WHAT IS AN ESCALATION CLAUSE?
An escalation clause, sometimes called an "escalator clause," is a strategy home buyers can use when competing with others for the same property. It can be a powerful technique when used correctly, but unfortunately it is seldom used as effectively as it could be. Such a clause increases, or escalates, a contract above its originally offered Sales or Contract Price when the Home Seller has received another Contract.
The intent of the Clause / Addendum is to crush competing contracts by automatically and incrementally increasing the buyer's Net* offer price by a pre-determined amount above other Net* offer(s). In Northern Virginia the addendum also has a limit or Maximum Sales Price CAP set with the escalation. For rather obvious reasons, not having a Maximum CAP would be ill advised for the home Buyer.
It’s an addendum to a real-estate contract, in which a prospective buyer says, "I will pay X dollars for this house, but if another buyer has a bona fide offer that has a higher NET*, then my offer will increase in increments of Y dollars to a maximum price of Z."
*Net - For The NVAR (Northern Virginia Association of Realtors), Escalation Addendum "Net" is defined as the contract sales price minus any seller concessions to the buyer.
Concessions are also referred to as Seller Subsidy,the amount the Home Seller (if agreed to) will credit toward the Buyer's Closing Costs at the settlement.
A excerpt of The 1st Paragraph of the NVAR Escalation Addendum Reads as Follows:
"If Seller receives one or more additional offers to purchase the Property from which Seller would
receive an equal or higher Net than the Net reflected in this offer, then this Contract's Sales Price shall
automatically increase by $ XXXX above any Other Offer's Net to Seller, not to exceed a
maximum Sales Price of $ XXX,XXX."
WHAT'S YOUR HOME WORTH IN TODAY'S MARKET?
ESCALATION CLAUSE EXAMPLE:
Here is a fairly simple example of how an escalation clause would work.
A home seller receives two offers to purchase their home.
Offer (A) Has a contract price of $600,000 with a $5000.00 Seller Subsidy / Concession and an escalation addendum with a CAP of $630,000 and incremental increases of $2000.
Offer (B) Has a contract price of $610,000 with no Seller Concession / Subsidy and an escalation addendum with a Maximum net of $642,000 and incremental increases of $6000. (See Table 1)
SELLERS AND BUYERS BOTH NEED TO UNDERSTAND AN ESCALATION CLAUSE
When Are Escalation Clauses Used?
Most often an escalation clause is used when a home buyer anticipates there will be one or more competing offers by other buyers. Typically, this occurs when confronted during a HOT market, commonly called a Seller's Market. They also occur when a home appears priced below market value. When this happens it is more likely to attract multiple offers. These are just a couple of the times when you may want to use an Escalation Clause, but there are a number of other occasions during which a Buyer might want to employ the use of an escalation clause in their offer to purchase.
Pros & Cons - First Let's Look at the Cons:
The Listing Agent May Not Understand
1. Many, perhaps most, real estate agents simply don't understand an escalation clause clearly, and so may be inclined to discourage their clients (the Sellers) from entertaining offers with an escalation addendum in favor of "simpler contracts". It's true — they can get complicated and sometimes confusing — particularly when the Listing Agent doesn't have a complete and comfortable understanding of them.
But actually, an escalation clause is very simple math which is made very easy to understand visually if the Listing Agent creates a simple Spread Sheet allowing the Sellers to clearly see the various comparative Net* offers and how the offers will or won't trigger each other's escalation clause.
SOLUTION: As a home buyer, make certain that your Buyer's Agent is completely comfortable with using, and also Explaining, an escalation clause to others clearly. This will be essential if the Listing Agent is not well versed in how they work. It would also be very helpful for you and your agent to include a simple Spread Sheet easily showing the Maximum and Incremental Value of your Escalation Addendum. You may want to have your agent include an easy-to-see Highlight Table of your offer to make it more readily reviewed by the Sellers and their Listing Agent. I like to make such a chart as the Listing Agent, as well, when Sellers have multiple contracts to consider, but not all agents will take this step, so including one for your offer will make it stand out from other offers. (See Table 2 Below)
It "Tips Your Hand" to The Seller
2. Using an escalation clause shows the Sellers how high a price you are willing to pay for their house.
In the EXAMPLE in Table 1 (repeated below), Offer (A) is telling the Sellers they are willing to pay $630,000 with a $5000 Seller Subsidy / Credit to the Buyer's closing costs. Offer (B) is telling the Sellers they are willing to go as high as $642,000 with no Seller Subsidy.
