What Is an Escalation Clause in Real Estate and Should You Include One?

If you plan to buy or sell a house anytime soon, you’ll appreciate having some familiarity with escalation clauses in real estate. An escalation clause allows you to automatically increase your offer, ensuring that you remain ahead of competing bids without having to constantly revise your offer price.

As a buyer, you may have your heart set on that dream home, only to face the disappointment of being outbid. Conversely, sellers hoping to attract the highest offers can use escalation clauses to increase their selling price. In this high-stakes game, an effective strategy can make all the difference. Enter the escalation clause — a tool that both homebuyers and sellers can use to gain a competitive edge.

Step one: Talk to an expert!

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In 2023, as many as 28% of homes on the market are selling above the asking price, suggesting that bidding wars are far from extinct. This is where the value of the escalation clause becomes evident.

However, escalation clauses are not always a magic bullet to buying a home, and sellers shouldn’t blindly choose an offer with the highest escalation cap either.

Let’s take a closer look at the ins and outs of the escalation clause and how you can use it to your advantage, regardless of which side of the deal you’re on.

What is an escalation clause, anyway?

The escalation clause is a part of a house-buying offer that says “I’ll pay more if someone else offers more.” It’s like saying you’ll pay $300,000 for a house, but if someone else offers more, you’ll pay an extra $5,000, up to a limit of $325,000.

“An escalation clause is an effective strategy when a buyer is competing in a multiple offer situation,” explains Oriana Shea, a top real estate agent in Long Beach, California. “If the buyer’s agent is not able to find out where the highest offers are and your buyer doesn’t want to overpay, this can be a good option.”

Each escalation clause can look different, with some having caps, and others asking for proof of higher offers. A recent survey from HomeLight found that bidding wars are happening on 45% of houses as of Q2 2023. This is why understanding how an escalation clause works can be so important.

How are escalation clauses used in today’s market?

Escalation clauses were especially popular from mid-2020 to mid-2022 when low interest rates and the pandemic’s emphasis on home drove housing demand through the roof.

Since then, they’ve become less prevalent but are still fairly common. Even though, as of this writing, mortgage interest rates are at 6.4% for the average 30-year fixed rate mortgage, home prices are proving resilient against the market slowdown.

“When the interest rates were so low, we were seeing escalation clauses on just about every transaction,” says Joanne McCoy, a top real estate agent in Lincoln, Nebraska. “Now, I would say, it’s probably 50% escalation clauses, and a lot of that is driven by the price point. For our market, if you get above $500,000 it’s not as crazy, but if you’re definitely under $400,000 you’re still seeing quite a few escalation clauses.”

Escalation clauses essentially cut to the chase in a bidding war and help speed up the sales process. But they are not without risk. According to the National Association of Realtors their use has waned a bit recently as some agents believe they give too much information away in the negotiation. Using an escalation clause doesn’t always mean you’ll get the house, but some think it can help.

With all these changes in the market, it’s really helpful to have an expert by your side. They can explain what’s going on in the housing market and how tools like escalation clauses can help you get the house you want.

Is an escalation clause right for you?

Now that we’ve gone through what an escalation clause is, its current trends, and its benefits, you might be wondering if it’s the right tool for your situation. We put together a short quiz together that can help you decide.

Remember, there’s no perfect answer, as every housing situation is unique. But this guide can give you an idea of whether an escalation clause might be a good fit for you.

Is the house you’re interested in located in a hot market (an area where there are more buyers than available homes)?

A) Yes
B) No

Are you comfortable potentially paying more than your initial offer for a house?

A) Yes, I’m prepared to go above my initial offer to secure the house.
B) No, I prefer to stick to my initial budget.

Are you prepared to cover an appraisal gap, if it happens? This is when the house appraises for a lower amount than your agreed-upon offer.

A) Yes, I have sufficient funds set aside.
B) No, I haven’t considered that possibility yet.

Do you have a flexible budget that allows you to increase your offer if a bidding war arises?

A) Yes, I have wiggle room in my budget.
B) No, I have a fixed budget.

Results

If you answered ‘A’ to most of the questions, an escalation clause might be right for you. This suggests you’re operating in a competitive market and are willing and able to adjust your offer if needed.

If you answered ‘B’ to most of the questions, it might be better to stick to a conventional approach. This could mean that your budget is more fixed, or that you’re looking in a market that isn’t as competitive.

Remember, these are general guidelines. A real estate agent can help navigate these considerations and tailor a plan that suits your specific circumstances. They understand the housing market and can guide you on whether an escalation clause is right for your situation.

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Benefits and risks of escalation clauses

In real estate, there are few strategies that are all benefit or all risk, and escalation clauses are no exception. Below is a comprehensive list of the advantages and disadvantages that come with using an escalation clause in your real estate contract.

Benefits of escalation clauses

• Competitive edge: An escalation clause can give your offer a competitive edge in a seller’s market by showing your willingness to outbid other potential buyers.
• Transparency: It provides transparency by specifying your maximum offer upfront, eliminating the guesswork for the seller.
• Speed: Escalation clauses can help speed up negotiations by setting out clear conditions for price increases based on competing offers.
• Control: They allow you to control how much you’re willing to increase your bid while still potentially securing the property.

