Escalation clauses – what they are and how they work..

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Escalation Clauses...

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Unless you have been living under a rock, it should be no surprise that we are are in a very strong seller’s market. In this market, buyers have been bumping up against multiple offers and bidding wars.

Highest and Best..

You’ve finally found the perfect home. You are all set to make an offer and your agent puts in a bid. You wait on pins and needles hoping that your offer is accept. Finally your agent calls you back with a big curve ball. The sellers have decided to go to “highest and best”.

So what does this mean?

It is a competitive bidding situation where qualified buyers must submit their final and BEST offer by a certain date and time. The seller will then choose the best offer in the pile. The decisions are final and there is no going back once the decision is made.

Escalation Clauses - What are they and how can they help buyers ?

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Bidding Wars..

Highest and best is designed to create a bidding war to secure the highest possible price for the seller. It is a mechanism that works very well for sellers in markets with high demand and low inventory – which is precisely what we have in the current Westchester market.

This presents obvious problems for buyers. How far do you go in order to secure a home? In a market this tight many buyers have already been through 1 – 3 rounds of competitive bidding which they have lost. They don’t want to lose out again, but they certainly don’t want to overpay for the home.

It’s a tough question. Overpaying can create its own set of issues, particularly with respect to the appraisal process. So if the buyer is financing a good part of the purchase (and most are) they run the risk of slamming into that obstacle down the road.

Enter the escalation clause..

The escalation clause is designed to get around some of these issues. It turns the tables on the highest and best tactic just a bit by giving some power back to the buyer.

Let’s take an example..

You want to make an offer of $500,000 on a home. This offer is consistent with recent comparable sales. But, you are willing to go up to $510,000. In a highest and best scenario, many would feel obligated to immediately go up to $510,000. However, that prices seems a bit high for this particular home.

Highest and best is meant to push buyers to put that extra $10k on the table and show all their cards. The escalation clause ensures that the buyer will only pay that $10k more if competing bids warrant such a price.

This is what it might look like..

The offer will be for $500,000 with the following escalation clause: In the case of a multiple bids the buyer will out bid all competing offers by $5000, with a ceiling for the final offer set at $510,000.

How does it work?

Let’s say the highest offer on the table is $502,000. Then the escalation clause puts your competing bid at $507,000.

If the highest offer on the table is $495,000, that puts your competing bid at $500,000.

In other words, this type of bidding offers sellers more than their highest alternate bid without giving away the store if the competition is bidding lower than expected.

It allows buyers to offer their best possible price without the risk of becoming an outlier who is overpaying by a large sum. It also can take the “edge” off of the sellers market frenzy and gives some control back to the home buyer.

But what if someone bids way more than I want to bid for the home?

That’s why there is a cap on the escalation clause. In this instance, you are making it clear that you are not going beyond $510,000. If the nearest competing bid is $509,000, your best offer is $510,000.

If a competing bid offers more than $510,000, then you will probably lose the house. That risk can’t be completely removed unless price is no object!

Let me make this clear: this type of bidding is not a guarantee. There is always the risk that someone with deeper pockets will be willing to overpay. That’s a risk everyone takes when the subject themselves to competitive bidding. It simply allows you to offer your best bid without subjecting yourself to a bidding war frenzy.

What are the caveats to an escalation clause?

This type of clause is not that common. Being uncommon, there is often pushback from sellers and their agents. Some will claim that it it is an attempt to “game” a highest and best bid. So what? Aren’t sellers trying to “game” a bull market with the pressure of a highest and best competitive bid? I have had agents reject outright any escalation clauses. In that case, I go back to my client and we devise the best “highest and best” offer that we can.

It is my belief that escalation clauses should be used carefully. Most buyers aren’t ready to step up to the plate and give their best offer until they have failed once or twice. As a buyers agent, I often suggest this type of tactic when my clients have been subject to multiple bidding wars. They are weary of losing out on homes by about $1000-$5000 and are willing go that extra mile to secure a home. They are tired of the game, but they don’t want to overpay.

Competitive markets can take all the enthusiasm out of buyers because they feel they have lost all control of the process. This gives them a modicum of control back. I also think it is useful when a bidding wars are too frenzied. It takes some of the heat out of them.

Further Reading:

Escalation Clauses

What is an escalation clause in real estate?

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