Table 1 (repeat from above)
Offer (A)'s Net value of $625,000 (Cap price of $630,000 minus the $5,000 Seller Subsidy) triggers offer (B)'s escalation clause to go into effect, causing the Net of offer (B) to be $631,000. ( Contract A's Net of $625,000 plus an escalation increment of $6000). Contract B's Escalation Addendum can go as high as $642,000, but only if there is another offer that Nets the Sellers at least $636,000 ($642,000 CAP minus the $6000 incremental increase.) However, offer (A) has a Net of only $625,000 and is the only other offer in this example. Therefore, the escalation clause of offer (B) is triggered but only to a net of $631,000. *In Northern Virginia when a Seller decides to "Trigger" an escalation clause they are required to provide a complete copy of the Contract which has "Triggered" the escalation. This ensures that buyers' escalation addendums are only triggered to the maximum value of their original offer.
There is nothing that requires the Sellers to accept or to work with your escalation clause. Sellers can ignore the addendum if they want to and counter-offer back to a Buyer with a contract price. They could counter back at your Maximum Cap or somewhere below or even above it. If this happens, then a Buyer is NOT bound to the escalation clause CAP either and could walk away from the deal or counter back to the Sellers as well.
Some real estate agents argue that giving away your Maximum Price — "Showing Your Hand" — makes the escalation clause too much of a disadvantage to bother using at all and instead advise their Buyer clients to just make their highest offer.
I wonder what the agents that recommend this approach are thinking; don't you? If we assume that you write your contract without the escalation clause and write an offer instead for what your Escalation Cap would have been, you've done far more than just "Tip Your Hand"; you have made your offer at your Maximum. Do the agents that recommend this tactic think that the Sellers are going to counter back to you at a LOWER PRICE?!
Getting The Home You Want
- If the market conditions are highly competitive — a "Seller's Market" — or the particular property is head and shoulders above the rest, or both, you as a Home Buyer are likely going to find yourself competing for the home against other would-be home owners. Using an escalation clause will give you the chance to beat these others and buy the home of your dreams rather than experiencing defeat after defeat from stronger offers from other home buyers.
Paying Less: Buyers may not always be able to get a "deal" on a house, but neither do they want to pay thousands or tens of thousands of dollars over what would have been enough to secure the home. Using an escalation clause will continually bump up the price you pay, but only if there are other offers that trigger it. So it gives you, the home buyer, at least an opportunity to pay less for the home.
Escalation Clause Mistakes You Want to Avoid:
Using Too Low an Incremental Increase
Depending on the County, Zip Code and Neighborhood in Northern Virginia, home prices can and do vary widely for the region as a whole. The median sales price is in the low to middle $400,000 range. It’s important to understand how these values can impact the relative value of the incremental increase used in the escalation clause.
Probably the biggest and most common mistake specific to the escalation addendum is when buyers "squeeze" the incremental increases — making the amount of the increments too small to be of consequence and importance to the Sellers. Buyers in the Northern Virginia region seem to use $1000.00 increments more than any other value. This amount is seldom enough to sway Sellers when another offer has other terms that can and often do mean more to them than $1000 in Contract Price.
Make sure your increment value will be NOTICED! This will vary, but as a rule of thumb somewhere around 1% of the list price is a good starting point. This will vary and is why you will want to make sure your Buyer Agent has the Know How and very honed negotiation skills; they will prove invaluable to you.
ANOTHER WAY TO SAVE WITH OR WITHOUT AN ESCALATION
WE HAVE THE ONLY DOLLAR FOR DOLLAR
GUARANTEED HOME BUYER SAVINGS WE'VE EVER SEEN!