Risks of escalation clauses

• Overpaying: There’s a risk you might end up paying more for a property than it’s actually worth, especially if you get caught up in a bidding war.
• Appraisal gap: You may face an appraisal gap if the final sale price is higher than the appraised value, potentially leading to financing difficulties.
• Seller manipulation: Although rare, there’s a risk that a seller could manipulate the process to get a higher price.
• Rejection: Some sellers or their agents might not accept offers with escalation clauses, preferring straightforward bids.

How should sellers handle escalation clauses?

“Escalation clauses are great but they’re not the end all,” explains McCoy.

She goes on to share that an escalation clause can create enticing offers for sellers, but a key aspect to consider is the buyer’s financing. When there are multiple offers, all featuring escalation clauses, one of the first things to examine is the financing type. Government-backed financing may not be as favorable as conventional financing with a larger down payment. Also, an all-cash offer is usually a top contender and might be prioritized.

To help you remember these points, refer to the table below:

“The advice that I would give a seller is to request proof of funds to close with the offer to make sure that the buyer has the assets needed to make the purchase as well as have your agent contact that buyer’s lender to make sure that they qualify for the higher price,” says Shea.

Understanding these benefits and risks is crucial for making an informed decision. Having a seasoned and HomeLight-recommended real estate agent can help navigate these intricacies and provide expert advice tailored to your specific needs and the prevailing market conditions.

Negotiating with escalation clauses

When you’re buying a house, you’re not just looking for a place to call home. You’re stepping into a negotiation ring where each decision can make a significant difference. That’s where the escalation clause can really shine.

An escalation clause is not just about stating a higher price. It’s about expressing your commitment, seriousness, and determination to secure the property. In a negotiation, these are powerful signals to send to the sellers.

Here are a few ways that an escalation clause can serve as a negotiating tool:

1. Shows you mean business: An escalation clause immediately communicates to the seller that you’re serious about purchasing their property. You’re ready to step up your game if needed, and that can be a game-changer in a competitive market.
2. Creates a competitive advantage: If there are multiple offers on the table, an escalation clause might set your bid apart. It shows that you’re not just willing to match other offers, but surpass them – a move that could put you in the lead.
3. Speeds up the decision-making process: Instead of going back-and-forth with counteroffers, an escalation clause simplifies things. It lays out the terms upfront, which can help the seller reach a decision more quickly.

However, just like any other negotiating tool, it’s important to use escalation clauses wisely:

Know your limits: While it’s crucial to show the seller you’re serious, you should still set a cap within your budget. Remember, the goal is not to win at any cost, but to secure a property at a price you’re comfortable with.

Work with an expert: A real estate agent can provide valuable advice on when and how to use an escalation clause effectively. They can also help you understand the potential implications and create a plan that aligns with your goals.

Consider the market: The effectiveness of an escalation clause can depend heavily on the market conditions. In a seller’s market, where competition among buyers is high, an escalation clause can be a beneficial tool. On the other hand, in a buyer’s market, a traditional offer might be more appropriate.

Understanding the role of escalation clauses in negotiations can help you navigate the real estate market more effectively. It’s not just about the highest price; it’s about demonstrating your commitment and making strategic decisions. If you want more advice on how to win your negotiations, you should read our latest post on the subject: How To Negotiate When Selling a House in 2023.

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The power and pitfalls of escalation clauses

To give a practical perspective, let’s explore some real-life case studies and hear from experts about their experiences with escalation clauses in the real estate market.

Case Study 1: Winning the bid

“We are seeing homes sell with multiple offers again,” Shea shares, emphasizing the heightened competition in the market. “We just had one of our buyers get their offer accepted because we put in an escalation clause. Our buyer was also contingent, and we still beat out the other offers.”

This particular case exemplifies the strategic advantage of an escalation clause. Despite being contingent on certain conditions, the buyer’s offer prevailed thanks to the inclusion of an escalation clause. It enabled the buyer to outbid competing offers without constantly revising their offer price, giving them an edge in negotiations.

Case Study 2: The appraisal gap challenge

In some cases, buyers become overly enthusiastic and submit bids that may not be supported by appraisals.

“There have been a few instances where it’s like — really, this is ridiculous how far you’re going over the list price,” McCoy says. ”That’s all fine and good, but there’s no way that house will appraise for that.”

While escalation clauses may initially seem promising, they can lead to disappointment if the appraised value falls short of the escalated offer. “Lately, it seems like appraisals are getting kind of tough,” adds McCoy.

That makes it difficult to justify the inflated prices proposed through escalation clauses. Therefore, while escalation clauses can generate excitement, they may not always result in a successful purchase at the top price.

“If you’re going to accept that escalation, then I’d try to get proof that the buyer has enough cash to make up the appraisal gap difference before you put a ‘sold’ sign out front and go down and take it off the active listings,” McCoy advises.

