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You put your home on the market and after a few days, you’re already seeing offers come in. It’s exciting stuff! But it’s also confusing. Some offers are straightforward, but others may have a price on the purchase agreement and a different price on the escalation addendum. Why is that?
Sellers get offers with multiple prices because in seller’s markets, when buyers are bidding against one another, some will strengthen their offer by using a strategy called an escalation clause. When multiple offers are on the table and the buyer doesn’t know the details of those competing offers, an escalation clause allows them to express to the seller that they’re willing to raise their bid.
Escalation clauses, which we’ll cover in detail ahead, tend to benefit sellers in competitive markets, but can backfire if you don’t manage them properly. Here, we’ll explain what an escalation clause is, how it works, and how to best navigate them as a seller.
What is an escalation clause?
An escalation clause is a section in a real estate offer, lease, or other contract that guarantees an increase in an agreed-upon price if a specific scenario is met. In real estate terms, it usually means that if a competing offer is higher than a buyer’s submitted offer, they will automatically increase their bid by a certain amount of money above the higher offer.
For instance, if a buyer offers $350,000 to buy a home with an escalation clause of $5,000, it means they’re willing to pay $5,000 more than a higher offer, provided it doesn’t exceed a predetermined limit. So if the highest bid is $375,000 and the escalation clause provides that the buyer will go up to $400,000, the buyer with the escalation clause automatically raises their offer to $380,000.
Buyers add escalation clauses when they assume a property will receive multiple offers and they want to ensure they can make their best offer without a lot of back and forth between real estate agents. But an escalation clause doesn’t always act as a trump card for buyers. There are many details to work out and things for both buyers and sellers to consider.
Three components of an escalation clause
When a buyer puts together an escalation clause, they must consider three things:
1. An escalation amount: This is the incremental dollar amount that a buyer is willing to pay above the highest competing offer. In the previous example, we used $5,000, which brought the final offer to $380,000, $5,000 above the previous highest offer of $375,000. It’s important to note, however, that this amount can repeat. The provided escalation amount says how much a buyer will increase their offer after every superior offer until reaching the escalation cap. So, if another buyer offered $395,000, the escalation clause would push the original buyer’s offer up to their escalation cap of $400,000.
2. A “bona fide” escalation trigger: Escalation clauses generally establish a minimum offer price. A higher competing offer triggers the escalation clause to increase the original offer. But this only happens if there is a “bona fide competing offer.” A bona fide offer is one made in good faith that is legitimate and enforceable. A verbal commitment from someone to offer more money doesn’t trigger the escalation clause.
3. An escalation cap: We touched on this before, but every escalation clause specifies a maximum purchase price. If a buyer fails to specify, theoretically, there’s no limit to how much they could wind up paying for the house. Of course, if they can’t pay, a seller will reject their offer.
Are escalation clauses good for sellers?
On the surface, sellers should love seeing escalation clauses. They don’t have to do anything and an escalation clause may automatically drive up the offer price for their home. But there are still a few things to consider.
First, suppose a seller accepts an offer with an escalation clause. In that case, they can no longer issue multiple counteroffers to other interested parties nor negotiate with the previous highest bidder. They legally must move forward with the escalation clause offer. That means if another buyer who didn’t include an escalation clause was actually willing to go even higher, the seller might miss out on some more money.
If a seller thinks a bigger offer might still be out there, it’s smarter to issue counteroffers to each party rather than accept the bid with the escalation clause. Buyers and sellers can go back and forth forever if they want on counteroffers.
Another option, if a seller sees multiple offers that exceed the list price, is to re-list the home with a new sales price. If you originally listed at $300,000 and saw multiple offers in the $350,000 range, it’s clearly a competitive market. Re-listing for a higher price may lead potential buyers to raise their offers a commensurate amount.
Accepting an offer with an escalation clause binds the seller to that offer. That’s not always the best option, so it’s important to think through the entire situation before accepting an escalation clause.
When would you accept an escalation clause?
There’s risk involved with accepting an escalation clause but that doesn’t mean it can’t be the best option. There are a few signs to look for when analyzing whether or not to accept an escalation clause:
- Significant earnest money: Buyers who put down a larger deposit than other offers and include an escalation clause show that they’re very interested in your home. If most buyers put down $5,000 as earnest money and another puts down $10,000 with an escalation clause, that’s serious commitment. As a seller, you can stipulate that some earnest money is non-refundable, meaning the buyers who still put down more earnest money than competitors are the most serious.
- Cash offers vs. lender financing: Sellers prefer cash offers. There’s no lender involved and no back-and-forth with a bank, so the entire process moves faster. If there are no cash offers, start to look at loan pre-approval. An underwriter has already approved a loan pre-approval, while a pre-qualified buyer hasn’t been through the verification process. Accepting an escalation clause from someone who doesn’t have loan pre-approval carries more risk than accepting one from someone with loan pre-approval.
- Contingency waiving: Another indicator of serious buyers is their willingness to forgo contract contingencies. Common contingency waivers include appraisal, inspection, and financing. If a buyer includes an escalation clause and waives certain contingencies, they’re trying to make the selling process as easy as possible for you. That’s a good thing.
Dealing with multiple offers
Typically, sellers only see escalation clauses in competitive markets. As such, they may have to navigate many offers, including several with escalation clauses. Remember, accepting an escalation clause outright binds you to that offer. When dealing with multiple offers, you can do a few things to simplify the process.
First, rather than accept an offer outright, ask all interested parties to bring their highest and best offers to the table. Any offer with an escalation clause has a price cap, so you’ll know right away who among those offers is willing to spend the most. By asking everyone else to bring their best bids, you can leverage that information against escalation clause offers. This makes negotiation easier for everyone as you can identify the best offers quickly.
That said, when the purchase price rises above asking, you need to make sure that all clauses and revisions are clearly worded. There can be no gray areas in a purchase contract — especially one with an escalation clause — so lean on your real estate agent and attorney for advice. This can help avoid any confusion or legal issues with the buyer down the road.
When you accept an offer at an escalated purchase price, you must provide documentation of the offer that triggered the escalation clause to the buyer. Once this is provided, a buyer and seller should sign an addendum or counteroffer detailing the escalation clause and the final escalated price to make sure everyone is on the same page.
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, you might cost yourself money or, worse, get dragged into court. This guide, along with your real estate agent, should help you successfully handle a competitive sale to get the best deal for you in the most timely manner.