Not Considering the Other Aspects That Make a Strong Contract
Don't make the mistake of thinking the Highest Contract Price will always win. As mentioned above, other TERMS of a contract can often prove more valuable to the Sellers. As a Listing Agent, I have seen it happen time and time again. A Seller will select the 2nd, 3rd or even the 4th best Price in favor of the offer with the best other terms. Before submitting your CONTRACT make certain you review it objectively and in detail with your Buyer Agent. Look for its strengths, but more importantly its weaknesses, and improve them if you can.
You'll benefit from More Tactics Writing a Winning Offer to Purchase.
A Few of the Terms to Examine Closely for Weaknesses
- Closing Date: This is often very important to Sellers. Closing sooner might benefit them in a variety of ways. Check with your lender to see when the soonest possible closing date they would be comfortable with would be, as well as the longest amount of time for which you can lock your loan. Use this as your starting point, but make sure the Sellers are aware you are flexible if they would prefer more time.
- Contingencies: As a Buyer's Agent I always recommend my clients have a Home Inspection so they have a good idea if there are any major problems with the home. There are ways to make this contingency more attractive to the Sellers so you don't have to give it up.
- (A) Contact the Home Inspector you intend to use for your home inspection and find out how quickly they can typically schedule and perform the inspection. Ask for this number of days to conduct the home inspection. Shorter contingency time frames will make your offer more attractive.
- (B) In Northern Virginia the Home Inspection Contingency allows for the option of making it VOID ONLY. This means that the Buyer has the Option to VOID the Contract if they don't like the results of the inspection — but not to negotiate for repairs for items in the home inspection. This too will make most Sellers view your offer as stronger when compared to other offers that are Not Void Only.
- Down Payment: If you are putting down less than you can afford to, raise your down payment amount to the highest you are able. A higher down payment always makes a Seller and the Listing Agent feel more confident that the loan will be approved. If you are putting down 5% but could easily put down 10%,15%, 20%, or more, then do it.
- Make it Personal: Did you take the time to write a personal letter to the Sellers? A house that someone has called home is far more than just the biggest financial investment most people ever make; it's where they have lived their lives, raised their families, and made memories with friends, relatives and neighbors. For these reasons and more it's the most personal and emotional possession they will ever sell. Connecting with them on a personal level will put you way out in front of other home buyers that don't take this simple but very meaningful step. Time and time again I have seen Sellers accept the 2nd or even 3rd best monetary net in favor of a contract that included a personal letter to them.
- Using an Escalation Clause When the Seller Has Requested Highest & Best
Sellers will sometimes request that the offers be Best and Final or Highest and Best. This means the Sellers don't want to deal with escalation clauses. Instead, they are hoping to receive the Highest Prices that each buyer is willing to pay. Just because the Sellers request that Buyers write their offers this way, does this preclude Buyers from using an escalation clause? The short answer is No. As the Buyer you can decide to write your offer using one regardless of the Sellers' instructions. However...
The real question isn't "Can You?" — It's "Should You?"
By ignoring the Sellers' request, you might irritate or alienate them; you don't know for certain why they have asked for highest and best. If you choose to submit your offer with an escalation addendum it can easily work against you; they might ignore your offer completely and work with offers that followed their request. They might even use your escalation clause offer to counter to the other buyer(s).
If you choose to ignore this signal from the Sellers that they don't want an Escalation Contract make sure you consider that this could make your offer, even if equal in net to others, seem less desirable to Home Sellers and the listing agent as well.
Using Low Round Escalation Intervals & Caps
Choosing a low and/or rounded escalation increment is a HUGE mistake, and also a very common one. The mistake begins when the buyer's agent and/or the buyer believe that simply beating the next best offer will Win the Day and secure the home. While this "might happen," it doesn't happen nearly as often as you might think, and the smaller the difference between two competing offers the MORE likely that the lower offer will be the WINNER! As mentioned before, other TERMS of a contract may completely cancel out the value of an incremental increase in price to the Sellers. Obviously, the smaller the incremental increase, the MORE likely this will be the case and just as obviously, the greater the incremental increase, the less likely. An escalation or escalator clause is a powerful negotiating tool, but only when you use it POWERFULLY.
