What Is an Escalation Clause in a Purchase Agreement?
What Does an Escalation Clause Do?
An escalation clause or escalator in a real estate purchase agreement contains the following basic elements:
- The buyer’s original offer or purchase price.
- Proof from the seller that other offers exceed a buyer’s bid.
- How much the buyer’s purchase price will increase to beat other offers.
- The price cap or the maximum purchase price that a buyer is willing to offer when there are multiple bids for a property.
Note that not all sellers accept home offers with escalation clauses. Some will want to avoid the tedious process of managing multiple offers and prefer to deal with buyers who will place their best and most competitive offers from the start.
What Is an Example of an Escalation Clause?
Suppose Buyer A finds a home they want to purchase and offers $200,000 for that property. Buyer A may ask their agent to include an escalation clause in the contract, indicating that they are willing to increase the original offer in increments of $5,000 to beat any higher offer, up to a maximum of $20,000 additional to the original purchase price.
Just then, a competing buyer, Buyer B, makes an offer of $210,000 to the property in question. Buyer A’s escalation clause will automatically raise their offer in increments of $5,000, up to $15,000, to beat the $210,000 offer. If no other offers are made, Buyer A will have the best bid and likely get the property for $215,000.
However, suppose another buyer (such as Buyer C) or even Buyer B is prepared to pay more than $220,000 for the same property. In that case, Buyer A will lose to the competing offer because their escalation clause’s cap is only up to $20,000 additional to the purchase price.
When and How Buyers Can Use an Escalation Clause
Buyers may use an escalation clause when they are confident in their ability to increase their bids on a property when there are several offers for it. The clause may make the buyer’s offer stand out in a seller’s market (i.e., when there are more buyers than sellers). This way, the buyer increases their chances of snagging the property.
An experienced agent can help buyers assess if an escalation clause makes sense for their financial situation and goals. If a buyer decides to write an escalation clause, then an agent may also work with them to figure out how much they are willing to pay to secure the sale. Buyers will need to think about the purchase price and escalation amounts that they can cover.
What Are Pros and Cons of an Escalation Clause?
An escalation clause benefits a buyer and a seller differently, both in terms of benefits and drawbacks. Here is a list of its advantages.
- An escalator increases the buyer’s chances of winning a bidding war.
- It makes the buyer’s offer more attractive in all real estate markets. Sellers will take the buyer’s offer seriously, minimizing the risk of being overlooked or neglected.
- Buyers get a convenient way to outbid other offers on the property. If someone bids higher than the buyer’s original offer, the buyer can easily win the house if their offer is still the highest.
- In some cases, an escalator may prevent a buyer from overpaying to get the property. This happens when a buyer wins the bid at an amount below the maximum escalation
- price, and the seller does not counter the buyer’s offer.
- For sellers, escalation clauses guarantee that they will always get the best (i.e., highest possible) offer.
On the other hand, here are some of the dangers of using escalators in real estate:
- The buyer loses their chances of negotiating a better deal. The clause lets the seller know the maximum amount a buyer is willing to shell out to buy the property. In some cases, a seller may even use this information to counter the buyer’s offer at the maximum escalated price.
- In some cases, a seller may reveal the maximum price or cap in an escalation clause to other bidders.
- An escalator may cause the buyer to spend thousands more than they can actually afford.
- An escalation clause will not guarantee that the seller will accept the buyer’s offer, even if it is the highest bid. Sellers have different ways of assessing and deciding on offers from buyers. Some will prefer a buyer who offers a lower cash bid than one who provides a higher financed offer.
- A buyer may end up offering and paying more than the property’s appraised value.
- In real estate investing, an escalation clause or an escalator is a provision in a real estate purchase agreement that states how much the buyer can increase their offer based on other competing bids.
- It includes a price cap or the maximum amount that a buyer is willing to offer when there are multiple bids for a property.
- Buyers use escalation clauses to keep their offers more attractive in a highly competitive market. However, an escalation clause does not guarantee that the seller will accept the buyer’s offer, even if it is the highest bid.
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