Mitigating the Dangers of an Escalation Clause in a Real Estate Purchase Offer

Mitigating the Dangers of an Escalation Clause in a Real Estate Purchase Offer

In a Seller’s Market, the process of buying a home is a sprint with dizzying turn-around times at every phase of the buying process. In Northern Virginia, the low inventory of real estate, particularly single-family homes, means that buying is highly competitive, and buyers have to resort to various aggressive tactics with high risk in order to close a deal. One popular technique is including an escalation clause in the offer to make it more attractive. These clauses are a good idea in some instances, but it’s important to consider the big picture when deciding how to include on in an offer.

What is an escalation clause?

In a real estate offer, when a buyer includes an escalation clause, it generally contains the following three elements:

  1. A firm offer of a specific price. John and Jane Smith offer $100,000.
  2. A commitment to escalate the offer price by a specific increment above any other offer that comes in. If the Joneses offer $105,000, the Smiths will pay $2,000 over that amount ($107,000). If the Wrights offer $110,000, the Smiths will pay $112,000, etc.
  3. A cap on the total offer. The Smiths will only pay up to $115,000. If the Halls offer $116,000, the Smith’s will not raise their offer to exceed it.

Often, an escalation clause will contain additional terms like a deadline for other offers to come in. There are various times when an escalation clause can be used to great effect. For instance, if all offers are to be considered at one time, an well-conceived escalation clause can put that buyer in the top bidding position without going too far over the second most competitive bid. Since it can also backfire in some circumstances, be sure to confer with a qualified, experienced real estate agent before including an escalation clause.

What are the risks associated with an escalation clause?

While an escalation clause can help a buyer to win the bidding process without a lot of back and forth, in other situations, it presents a risk. A seller can look at the cap and know what the buyer is willing to spend and may come back with a counter-offer at that amount, knowing that this is within the buyer’s contemplation. The seller can also be open about the existence of the clause to other buyers and solicit bids over the cap amount. Much depends on the timing of bids, the number of bidders and the amount of the cap – too much and it looks like the initial offer amount is trying to buy on the cheap; too little and it might not beat out other bids.

Another important risk is less likely to be considered by the buyer. When budgeting for buying a home in a seller’s market, a buyer will often be completely focused on getting a home, especially after losing multiple bidding wars, as often happens. The buyer stretches their budget to the max, forgetting that they may have additional expenses very soon after the sale. For example, in a seller’s market, most buyers will use multiple techniques to appear more attractive, and waiving the home inspection and other contingencies is one of the first to be used. If a buyer has waived the home inspection, they may not be aware that some major repair will be needed. Having spent their entire budget on an escalation clause, they will be out of luck when they move in and realize the problem.

The escalation clause can also impact the buyers’ ability to finance the purchase. Buyers qualify up to a certain limit, and their offer with the escalation clause may put them close to that limit. However, the lender will require an appraisal of the home and insist on a specific loan-to-value ratio If the appraisal results in a lower value than the escalated offer, the buyers have to come out of pocket to reach their escalated offer.

A Walk and Talk Consultation Mitigates the Risk

By working with a certified home inspector, a buyer can make an offer that is both competitive and within their overall budget. Unlike a contingency inspection, the walk and talk consultation takes 30-60 minutes during a showing appointment or other buyer visit. The home inspector can quickly assess whether there are major problems with key areas like the roof, obvious code violations or other, potentially costly aspects of the home. Flagging these issues will allow the buyer to make an offer that fits within their financial ability, both from a debt and a cash perspective.

At Biller & Associates, we have successfully worked with dozens of buyers to assess multiple potential homes to make sure their offer is as competitive as they can actually afford. If you are considering a home purchase in Northern Virginia, contact us to learn more about a walk and talk consultation.