If you were the Seller of a home worth in the neighborhood of $400,000, $500,000, $600,000 or more, how much of a increment do you think would be SURE to sway you? If each offer had identical strengths and weaknesses, it might not take much at all — even a dollar might do it. That is the HUGE mistake — mentioned already — you don't just have to beat the other offer; you must beat it by enough to be meaningful enough to overcome any shortcomings the rest of your contract might have compared to your competitors' offers.
Most escalation clauses are written weakly, or meekly at best — not at all powerfully — with too low an increment to be MEANINGFUL to Sellers. The key to using an escalation clause POWERFULLY isn't just to be higher than other offers; it's to be meaningfully higher. When you write your escalation clause Powerfully, it will be a powerful tactic and tool to help you secure the home you want.
So how much of an increment is meaningful? There is no exact number that will be meaningful to every Seller. This aspect of strategy is much more art than it is science. For many Sellers, though, that tipping point seems to be about 1% or more of the List Price of the property (assuming your contract is relatively as strong as the next best net offer).
What about round Intervals and Caps?
Most contracts and escalation clauses seem to be written in round numbers. By writing your Increment and Cap near the next highest round number, your offer will stand out and also look different from the vast majority of offers. This is NOT a major advantage. It's more of a micro advantage, but when you are competing, you should use every tactic and advantage you can to tip the scales in your favor. So what constitutes a ROUND number? In the case of most properties, a round number will end with 3 or perhaps 4 zeros, not counting numbers to the right of the decimal place. For example, $1000...$5000 or maybe $10,000, with respect to increments or similar with respect to CAPS or initial CONTRACT Price. It's important to understand that this isn't to look "different" just for the sake of being different; it is different and stronger than most offers are written and so sets you apart from others with a more powerful offer.
Example: You've found a home you want to call your own. You've examined the neighborhood and compared other recently sold properties with the help of your Buyer Agent, and you've decided to use an escalation clause in as powerful a way as you can, including using a higher, NON-rounded contract price, increment and cap. If you had decided to use the more common rounded numbers, your offer might look like the ORIGINAL in Table 3, but you've opted to use the micro-advantage of the non-rounded higher tactic. so your offer might look more like the IMPROVED version.
When you compare the Original with the IMPROVED, the improved might cost you as much as $2,895 to $2,950 more than the Original. If financed with a 30 year mortgage at 4.25% , that's only $14.51 per month. The IMPROVED version is, however, substantially stronger than the ORIGINAL, and based on how most buyers structure their Escalation, it will be much stronger than those as well. (But DON'T forget to look at the Strength of the rest of your offer.)
Using an escalator clause with this strategy is Not designed to make sure you pay the absolute Least for the house. Its intent is to make sure you have the best chance of Defeating other Contracts FIRST and then hopefully still saving some money. The losing competitors for the House Save the Most Money, but they still don't have a House.
Recap and Conclusion
An Escalation Clause can be an effective and powerful strategic tool to give home buyers an advantage over competing offers, when used correctly. Remember that it is only One Tool and other TERMS might be more valuable to the Sellers than just a few thousand dollars in Sales Price.
Make sure, whether you are Buying or Selling a House, that your agent is fully comfortable with and has strategies for using and responding to contracts with escalation addendums.
This information about "What an Escalation Clause is and How to Use it" is brought to you courtesy of Dave Martin Realty Group, your Northern Virginia residential real estate experts. If you're considering selling or buying a house in the Northern Virginia metro area, we'd love an opportunity to earn your business, provide you an outstanding experience, and demonstrate to you that:
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Disclaimer: Nothing offered here should be considered Legal, Financial or Accounting Advice. Each individual situation is unique and you should consult an attorney or other licensed professional for advice on your particular situation.