What Is an Escalation Clause? Here’s How They Work

This is where real estate escalation clauses come into play. An escalation clause, sometimes known as an escalator, is a clause that’s added to your real estate contract that allows your offer to “escalate” beyond the highest competing offer that’s made.  

But are escalation clauses always necessary? For real estate investors or home buyers, are they even the best move? That depends! In this article, we’ll take a look at what you should know about escalation clauses, and how they work.

What Is An Escalation Clause?

An escalation clause can be added to an offer that you make on a home. The idea behind this clause is that it can help to give you a good chance at securing a property, even in a multiple offer situation.

With this clause, you essentially state that you are willing to outbid any other highest offer, usually up to a specific amount. If your original offer is outbid by another competing bid, the clause will be triggered, and your bid will be increased. 

You should also specify the maximum amount you’d like the escalation amount to be and in most cases, place an upper limit on the clause stating the highest amount you are willing to go to. 

Generally, an escalation clause will have three basic components: 

The initial offer price of the home in question

How much the price will automatically increase based on another offer 

The maximum purchase price that the home buyer is willing to bid

Here’s an example:

Let’s say a prospective buyer makes an offer of $500,000. An escalator clause could state that should additional offers come in, the buyer will beat the best offer by $5,000. This means that if an offer of say $510,000 comes in, then the escalation clause kicks in and triggers a new offer of $515,000. 

Use of Escalation Clauses

Are escalation clauses a good idea? One of the main reasons that potential buyers use price escalation clauses is to help give them an edge in hot real estate markets. If you are looking to purchase a property in a seller’s market or when demand outweighs supply, an escalation clause might be beneficial to you. In a hot market, the demand for properties is high, but the availability is low. When there is a property listed it sells fast. Putting an escalation clause in with your offer, in some cases, can help to give your offer a better chance of beating a higher offer, even in a fast-moving market. It can also help you to succeed if there’s a bidding war, allowing your offer to be one step ahead of the highest price. 

Likewise, an escalation clause could also help to give you a competitive advantage when it comes to extremely desirable homes as well. If you’ve found the home of your dreams, for instance, and you don’t mind paying what you need in order to secure it.

Risks of Using an Escalation Clause

Like everything, there are pros and cons to escalation clauses, and they may not be right for every situation. While the main benefit of offering an escalation clause is that you increase your chances of getting the house, there are some potential downsides to using these clauses as well. 

Changing Markets

When making your offer, keep in mind that there’s always a chance that the market will shift. Paying above market value for a property could put a homeowner at risk for an underwater mortgage, should prices drop. It’s best to keep your exposure and risks low by ensuring that you don’t pay above the odds for a property, no matter how tempting it may be.

Buyer’s Remorse 

In some cases, an escalation clause could drive the price of the property higher than you’d hoped. In these cases, you may end up with buyer’s remorse. An offer that’s too high could increase the risk of a would-be buyer getting cold feet and dropping out, something that many sellers won’t want to risk.  

Escalation clauses on properties often end up working similarly to an auction in that prices are driven higher. If you do decide to make an offer with an escalation clause, make sure you cap your offer at a level that you’re comfortable with.

Sellers Not Accepting Offers With Escalation Clauses

While the whole point of escalation clauses is to increase your chances of securing the house, sometimes this method can backfire. In some cases, the seller will refuse an escalation clause because of the risks or complications involved, especially when it comes to uncapped offers. Not all sellers are willing to accept the risk or delays that these offers might cause.

Dishonest Offers

Another risk of escalation clauses is that you’re essentially trusting that the seller and real estate agent to be operating honestly. You don’t know who is making that other offer, and there’s always a chance that a less-than-reputable agent and seller could be working together to drive the price higher. If you do choose to use an escalation clause, ensure that part of the clause should state that the listing agent will share any bona fide offer that triggers the clause. This is important for ensuring transparency and honesty. 

An Appraisal Gap

Finally, one of the biggest risks of using an escalation clause is that the amount that you’ve agreed to pay ends up being higher than the property’s appraised value. This is known as an appraisal gap. When this happens, the bank will refuse to issue a loan for the amount that’s over the appraised value and you could end up having to foot the bill yourself. Make sure the amount that you offer isn’t above the property’s appraised value, or more specifically, above the amount that the bank is agreeing to finance unless you have the financial means to cover the difference yourself.

How to Create an Escalation Clause

There are two basic ways that you can structure your escalation clause: capped and uncapped. Capped escalation clauses state that the amount that you’re prepared to offer caps out at a certain point. Uncapped escalation clauses, on the other hand, are far more risky. With this type of clause, you promise to pay a certain amount over the top bid without any ceiling cap. Naturally, this can present a problem should you end up bidding $100,000 above the property’s appraised value, without even realizing it. For this reason, many real estate agents will ignore offers with uncapped escalation clauses.

Making Your Offer More Attractive 

While the amount that you offer is one important consideration, for sellers, there are other points that often add weight to an offer as well. A seller will usually prefer an offer that will give them the ability to close quickly and efficiently. This means that the highest offer may not always be the one that they end up choosing. Making a cash offer, for example, could make your offer more attractive than one that has 90% financing. Additionally, steps like waving due diligence or simply increasing your offer instead of putting it in an escalation clause could also make your offer more attractive; although these have their own set of risks as well.

While an escalation clause isn’t for everyone and certainly should not be applied to every situation, there are circumstances where they can be useful. And you can certainly see their appeal in a competitive market like Colorado Springs. Just make sure you take steps to protect yourself from any risks. A good buyer’s agent will help you to determine whether an escalation clause is the best course of action for you and will also be able to advise you on strategies and alternatives to escalation clauses that you can use to secure your dream home, ones that will be in your best interest. 

Are you looking for a buyer’s agent in Colorado Springs? At Springs Homes, our team of experts has extensive experience representing buyers. We can help you to be competitive offers to secure your dream home. Reach out today and let’s find your home.

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