What Is an Escalation Clause in Real Estate and When Should You Use One?

What is an escalation clause in real estate, and how does an escalation clause work? When you’re deciding on what price to offer on a home, the situation might call for a single price or, in some cases, numerous prices via an escalation clause.

In a fast-paced, highly competitive seller’s market, having an escalation clause as part of your offer on a house can benefit the homebuyer and seller alike. But it does come with some downsides, so it’s important to know the pros and cons before you include one in an offer (or accept one as a seller).

Here’s what to know about what an escalation clause is, and when it’s a smart tactic for your real estate deal.

What is an escalation clause in real estate?

An escalation clause is a real estate contract, sometimes called an escalator, that lets a home buyer say: “I will pay X price for this home, but if the seller receives another offer that’s higher than mine, I’m willing to increase my offer to Y price.”

In theory, an escalation clause is fairly simple. In practice, there are a lot of details involved.

While escalation clauses vary significantly, the general escalation addendum has a few basic components:

The buyer’s original offer price
The maximum a buyer is willing to pay for the house in the event that the seller receives multiple offers on a house
The amount a buyer’s offer will be escalated over competing offers

What is a typical escalation clause?

Here is an example of an escalation clause:

Buyer Brown offers $300,000 for a home or piece of real estate. Her real estate agent adds an escalation clause that, in the case of a higher competing offer, will increase Brown’s offer in increments of $2,000 above the competing offer.

Her escalation clause goes up to a maximum of $310,000. If no other offers are submitted, Brown’s offer remains at $300,000.

If Buyer Green offers the seller $303,000, then Brown’s offer would automatically escalate to $2,000 above that, bringing Brown’s offer to $305,000. If Buyer Orange offers $311,000 for the home, then Brown’s maximum of $310,000 will be exceeded, and Orange will have the top offer.

When homebuyers should use an escalation clause

Buyers might want to include an escalation clause in their offer when they are fairly confident that there will be multiple offers, which could fuel a bidding war that will drive up the price of the house. An escalation clause helps a buyer in a few different ways:

If the seller receives multiple offers, an escalation clause can help a buyer hold on to a home they really want.
An escalation clause shows a seller that a buyer is serious about the house, which could help make the buyer’s offer stand out.
If a bidding war ensues, an escalation clause can keep a buyer from getting swept up in the frenzy and offering more than they can afford.
If a buyer’s offer is accepted and ends up being the only offer submitted, it technically remains at its original price—a seller cannot counteroffer asking for more money.

Yet despite the many benefits of an escalation clause to buyers, it can present some downsides, too. Namely, buyers who submit an offer with an escalation clause are laying all their cards on the table: The seller knows immediately how far the buyer will go to secure the home.

As such, a seller who is presented with an escalation clause could counteroffer rather than accept, and ask for a higher price. While there’s no guarantee that the buyer will agree to pay more, it is likely that they will because they’ve already made it clear that they can.

Is an escalation clause a bad idea for the seller?

Home sellers generally favor an escalation clause for the following reasons:

They are able to see a larger dollar amount (potentially) coming down the road.
When a buyer opts to include an escalation clause with their bid, the seller sees right away that the buyer means business and truly wants the property.
An escalation clause streamlines the contract paperwork and the decision-making process.

But there are drawbacks, too—namely the ability to negotiate the price. Once a seller accepts an offer with an escalation clause, no bargaining or counteroffers beyond that can take place. So while a buyer might be able to pay an ever higher price than what they’ve put in their escalation clause, if no other bid beats theirs, they have to pay only what their clause states.

Some home sellers simply state that they will not accept an offer with an escalation clause, since they’d prefer to see just how high the bidding will go.

Sellers might also lose out if the top price in the escalation clause is more than the amount for which the house is appraised by the bank issuing the buyer’s home loan. Banks, as a rule, don’t lend more money than the market value of any given home or piece of property.

So if the top amount in the escalation clause exceeds the appraisal number, the buyer has to pony up the difference in cash. If he or she can’t, the deal might fall through.

How the offer review process factors in

In hot real estate markets, a wide variety of offer-review processes can be available. Some might specify, for example, that the property is going on the market on Friday, and that all offers will be reviewed the following Thursday. The sellers and their agent will make a final decision that day.

This situation can be ideal for an escalation clause, when a buyer knows it’s an all-or-nothing offer.

Other sellers, however, take a back-and-forth approach. They might collect offers from buyers for one week, and then respond to a handful of the best offers by saying “send us your highest and best offer.”

This technique is particularly disliked by many homebuyers for its lack of clarity, but it’s important to know that it exists. Before writing an offer, a buyer’s real estate agent can inquire to feel out the details and make sure the buyer is prepared for the situation.

In such a multistage situation, writing an escalation clause into the initial offer could put the buyer in a weak position during the second round. It’s perfectly legal for a seller’s broker, with the seller’s permission, to reveal to all potential buyers what the top initial offer is and to ask everyone to beat it.

In this case, the escalation clause would reveal that buyer’s maximum, losing that buyer their competitive edge.

Should you use an escalation clause?

If you’re considering an escalation clause, your real estate agent is probably busy researching the circumstances around the seller’s process of reviewing offers. The real estate agent’s knowledge of normal practices and probable outcomes in your market will make your offer much more likely to succeed.

Escalation clauses in real estate can cause a lot of stress for homebuyers, but when they’re boiled down to the basics, they’re fairly straightforward. Remember to be realistic, to be comfortable with how much of a competing bid you’re willing to offer, and to confidently go after a piece of real estate at that price.

Buyers shouldn’t be tempted to escalate their purchase price to a figure that they would not be comfortable paying. And keep the appraisal number top of mind, since the lender in the deal might not approve the loan if the escalation clause is put into play with a too-high bid in terms of the home’s value.

Source: By Sally Jones for Realtor.com