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Ask Adam: How Does an Escalation Clause Work?

by ARLnow.com — November 1, 2012 at 1:45 pm 11,719 26 Comments

This periodic sponsored Q&A column is written by Adam Gallegos of Arlington-based real estate firm Arbour Realty. Please submit follow-up questions in the comments section or via email.

Question: Can you please explain how an escalation clause works?

When there are multiple offers on a property and you are considering making an offer above the list price, it may be a good idea to use an escalation clause. The challenge when competing for a home is that you (usually) are not privy to what the other offers are. An escalation clause allows you to bid competitively with the other offers, without paying more than you need to.

Let’s use the example of a $500,000 listing.

  • Mike offers $505,000
  • Susie offers $490,000
  • Bill offers $500,000 with an escalation to $507,000 in increments of $1000
  • You offer $500,000 with an escalation to $510,000 in increments of $1000

Your offer will escalate to $1,000 above the next highest offer. In this example, your offer escalates to $508,000, which is $1000 above Bill’s max of $507,000. It works a lot like bidding on eBay.

Let’s try another example where you don’t use an escalation clause. Again the list price is $500,000.

  • Mike offers $505,000
  • Susie offers $490,000
  • Bill offers $500,000 with an escalation to $507,000 in increments of $1000
  • You offer $510,000

You are committing to paying $510,000 for the home regardless of what the other offers are. You could have possibly saved $2,000 by using the strategy in the first example.

How do you know what the other offers are? Usually they are not revealed until after the seller has made a decision. The sellers will complete the escalation addendum with the details of the next highest offer including the offered purchase price and total concessions. When representing a buyer, I will normally ask for the pages of the other contract that provide proof of the offer price and concessions.

Please keep in mind that there are many factors in addition to price that are considered by a home seller, especially a home seller with several buyers to choose from. Be sure your offer escalates in increments large enough to make your offer more competitive than the others. This is especially important if other areas of your contract are somewhat weak.

Within the escalation clause addendum there is an option to waive the appraisal valuation. If selected and the lender’s appraisal is less than the sales price, the purchaser agrees to proceed to settlement without regard to the amount of the lender’s appraisal. Note that this is not an option for VA or FHA purchasers. If it is something you are considering, please do not do so lightly.

Another example… Let’s say you escalate to $510,000 and the home only appraises for $480,000. If your lender is requiring a 20% down-payment, they are only going to be willing to lend 80% of the appraised value. In this example, 80% of $480,000. At closing you will need to come up with 20% of $480,000 and an extra $30,000 to cover the difference between the sales price and the appraisal price.

On the flip side, if you keep the appraisal contingency in place, you may have leverage to negotiate a lower purchase price if the appraisal comes in low. You would also protect yourself with a the ability to discontinue the purchase if the appraisal is low.

Additional Tips:

  • Don’t get caught up in the game of winning. Decide on a price that you would feel comfortable with and don’t go above that amount.
  • I only briefly touched on the appraisal contingency. Be sure to discuss this with your Realtor and/or attorney to fully understand how it works.
  • Discuss your offer with your lender prior to presenting it to the sellers. You want to make sure that he or she is comfortable with the terms you are offering.

The views and opinions expressed in the column are those of the author and do not necessarily reflect the views of ARLnow.com.

  • novasteve

    Need my eyes checked, I thought this was about Metro getting escalators to work.

    • sam the cat

      Not gonna happen….ever

    • HayyDiosMio

      they do work, it’s in “stair mode”.

  • John Fontain

    As I said in response to a previous column (see link below), buyers should rarely use or even consider using escalation clauses. And realtors who encourage their use are often times providing poor counsel. The above article is the theory of how they are supposed to work. The below is how they really work in many cases…

    http://www.arlnow.com/2012/09/18/ask-adam-winning-the-home-in-a-competitive-situation/#comment-232108

    • arlhomeowner

      That was not my experience. I bought my Arlington home in March 2009. I was 1 of 4 offers and I used the escalation clause. I didn’t have the highest offer, but I still got the house. If I hadn’t done that I never would have gotten the house, as it sold for roughly 10% more than asking. My realtor recommended using it, and he was right. Basically, get a realtor that you can trust.

    • GreaterClarendon

      We used an escalation clause in 2007 to buy our single family home in the Clarendon area, and ended up paying less than the two other full price offers on the house – true story. Really pretty simple really, we had heard at the open house that the house already had one full price offer, so we knew we had to go in at full price – but since we felt the house was undervalued – we did an escalation up to $50K more than the asking price, in $10K increments. We used Redfin as our Realtor and designed our own offer, which at the time was rebating 2/3 of their commission back to us (it’s less generous now). The price only escalated to $10K more than the asking, and we got rebated ~$12,000 – a win / win and beat the traditional Realtors at their own game. So yes, there are scenarios where an escalation clause makes sense.

    • Shut up John

      John you prove time and time again on this list that you have no idea what you are talking about. You just don’t understand, so don’t comment.

      • John Fontain

        Thank you for your valuable insights and feedback.

  • arlmimprov

    You forgot ‘the cap’. I’ve never made an escalation cause without a ‘cap’. There is a certain price where I feel the house is no longer worth the price. NEVER go beyond what you think a house is worth. Always write a cap for the escalation in your clause.

  • Hank

    So what would prevent a shifty sellers agent from asking a friend or family member to submit a phony bid that would max out the highest escalation cause (and give them a cut of the commission course)? Besides the fact that it would be fraud if you could somehow catch them and prove it.

