Are Escalation Clauses a Trap?

Question: A few of our friends who bought homes recently told us that we should expect to use an Escalation Clause/Addendum when we make an offer, if we want our offer accepted. Is that your experience and is there a better way of making a competitive offer?

Answer: I thought this would be an appropriate follow-up column to last week’s columnon the dangerously under-supplied housing market and it’s also become a frequent topic of conversation with clients.

With so much competition for hard-to-find homes that have just come to market, it’s critical for buyers to understand the purpose and risk/reward of using Escalation Clauses/Addendums in their offer.

Please note that this column is specific to contracts in Northern VA; Maryland and DC contracts vary in language and use.

What Is An Escalation Clause/Addendum (EA)?

An EA allows you to make an offer at a starting price while agreeing to increase your offer to a higher price if another offer is higher than yours. It includes a ceiling/maximum escalation value and an escalation factor, the amount your offer will increase by, over the next highest offer.

The contract allows for the seller to execute a purchase contract (ratify) at an escalated value, without the buyer having to agree to the new price. However, to protect buyers, the seller is required to deliver the next highest contract that was used to escalate your offer.

That other offer must also be materially similar, meaning the other offer cannot include seller credits or a material difference in contingencies (e.g. the other buyer has to sell a home before buying this one).

When To Use an EA

EAs are best used when there are multiple confirmed or expected offers and the seller has set a deadline, asking for best-and-final. It is very common in our market for sellers to set an offer deadline after their first full weekend on market and often those deadlines are set with the expectation that all offers will be best-and-final and the seller will make a decision shortly after the deadline, without any back-and-forth with buyers.

Buyers are often skeptical of this practice and assume that sellers will come back for more negotiating anyway, but in my experience, most sellers stick with the plan and a buyer who leaves something on the table is often informed that another offer was selected.

Managing the Risk & Reward of an EA

Used correctly, EAs allow you to maximize the chances of your offer being selected, without grossly overpaying relative to the rest of the market. It allows you to offer as much as you’re willing to pay for a home, without actually committing to pay your maximum if nobody else in the market values the home as much as you do.

In my experience being on both sides of the transaction, and speaking with colleagues, the winning offer in a multiple offer bid almost always includes an EA, however, the winning offer escalates all the way to its ceiling only about half of the time.

The clear risk to you is that you’re exposing the highest price you’re willing to pay to a seller and if there aren’t other offers that justify automatically escalating your offer, the seller may attempt to simply counter your offer at a number equal to or close to your escalation ceiling.

There are things both the seller’s agent and buyer’s agent can/should do ahead of accepting/offering EAs to avoid a potential messy situation where this occurs.

As the buyer, you should think about how you will respond if the seller attempts this. I have had (buyer) clients walk away from a deal when this occurs, leaving the seller with nothing or a much worse offer, but have also had (buyer) clients thrilled to be countered at a price below their escalation ceiling, even if there weren’t other offers to support it.

Key Takeaways

  • EAs have become common-place in the market
  • EAs should be used when there are confirmed or expected multiple offers and a deadline has been set by the seller
  • EAs help the seller get the best price and allow buyers to maximize their chance of securing a home without grossly overpaying relative to the market
  • EAs carry a lot of risk and reward, so be sure to understand them before including one in your offer

If you are thinking about getting into the market for a home purchase and would like to discuss strategies that will help you maximize your chances of a successful home purchase, without exposing yourself to unnecessary risk, feel free to reach out to set-up a meeting with me. You can reach me any time at Eli@EliResidential.com.