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Ask Adam: How Does an Escalation Clause Work?

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.

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