This sponsored, biweekly Q&A column is written by Andrew Goodman, broker/owner of Goodman, Realtors. Based in Bethesda, Andrew serves clients in Maryland, D.C., and Northern Virginia. Please submit comments, questions, and opinions in the comments section or via email.
Question: What is an escalation clause and what is the purpose of it?
An escalation clause is a document that allows you to increase your offer in the event that another offer is submitted on a property of interest. This clause comes in handy during bidding wars because it allows buyers to automatically increase their offer by an escalation factor up to an escalation cap amount.
An escalation factor is the amount of money a buyer is willing to increase their offer above the next highest net bid. In the event that the seller receives one or more offers to purchase a property, the escalation clause will automatically increase the proposed offer by the escalation factor, not to exceed the escalation cap.
The escalation factor is based on the net proceeds to the seller, not just the sales price.
Now, most buyers would assume that making the escalation factor $100 could work. However, I always recommend making the escalation factor at least $2,500. When deciding on the escalation factor, you should ask yourself this question: How much money would it take the seller to choose my offer if the competing offer was the perfect offer?
In other words, an all-cash offer with no contingencies.
What amount of money would it take the seller to take on the risk of a contract with contingencies or one that needed to obtain a loan versus an all-cash offer with no contingencies?
Some sellers care only about the money, but if advised appropriately, the seller should see the potential risk involved with a contract that has contingencies. I’m not saying that all loans are risky, nor am I saying that there could be issues accepting a contract with contingencies, but it’s just a fact that an all-cash offer is superior to an offer with a loan.
Of course, if you’re submitting an all-cash offer with no contingencies, your escalation factor is not as important since there is no risk to the seller. In that case, your focus should be on what to make your escalation cap.
The escalation cap is as high as you’re willing to increase your offer before your escalation stops. So your escalation clause will be valid for any value under your cap. Once your cap is reached, your escalation clause is no longer valid.
Choosing the right cap should be based on recent sales, trends and market conditions. I always ask the question: If another offer came in $1,000 higher than your cap, would you be upset losing the property?
If your answer is yes, then you should reconsider your cap. The cap should be the highest sales price that you are comfortable paying for the property and you should keep the $1,000 rule in mind.
Use this example:
Offer #1 Offer price: $500,000 Escalation Factor: $2500 Escalation Cap: $550,000 All Cash No contingencies
When analyzing these two offers you first notice that the offer prices are different. Since there are two offers, Offer #1 is automatically increased by its escalation clause because Offer #2 already starts off higher.
Offer #1′s escalation cap is $550,00, so that offer capped out since Offer #2 doesn’t stop until $560,000. Offer #2′s offer is now $551,000 because the escalation factor of $1,000 is to be added to the next highest bid, which in this case is $550,000. Offer #2′s cap was never reached.
However, if I were the agent representing the seller, I would advise him or her to accept Offer #1. Even though it’s a lower offer, the small $1,000 escalation factor only makes it a $1,000 difference between the two offers. I don’t believe $1,000 is worth the risk of all of the potential issues that could arise with Option #2′s contingencies.
Once a bidding war has ended, the winning party is to receive proof indicating why their offer was escalated. Again, an escalation clause is not based on the highest sales price, but rather the highest net value to the seller. So make sure you receive not only the first page of the competing offer, but also the seller subsidy page to clarify if any closing costs were being asked to given back to the buyer.
The escalation clause also allows you to automatically adjust your financing for the property as the price of the home is escalated.
Please note that not all sellers or listing agents accept escalation clauses. In some cases, listing agents will advise their sellers not to entertain escalation clauses or limit the escalation. If the home doesn’t appraise or if there is an appraisal issue, the escalation could be pointless if the buyer doesn’t have the funds to make up the difference. That would require the seller to reduce the price from the escalation after that bidding war.
Please consult your realtor before submitting an escalation clause.