition to the initial offer, Molly has her Realtor include a clause that states she is willing to pay more in the event a higher competing offer is submitted in the interim. Her clause will identify that she is willing to pay more and the increments she is willing to beat out other buyers by—up to a maximum offer, of course. In other words, Molly could include a clause that specifically increases her offer by $2,000 more than the latest competing offer. More importantly, she will cap her clause at $110,000. That means if another offer is submitted after Molly’s initial offer, let’s say at $105,000, the clause will automatically bump up Molly’s offer to $107,000 and will continue to do so until the cap is hit. Of course, if no other offers are submitted, Molly will get the house for her initial offer, provided the owner accepts it.
Real Estate Escalation Clause Language
Few things are more important to the real estate escalation clause than the language used to enact it. As with just about any other contract, how you word your escalation clause can make all the difference, so you will want to be as specific and deliberate as you can. Sometimes a single word can convolute your entire statement, so be sure to get the right point across.
To be clear, this is what the average escalation statement will look like:
The buyer in a respective deal offers to pay $____ for the property, but in the event the seller receives a bona fide offer that exceeds the initial offer, the buyer is willing and able to increase the price to $____ above the amount of the other offer, up to $____.
It is worth noting that some words carry more weight than others. The emphasis of a bona fide offer, for example, stresses the importance of initiating the escalation clause only in response to a legitimate and enforceable offer. Otherwise, illegitimate offers may cause the owner to increase your offer without a reason to do so. Not surprisingly, it’s of the utmost importance that you carefully calculate your clause’s language.
Escalation Clause FAQs
It can be tricky to know when you should or shouldn’t use an escalation clause when closing on a property. The questions below will provide more information on how to utilize this tool in your next deal.
When Should I Use An Escalation Clause?
Escalation clauses are commonly used when a lot of interest has been expressed in a particular property; in other words, when multiple offers are expected to be submitted on the same home. In a scenario where you can imagine a property receiving multiple inquiries, it may be in your best interest to submit an offer complimented by an escalation clause. That way, your offer won’t automatically be ignored if—and when—it’s beaten out.
According to financial express at Marketplace Fairness, “An escalation clause is a term in a real estate offer that allows the buyer to increase their offer price in the event that a competing offer is made”. At the very least, an escalation clause is best exercised when an investor wants their offer to remain relevant. That said, it only makes sense to submit an escalation clause with an offer when you are confident in the property and its ability to make up for any additional spending the clause may lead to.
When Should I Not Use An Escalation Clause?
There are a few situations where you should not use an escalation clause. The clearest example is if multiple offers seem unlikely. Sellers should only utilize an escalation clause if they are confident they will receive multiple offers on the home. Otherwise, the seller loses their negotiation power if only one offer is submitted. Although it is uncertain, the seller may accept the first offer made on the property if no other offers are submitted.
Not all sellers will accept escalation clauses. Remember that these clauses allow buyers to bid against each other, so their first bid will not likely reflect what they are actually willing to pay for the property. When a seller rejects an escalation clause, they pressure buyers to place their most competitive and highest offer. Speak with your agent about whether or not the seller is accepting escalation clauses, and avoid using one if not.
Finally, do not use an escalation clause if the conditions will exceed your overall purchasing power. It’s easy to get caught up in negotiations, specifically if there are multiple offers being considered for a property you really want. However, an escalation clause should never be used if it jeopardizes your financial situation.
Can You Pull Out Of An Escalation Clause?
You can pull out of an escalation clause if other conditions included in the offer were not accepted — but only if the contract clearly states these contingencies and they are agreed upon. For example, if the seller accepts your offer and then fails to repair the roof as specified in the contract, you may have leeway to pull out of the deal.
You cannot, however, pull out of an escalation clause simply because you changed your mind. The sellers have likely turned down other offers in favor of yours, and once signed, the contract becomes an official legal document. You will be hard-pressed to find a way out, but you can try meeting with a real estate attorney.
The best way to avoid second thoughts is to clearly review the details of the contract and clause before submitting an offer. Only use an escalation clause when you are certain about the property and feel it is necessary to secure the deal. This will help you avoid wanting to back out from the clause.
