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To give you an advantage in a competitive housing market, you can put an escalation clause into your purchase contract, but they can be a risky play.
An escalation clause is a condition that can be put into a homebuyer’s purchase contract
It’s designed to beat competing home offers by automatically increasing your bid above the highest offer by a predetermined amount
Escalation clauses are typically used in a competitive housing market
Putting in a bid on a home in a competitive market can be an intimidating process, especially when you’ve found “the one”. You don’t want to be underbid and miss out, but you don’t want to overpay either. So how do you beat out multiple offers while also sticking to your housing budget? One way to do this is by putting an escalation clause in your purchase contract. An escalation clause, also referred to as a “sharp offer” or “relative bid”, is a provision you can add to an offer or counter offer that says you’re willing to pay a specified amount more than the highest bid. An escalation clause in a house offer could say something like “My purchase price will be $1,000 higher than any other offer on the home” and could also include language that waives inspection and appraisal contingencies (more on that later).
To prevent you from putting in a relative bid that’s out of your price range, escalation clauses often include ceiling caps to make sure you’re not putting down a bigger offer than you can afford. Using the prior example, if your ceiling cap was $250,000, and you’re wondering how to write an escalation clause effectively, you could try this example: “My purchase price will be $1,000 higher than any other offer on the home, but is not to exceed 250,000”.
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An escalation clause is simply a condition that you put into a purchase contract if you suspect that a coveted home will get multiple interested buyers. Once the competing offers start rolling in, your escalation clause increases your bid by the amount you specify in the clause.
Escalation clauses generally include a few basic components:
In most cases, proof of a competing offer is needed to officially trigger an escalation clause. (However, keep in mind that there’s no surefire way to verify that the competing offer that triggered the escalation clause was a legitimate offer; the seller could have simply gotten a family member or close confidant to put in a higher offer to trigger your escalation clause.)
It’s also entirely possible that the person you’re competing with for that coveted home also has an escalation clause, or that multiple other buyers have escalation clauses. In those situations, the buyer with the higher price cap or unlimited cap will end up with the highest final offer price.
In some cases, the accepted offer might not have an escalation clause, and might not even be the highest bid. It ultimately comes down to how the purchase is being financed. A cash payment offer may have an advantage over a higher mortgage-financed offer. (Sellers generally prefer cash offers, as they don’t have to worry about the lender pulling the loan at the last minute).
Here’s how an escalation clause could play out between four buyers if two used escalation clauses and two didn’t.
|Buyers||Escalation||Initial offer||Price increase||Ceiling cap||Final offer|
As you can see, Buyer #2 had the highest escalated increase, but their ceiling cap limited their offer potential, topping out their final offer at $475,000. Buyer #1 had the lowest initial offer but with a ceiling cap of $525,00, they were able to beat out Buyer #4 by their escalated increase amount of $2,000.
It’s very possible that the seller may give the other buyers one last chance to beat Buyer #2’s bid, but they’ll need to bid at least $525,000 to beat Buyer #1. But as we just touched on, the most attractive offer won’t necessarily be the highest offer.
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As a buyer, escalation clauses can make sense if you feel it gives you an advantage during the offer process. However, that’s a big “if”.
For starters, you should be sure that the home is receiving multiple offers. Not simply one or two others, but multiple offers. Escalation clauses are generally only used in hyper-competitive bidding wars.
Secondly, you should ask yourself whether or not it’s a “can’t miss” home. If there’s a home shortage in the area and the property in question happens to be your dream home and it checks all the boxes, it might be worth using an escalation clause. You’re essentially saying you can afford a certain amount more than the asking price, and if you suspect there will be other high offers near or around your ceiling cap, an escalation clause would make sense.
However, escalation clauses have a number of downsides as well.
In the event you completely miscalculate the market and you’re the sole buyer, the seller could easily just counter your initial offer with your ceiling cap amount. A smart seller may not take that risk in a tight buyer’s market, but they’re free to. Putting an escalation clause in a purchase contract really just exposes your hand to the seller.
In a competitive market, escalation clauses also incentivize further risky behavior on the part of the buyer, like waiving certain contingencies to gain a competitive advantage over the other bidders. A little background, a contingency in a purchase contract essentially tells the seller that the offer will only be accepted if certain conditions are met.
In a competitive market, you may be tempted to waive appraisal and inspection contingencies. (Appraisal contingencies protect buyers if the bidding price is higher than the appraised amount; inspection contingencies allow buyers to conduct an inspection after accepting the offer and back out if they so choose.)
As the buyer, it’s important to draw the line somewhere and be sure you’re not getting swindled into paying too much for a home without inspection and appraisal contingencies.
Escalation clauses ultimately protect sellers by promising them a certain amount above the initial asking price. The buyer is telling you how much they’re willing to pay for the home, and that gives you significant negotiating leverage.
Say, for example, the initial asking price is $300,000. Your buyer’s initial offer is $315,000, but you notice their ceiling cap is $330,000. In this situation, you could counter with their capped amount, since they’ve put in writing that they’re willing to pay that much.
However, escalation clauses have their drawbacks as well. If you accept an offer with an escalation clause, that’s it, there’s no going to a second round of bids and securing a higher offer. In a competitive seller’s market, you could be limiting your profit potential.
Keep in mind that as the seller, you also have the power not to accept the offer with the escalation clause, or you can simply exclude escalation clauses altogether. If the offer with the escalation clause is the highest, you don’t have to accept it. Maybe it has too many contingencies, or maybe their closing date is 60 days from the accepted offer date. If that’s the case, you can turn around and see if any other bidders can beat the highest bid. If they can’t, then you always have the escalation clause bid to fall back on.
Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.
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