In most years, there are super hot spots where getting a property is a challenge. This year however, those hot spots have basically been everywhere - coast to coast. While eventually much of this will moderate through price increases, in the short-term it makes sense to discuss escalation clauses: What are they, How do they Work, and Should I Use an Escalation Clause in a home purchase contract.
What Are Escalation Clauses
Many of my clients have heard the term Escalation Clauses, but they aren't sure how they work. The easiest way to explain them is in the context of what a traditional offer might look like. In a standard or traditional offer, the contract simply says the buyer offers to pay the seller a fixed number - let's say 400,000 for instance. That is pretty simple and clear to understand. An escalation clause, however, assumes that there are going to be multiple offers, and then the purchase price is written as: Buyer offers to pay the seller (X) over the highest offer. On a home of $400,000, X would typically be a number between 2 and 5K. (It's not usually $1! It's not the 'Price is Right' people.) This means, in practice, that as a buyer you don't really know what you are offering on the house. Ultimately, what you are saying is no matter what someone else offers, I'm willing to pay more. Even so, this won't guarantee that you'll get the house. I've had listings that have received multiple escalation clauses - and only one person can get it. (Usually the offers have different escalation bump amounts or have other factors that allow a seller to choose the best offer).
On the surface, escalation clauses sound like an aggressive buyer strategy to put them in a great position to buy a home. In practice, however, there are often issues with these strategies.
How Escalation Clauses Do and Don't Work
Most buyers assume that when there are multiple offers, most of the offers look "like theirs". If a listing does get 4-10 offers, many of them do tend to look similar. But there are always offers that have major differences, and those differences are often crucially important and can affect how "reasonable" your escalation clause looks in hindsight. OK, that was really vague, lets see if I can make it more concrete. Some buyers are competing in a market with a lower LTV (Loan to Value) which means as a percentage they are borrowing more. This is very common in the starter market, where we see a large number of buyers with 3.5 or 5% down. Very often, these buyers will lose repeatedly in a super hot market to buyers with a more significant down payment (as they should), and quickly they develop a new strategy to win the listing - overpay. In this market, I have seen buyers with low LTV offer 15% higher than the listing price in an attempt to win the bidding war. Some sellers and seller agents will look favorably on these offers, but these offers always come with mortgage contingencies, and the plan here (on the buyer's end) is to let the bank's appraisal play referee and come in and knock the price down. It's a high stakes game of poker for these buyers, hoping that a month into the transaction the seller will be willing to reduce the price significantly in order to keep the deal together, otherwise the seller will blow up the whole transaction and start with someone else.
Another way offers can differ is with by reducing the number of contingencies. Typically, there are three main ones, the home inspection, the appraisal, and the mortgage contingency. Offers that look similar in price can often be separated by certain buyers that have waived some - or all - of these contingencies.
The bottom line is, when you have a pile of offers, they don't all look the same, and some are going to have higher prices to cover up other weaknesses. When you put in an escalation clause, however, you are often giving the seller the best of both worlds - a higher price, and a stronger offer. You should know going in that you are probably "over offering" what you need to in order to win.
And, as noted above, an escalation clause isn't a guarantee. If there are multiple escalators, you could lose. In addition, the complexity (and risk) of a buyer getting buyer's remorse is significantly higher, and long-time listing agents know this. So jaded they are about escalators, that some listings agents will advertise that they will discourage their seller from taking any offer with a escalation clause in it. This means as a buyer, you should remember to ask the listing agent about their feelings on escalation clauses - otherwise you could be taking yourself out of consideration.
Should I Use an Escalation Clause in A Home Purchase Contract?
I generally advise my buyers not to use escalation clauses. Not knowing what you are going to end up paying is a sure way to start heading down the buyers remorse pathway. Even so, there are exceptions. Here are the reasons you may want to think about using an escalator.
A) You know it's going to be competitive or hyper competitive
B) You need a house soon, or you're going to be homeless
C) You recognize you won't be able to get a similar house; it's perfect for you
D) You have the financial flexibility to put more down if the house doesn't appraise at the final purchase price (and it may not).
You'd want at least 2, and probably 3 of these conditions in place. Most of the time, it makes much more sense to have a productive discussion about what the value of the house is to you, and to offer that price - without an escalator- as a number you have confidence around. In addition, making your offer stronger in other ways - fewer contingencies, aggressive dates, more money down - is often a key deciding factor for quality offers. Although some sellers will only focus on price, most listing agents know that an offer strength is much broader than just the top line number.