    • John Fontain

      In short, nothing. Heck, the sellers themselves could have a friend write an offer for $509,000 knowing full well that your escalation limit of $510,000 would be triggered and there would be zero chance that their friend would actually have to buy the house. That’s $10,000 extra for the seller to split with their friend that you (the buyer) didn’t need to and shouldn’t have paid.

      • arlhomeowner

        The Sellers agent doesn’t know if or what the buyer’s cap is. Why would you tell them how much $ you are willing to spend? Dose not make sense…? Just offer that much up front.

        • John Fontain

          I don’t understand what you are trying to say.

          • arlhomeowner

            Having someone submit a phony bid that would max out the highest escalation cause, how does the seller’s agent know the highest amount?

          • Hank

            Huh? The sellers agent is working with the sellers to compare offers and decide which one to accept.

          • John Fontain

            Because the seller’s agent received the offer from the legitimate buyer which included a Sales Price Escalation Addendum which read as follows:

            “If, prior to Seller’s Ratification of the Contract, the Seller receives one or more additional written bona fide offers to purchase the Property with terms acceptable to Seller (”Other Offer(s)”), and from which Seller would receive an equal or higher Net than the Net reflected in this offer,
            then this Contract’s Sales Price shall automatically increase by $___________ above any Other Offer’s net to Seller, not to exceed a maximum Sales Price of $__________. If other offers include escalation terms, this automatic increase can be used multiple times.”

            So the seller knows the maximum price you are willing to pay.

        • arlmimprov

          We got our house for well below our cap…escalated 5k above list and beat out 5 other offers. The price never came close to our cap- but it is the reason we got the house.

          I inherently distrust escalation clauses–but both my homes were bought in neighborhoods where there are always numerous offers and inventory is tight–turnaround 24-48 hours so it has been a necessary evil.

      • Shut up John

        It is called ethics John, just because you have none does not mean that other people don’t have them either. Oh, that and that fact that when you have a buyer on the line you are not going to risk fraud for an extra $1000 that may sour the deal. Please keep your UN-observant comments to yourself.

        • Seriously Curious

          Maybe John is a little extreme….but it makes me really wonder about these bidding wars. Forgive me, I’m just curious, but could you ask for a contract contingent on falling within a certain range of the actual appraisal amount? Or do sellers usually not want to deal with such a contingency? I guess it depends on how “hot” the property is? Thanks all.

          • John Fontain

            You can and should include the appraisal and financing contingencies in your offer. The seller may select someone else who doesn’t have those contingencies in their offer, which would often come from a buyer with a large cash down payment or an all cash offer.

            If the seller received a high cash/all cash offer from someone else, your offer likely wouldn’t have been selected anyway (all other terms being equal), so including these contingencies doesn’t harm you and does protect you in the event no high cash/all cash offers exist.

        • kung_fubar

          Is this Mrs. Fontain?

        • John Fontain

          “It is called ethics John, just because you have none”

          Yep, me pointing out the pitfalls of escalation clauses and how they are often abused to the detriment of buyers = me not having ethics. How unethical of me to warn prospective buyers of the dangers involved!

          “Oh, that and that fact that when you have a buyer on the line you are not going to risk fraud for an extra $1000 that may sour the deal.”

          There is no risk that the deal may be soured because the seller already knows the buyer is willing to pay more. They’ve already put this in writing. Now all the seller needs to do is to get a friend to put in an offer $1 less than the legitimate buyer’s maximum price and you’ve scored extra cash with no risk of souring the deal. The legitimate buyer can’t back out because the escalation is not a counter offer, it’s an automatic adjustment of their original offer. If the legitimate buyer backs out because the escalated price rises, they lose their earnest money deposit. As to the idea of doing this solely to gain an extra $1,000, you sound naive to common practice. Escalation clauses are rarely limited to just $1,000 more than the original offer price. Often times, they are tens of thousands more. During the bubble, I witnessed a transaction in which an escalation clause resulted in the buyer paying $208,000 more than asking price.

          • arlmimprov

            $208k above list is ludicrous. Somebody got caught in the hype and overpaid. We bought our first home at the very height of the market and saw some crazy stuff. We never got caught up in the hype. We walked when we thought things were overvalued and we took a loan we could afford on conventional terms.

          • Shut up John

            John, You just don’t understand. You continue to prove it. At this point in the market the escalation clauses are not tens of thousands of dollar. And I think you just made up the $208,000 escalation number. If you have nothing to add, which you rarely do. Just don’t comment.

          • Quoth the Raven

            What’s with the anger? All John is doing is suggesting that in his opinion, folks shouldn’t use these clauses. Shouldn’t buyers be careful about using these clauses? Isn’t that good advice?

  • Alex

    I think there is always a risk of unscrupulous sellers/agents in an escalation clause situation as John says. But a couple of things to keep in mind. The only time an escalation clause might be useful is in a seller’s market. If it’s a buyers market, just don’t use one. It doesn’t make any sense, and this is the situation where you are most prone to being scammed by a buyer or agent who just doesn’t understand the market doesn’t support the price they emotionally feel the property is worth. If it is a seller’s market it means there are other people competing out there for that property. Here, as long as you put in a cap price that is close to or only slightly over the intrinsic worth of the property, at best, the escalation clause may work as intended. At worst, the seller may pull the scam as described by John, but you haven’t dearly overpaid for the property. Being “scammed” of that extra little margin can be thought of as the “insurance” cost (insuring that you get to purchase a desired piece of property) of buying something in a seller’s market.

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