real estate

How and when to use an escalation clause

In rebounding real estate markets where home sellers frequently get multiple offers, some buyers rely on an old tool: the escalation clause.

An escalation clause is designed to edge out competing bids by automatically raising an offer when a competing bid comes in. It's also known as an escalator clause.

"Escalator clauses are becoming more widely used as we see an increase in multiple-offer situations," says Toika Collida, a real estate agent with the Kelly Hager Group in St. Louis. "When a buyer is faced with competition on a home purchase, our team encourages the use of an escalation clause in the contract, which gives our client the best opportunity to be the selected offer."

How it works

"An escalation clause is when a buyer is willing to go over the highest offer, up to a specified amount," says Kristine Halverson of Prudential California Realty in Santa Monica, Calif.

A buyer's escalation clause is triggered by a competing offer. When that competing bid is made, the escalation clause automatically increases its own offer by a preset amount. The clause limits (or "caps") the buyer's maximum bid. For the clause to be triggered, sellers need to prove there was another bona fide offer, Halverson says.

Typically, a copy of a competing offer serves as the proof needed to trigger an escalation clause. But in practice, some agents say that kind of proof can be problematic.

"There is a leap of faith that these other offers are legitimate," says Nick Segal, president and co-founder of Partners Trust Real Estate Brokerage and Acquisitions in Beverly Hills, Calif. "Offers have been known to be fabricated to support getting a buyer using an escalation clause to pay their ceiling price."

Naturally, the kind of behavior Segal is describing is unethical, but it does happen. And even if all the offers are on the up-and-up, it's important that buyers remember not to take anything at face value.

"Sometimes a competing offer may be for a price, say (the seller wants) $300,000, but also (includes) $10,000 in buyer closing costs paid by the seller, so in effect, it's $290,000," says Rob Levy, principal broker with Keller Williams Realty Professionals in Portland, Ore. "But the other buyer's actual written offer is for $300,000, so the escalation can be interpreted as $310,000."

No guarantee

While an escalation clause is designed to keep your offer competitive, it shouldn't be mistaken for a guarantee that the seller will accept your offer, even if it is the highest bid.

"The bottom line is with or without escalator clauses, a seller is free to accept the offer they choose to work with," says Chris Morenza, a Re/Max agent in Miami. "In many cases, a seller sees a lower cash offer as better than a higher financed offer."

When to use it

While all agents agree that buyers should only use an escalation clause when there is a possibility of multiple offers, it doesn't necessarily follow that a buyer should always include an escalation clause just because the market is competitive.

"Buyers who are ambivalent about a particular house, but just want to purchase so they are no longer renting, may find themselves feeling frustrated after getting beat a few times," says Jamie Skojec, founding principal of Home Source Realty in Northern Virginia. "But getting desperate and just offering more isn't always the best solution."

In that scenario, Skojec says it's best for the buyer to keep putting out offers and save the escalation clause for a home they love.

Appraisal value

While an escalation clause may help you win a bidding war, it may also open a buyer up to another problem -- offering more than the appraised value.

"If you decide to offer any amount above asking price and waive the appraisal valuation, you're going to be agreeing to purchase the home regardless of what an appraisal will come in at," says Skojec. "If the lender's appraisal comes in lower than the amount offered, you're going to be paying the difference from your own funds."

For that reason, Skojec says it's a good idea for buyers to write an escalation clause that retains an appraisal contingency, meaning that the actual purchase price will conform to the lender's appraisal.

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