How Does It Affect the Offer Review Process?
Escalation clauses are most likely to impact the offer review process in competitive markets. Essentially, when sellers receive numerous offers they are going to select one with the best price and lowest action required to close on the property. In these situations, buyers and agents typically have some form of warning. For example, if there will be a second round of offers buyers will be notified to submit their best, and final price. When contingencies are attached, it could make the final offer somewhat less competitive.
Keep in mind that contingencies are used for a reason. If you are going to forego them when making an offer, you need to be sure you are still getting a good deal on the property. Your agent can help guide you through adding contingencies while maintaining a competitive edge, even in fast-moving markets.
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Pros Of Using An Escalation Clause
Using an escalation clause has many apparent advantages, not the least of which combat the possibility of becoming an afterthought. If for nothing else, the single most important reason investors include an escalation clause in their initial offer is to remain relevant. In suggesting you are willing and able to increase your offer when necessary, it’s a lot less likely to be relegated to the trash bin. However, of particular importance is the ability of an escalation clause to keep an interested buyer in the running. An escalation clause is nothing less than a rebuttal to the most recent offer, and it could be the one decision that lands you the property of your dreams.
Outside of the obvious, the inclusion of an escalation clause in real estate deals may result in the following additional benefits:
Escalation clause real estate contracts provide peace of mind for buyers who want the subject property.
Done correctly, including this clause in real estate deals may prevent the buyer from overpaying. Provided the verbiage is up to the task, the clause should escalate the offer just enough to land the deal without going too far over.
This clause works heavily in favor of sellers, as they are almost always guaranteed a higher offer under the right circumstances.
Prospective buyers won’t be left out of negotiations or overlooked in the event they provide an escalation clause.
Sellers may look at offers with an escalation clause more seriously, giving the edge to anyone willing to include one.
Cons Of Using An Escalation Clause
While I can wholeheartedly argue that including an escalation clause in your next offer has inherent benefits, it’s not without its flaws. Namely, an escalation clause requires interested buyers to lay all their cards out on the table; as an investor, that’s not a good thing by any stretch of the imagination. You see, by including an escalation clause in your offer, or more importantly, a cap, you are identifying the maximum amount you are willing to spend. And while a seller may appreciate your honesty, it all but destroys your chance of negotiating a better deal. What’s more, a poorly calculated escalation clause can eat into your bottom line. Sure, it could help you land a deal, but at what price? If you aren’t careful, this clause could have you spending a lot more on a property than you should have.
In addition to disclosing the amount investors are willing to pay, there are a few other downsides to including an escalation clause in real estate deals:
Their inclusion downplays one of an investor’s greatest advantages: negotiations. By including a clause that discloses the amount someone is willing to pay, there’s less room to negotiate profit margins.
While the real estate industry has come a long way, there are still many people that don’t know what an escalation clause is. If a listing agent doesn’t understand what this clause is, for example, the inclusion of it may cause some confusion and delays.
Select sellers may be put off by the inclusion of escalation clauses. While they are most likely welcoming of the idea of investors paying more, they are usually made with the original intent to undercut impending offers.
There are times when the inclusion of an escalation clause can cause issues with bank appraisals.
While rare, some sellers don’t want to deal with the inclusion of an escalation clause.
How Appraisals Can Affect An Escalation Clause
When writing an escalation clause it’s important to remember that lenders will appraise a home and only offer you the amount that the home appraises for. If you write an escalation clause without referencing the appraisal you will be responsible for the difference if the appraisal comes in lower than your final offer amount. For example, if your escalation clause brings your total offer to $450,000, but the house appraises at $400,000, you will be responsible for covering the $50,000 difference without help from the lender. To avoid this issue, you can write an appraisal contingency into your escalation clause, which means that your final purchase price will align with the appraised value of the property.
Real estate escalation clauses are designed to keep offers competitive. It will not guarantee a property, but it can certainly give you an edge against other buyers. Not all transactions will demand the use of an escalation clause — however, this is still an excellent tool to have in your back pocket. You never know when you will find the perfect investment property and how an escalation clause could offer you the chance to secure it.
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