In a hot market, some real estate companies are arming their agents with what is called an “escalation clause” to use when presenting an offer to a seller. In short, an escalation clause says that said buyer will pay, for instance $1,000 over the highest offer. Sometimes with a cap, sometimes not. A cap would be something like “$1,000 over the highest offer up to $200,000” for instance. And they are using these to try to win a bidding war. Sounds like a great way for a buyer to win the house they want and the seller to make more money, right? Well, on the surface that might be true, but a deeper examination of them makes them not sound so great. Let’s take a look.
From the very start, an offer with an escalation clause presents a challenge to both a buyer and seller because a contract offer with the clause attached, cannot be signed into a binding contract because the clause doesn’t set an actual price (especially one without a cap, because when does the escalation end?). Which is an important part of a purchase contract. So, you could make a decent argument that the escalation clause isn’t actually a legal document.
So why do it? The simple answer; it is viewed from the buyer’s perspective to give them a higher likelihood of getting the house they want. And from the agent’s view, it makes them look like they are innovative and helping their clients win the house. Both of which could be true. I will not argue that the escalation clauses cannot work, because they probably can. However, is it the best thing for either side? Let’s take a look.
First, from the buyer’s side of things, there are 3 pitfalls to using the escalation clause.
1. You are giving away your top price (if there is a cap).
Back to the example of “$1,000 over the highest offer up to $200,000”, that $200,000 represents to the seller what you are willing to go to. And now you have lost any negotiating power because the seller knows what number you will agree to.
Even the most inexperienced negotiator knows that you don’t give away your top price at the very start. So why are seasoned negotiators like Realtors are supposed to be, advising their clients to do this?
2. You will potentially (and maybe most likely) will pay more than you have to for the house.
Think about it, what if the next highest offer for the house in this example is $195,000? Do you think the seller is going to sell you the house for $196,000, or just say they will take the $200,000 you will go to? Yeah, I think you know the answer to that. So now by using the escalation clause, you have overpaid for the house by $4,000.
Some agents will tell you the way around that is to request that the seller show you the highest offer they have so you know what it is. Unfortunately, the seller is under no legal obligation to so, and secondly, they cannot disclose another buyer’s offer without consent from that buyer. And you do think a buyer in a negotiation is going to let another buyer see their offer? No way.
3. Doing this shows you will do anything to get the house.
First rule of negotiations is you don’t show the seller how much you love whatever it you are buying. Because that is taking away your “walk-away” power. If the seller knows you won’t walk away because you are too emotionally invested in the house, they have you where they want you. An escalation clause screams how much you love the house and have to have it. And that is music to a seller’s ears.
And that isn’t just about getting the price they want. It will also filter down into other negotiable items in the contract such as closing cost coverage, home warranty purchases, closing date, etc. After that, it still isn’t over. Showing your need for the house also harms your ability to negotiate any repairs you may want on the house before you close.
So, as you can see, the escalation clause probably isn’t a good idea for a buyer unless their singular focus is to get the house, no matter the cost.
It might seem from it not being a good thing for the buyer, that it must be a good thing for the seller. And while that is true from the standpoint of what is mentioned above, there are reasons why this isn’t a good idea for the seller either.
1. Dealing with “monopoly money”
When a buyer presents an escalation clause to a seller, it typically pushes the purchase price beyond the list price. Which on the surface sounds like a great deal for the seller. However, the house will still have to appraise for that higher amount to ensure the seller sees any of that extra money. Because the buyer is under no legal obligation to buy the house over the appraised price. So until the appraisal verifies that higher amount, that money isn’t “real.” And since most sellers are going to price their homes at the very top of the market, going over that amount could present appraisal issues. This could delay closing, not allow the seller to get as much money as they were counting on, or even have the buyer walk away and now they have to re-list their house.
2. Dealing with a “win at all cost buyer.”
A buyer presenting an escalation clause has said the seller that they are a win at all cost buyer. Which likely means if you choose their offer, you are going to be in for a fight on everything from above like closing cost coverage, home warranty purchases, closing date and inspection items. While the seller might have the upper hand knowing the buyer is all in on the house, that will not stop the buyer from making negotiations a fight. Which in many cases leads to a deal falling through.
3. Might not pick the “strongest buyer.”
The escalation clause, in many cases can cause a seller to focus only on it and the extra money, and miss things about each buyer which might show that there is a stronger offer on the table, even if it is for less money.
Things like the type of financing used, down payment amount, closing date, contingencies included, etc. are all major factors to a deal. For instance, the escalation clause buyer might be using FHA financing (due to a lower credit score) with a very small down payment. And another buyer might be using Conventional financing and is putting down 20% or more towards the house. Some things to consider for the seller is that the FHA buyer might barely be qualified for the loan. And if anything happens in the 45 days in which it takes to close, such as a change in their credit for any number of reasons, or if what they had for the small down payment isn’t available anymore, it likely will kill the deal entirely because the lender will no longer approve the loan. However, that Conventional buyer has a higher credit score (due to being eligible for a conventional loan) and is putting down more money. Which means they have more leeway should anything occur with their credit or expenses that take some of the down payment money away. They should be still ok to get the loan.
As you can see, the use of an escalation clause isn’t a very good idea on either end of the deal. There are far better ways to go about putting together an offer and contract on a house that allow each side to have a better chance of the deal going through and making it to closing.
As a real estate agent, I find that the best transactions are the ones where there is a some give and take between each party. And one side doesn’t feel like they are getting railroaded. When a deal gets overly one-sided, problems start to arise.
The goal of a buyer is to buy a house they love within the budget they have. A seller’s goal is to sell the house for what it is worth. Both want the same thing, and that is for the deal to close. One way to do that is to avoid things that could cause issues, and the escalation clause is one of those things. So avoid using it unless you absolutely have to.