Case Study 3: Changing your mind

“I think some buyers are nervous about not knowing what that higher offer could be,” says Shea, acknowledging the anxiety that buyers may feel when considering escalation clauses. “The misconception is that they will have to pay what they suggested in the escalation clause. This is not the case. They have to send you a counter, and the buyer would have to sign the counter agreeing.”

Buyers often fear that by including an escalation clause, they commit to paying the escalated price mentioned in the clause. However, Shea clarifies that this is not how escalation clauses work. Instead, if competing offers trigger the escalation clause, the seller is required to provide a counteroffer stating the new price. The buyer then has the choice to accept or decline the counteroffer based on their comfort level and affordability.

Shea further emphasizes, “The reality is that if they come back with something that is beyond your comfort level or affordability, you just decline it.” Buyers should understand that they maintain control over the final decision-making process. If the counteroffer exceeds their budget or comfort zone, they have the right to change their mind.

Case Study 4: Well, that backfired

The use of escalation clauses requires careful consideration to avoid potential pitfalls.

“On a few occasions, it’s backfired on buyers,” says McCoy, highlighting the importance of understanding the dynamics of counteroffers in conjunction with escalation clauses.

McCoy explains the scenario, stating, “Let’s say they submit an escalation clause noting that they’ll go $10,000 over the list price. If the sellers haven’t received any other offers making up that big amount of difference, they might just counter back to that buyer and say, ‘Well, you’ve already told me you’d be willing to pay that over the list price. So, let’s just counter back at that price.'”

McCoy’s experience sheds light on a potential challenge that buyers can face when using escalation clauses. If the sellers receive no competing offers that meet or exceed the escalated price mentioned in the clause, they may opt to counter the buyer’s offer at the escalated price itself. This situation arises from the premise that the buyer has already indicated their willingness to pay that higher price.

How to craft an effective escalation clause, step by step

Knowing how to write an escalation clause can help you stand out in a competitive market.

Here’s a step-by-step guide:

Step 1: Start with the basics

Your escalation clause should clearly state your starting offer and your willingness to exceed that amount if there are higher bids.

Step 2: Define your escalation increment

This is the amount by which you’re willing to outbid other offers. It should be a reasonable figure that reflects the market value and your budget.

Step 3: Set your cap

This is the maximum amount you’re willing to offer for the property. This cap should be within your budget and the potential appraisal value.

Step 4: Request proof

In order to prevent potential foul play, your clause should request proof of any higher offer that would trigger your escalation clause.

Step 5: Review and revise

Once you’ve drafted your escalation clause, review it with your real estate agent or attorney. They can help spot any potential issues and provide legal advice.

Sample escalation clause to get you started

[Your Name]

[Your Current Address]

[City, State, Zip Code]

[Email Address]

[Phone Number]

[Today’s Date]

Property Address:

[Address of the Property You’re Making an Offer On]

[City, State, Zip Code]

Offer Price:

[Your Initial Offer Price]

Escalation Clause:

This offer includes an escalation clause. The undersigned buyer(s), [Your Name], hereby agree to increase the offer price by [Escalation Increment] over any bona fide offer that is higher than the original offer price, up to a maximum offer price of [Maximum Offer Price].

The seller must provide a copy of the competing offer that triggered the use of this escalation clause.

Cap Price:

[Maximum Offer Price]

This offer, along with the escalation clause, is valid until [Expiration Date and Time]. If the seller does not respond by this time, the offer shall be considered void.

This offer is contingent upon a home inspection satisfactory to the buyer, as well as financing and appraisal of the property for at least the purchase price.

Buyer Signature: ________ Date: ________

Remember…

Please note that this is just a template, and real estate laws and practices can vary by region. Always consult with a real estate professional when drafting and submitting an escalation clause. This sample escalation clause is for educational purposes only and does not constitute legal advice.

Creating an escalation clause is not a guarantee of success. Your offer is one piece of your overall strategy, and a top real estate agent can help you create a comprehensive approach to meet your buying goals.

Finding success in competitive markets

In today’s competitive real estate market, the escalation clause is a powerful tool that can help you secure the home of your dreams. But like any tool, it requires the right knowledge and skills to use effectively.

Understand the risks and benefits, assess your personal situation, and carefully craft your clause to greatly enhance your chances of success. But remember, an escalation clause isn’t a standalone strategy — it should be one element of a broader home-buying plan.

While this article serves as a comprehensive guide, there’s no substitute for personalized advice from a real estate professional. Real estate markets can vary greatly by location and time, and a professional can provide the most accurate and up-to-date information. Experts can also guide you through the process, helping you to navigate tricky situations, understand complex legal language, and make sound decisions that align with your goals and circumstances.

This is where HomeLight comes into play. By connecting you with top-performing real estate agents in your area, HomeLight ensures that you have the expertise and support you need, exactly when you need it. Whether you’re considering using an escalation clause, need advice on bidding strategies, or just want help finding the perfect home, HomeLight agents are there to guide you every step of the way.

Disclaimer: Information in this blog post is meant to be used for educational purposes only and is not to be taken as legal advice. HomeLight always encourages you to reach out to your own advisor.

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