Escalation Clause: A Guide
Transcript:
Ryan Renner [00:00:00]:
Let's talk about escalation clauses. What is it? When is it used? What are some pros and cons? And also, when you shouldn't use it. My name is Ryan Renner, and I'm a real estate agent in Omaha, Nebraska with Better Homes and Gardens Real Estate The Good Life Group. Now before I go into too much detail, I want to say that this applies specifically to the Omaha, Nebraska market. Every market is different, so don't rely on this video if you are purchasing a home in a different area. Talk to a local real estate agent or an attorney. So what is an escalation clause and when is it used? An escalation clause is an addendum or a clause that is added to a purchase contract. It's sometimes more formally called multiple offer addendum, but most people know it as an escalation clause.
Ryan Renner [00:00:54]:
An escalation clause is used when there are multiple offers on a property. It's as simple as that. If there is a bidding war, you might consider using an escalation clause. The goal of the escalation clause is to help a buyer beat out other offers but not pay too much. It's a tactic to prevent a buyer from bidding against themselves. Let's take a look at what exactly an escalation clause looks like. Here is an example of a multiple offer addendum or escalation clause. So I filled in this in a few spots already.
Ryan Renner [00:01:27]:
You'll see it in the yellow highlights. So let's talk a little bit about it. So this top portion right up here just tells you when the addendum is, you know, added and what the address of the property is. The important stuff to note is going to be right here. So you've got $1,000 and $320,000. So in this example, let's just say the house is listed for $300,000 and on the purchase offer, the purchase contract, this person wants to offer the list price. So their offer is for $300,000. But in the event of multiple offers on this property, the buyer will match a competing net offer.
Ryan Renner [00:02:15]:
So the purchase price minus seller paid costs for competing buyer, and increase the offer, the net offer, to the seller by one $1,000 up to a maximum purchase price of $320,000. A caveat. If the competing offer waived a home warranty, the buyer will also waive the home warranty. And this is also important. This last bit here says upon successful acceptance of this offer, the seller is to disclose or show proof that there was a competing offer before the final acceptance by the buyer. If the seller is unable to disclose or show proof of said competing offer, the buyer is no longer bound by this addendum at buyer's option. So they have the option to get out of the contract or they can stay in the contract. So this is a little bit complicated, some sort of legal phrases.
Ryan Renner [00:03:16]:
Let's take a look at this in a more practical way. So let's use a hypothetical situation. You found this house right here and you love it. You've talked to your real estate agent, and it's listed for $300,000. So the list price at $300,000, You've talked to your agent and decided, I love this house, so I'm going to offer, up to 320,000. So your offer on the purchase contract, you decide, is going to be the List Price. But you're including an escalation clause that says I'll beat any other offer by $1,000 up to $320,000. So this is your offer right here.
Ryan Renner [00:04:00]:
Now, there are 3 other offers on the property. One common question I get asked a lot from buyers when there are multiple offers is, what are the other offers? Well, you're not going to know that. In this scenario that we're going to talk about, we'll just assume that we know what those other offers are, but we generally are not told what the other offers are. In some cases, you might know, but 9 times out of 10, you're not going to know what the other offers are. You may know how many offers there are. You may know a ballpark of we have several offers, but you may not always know how many offers there were and definitely not what the offer itself was. So in this scenario, we know that there are 3 other offers. And offer number 2 is also going to offer 300,000 let's just assume that all these other offers are offering $300,000 and they're gonna utilize an escalation clause as well.
Ryan Renner [00:05:01]:
This other offer, offer number 2, said, you know, we'll escalate up to $305,000. Offer number 3 says we really, really like it. We're gonna do $309,000. And I guess offer 4 decided, Okay. We're just gonna stick with list price. We're not gonna do an escalation clause. So in this scenario, with your escalation that went to 320,000 beating any other offer by $1,000, you would be selected and you would win this property for $310,000 because the next highest offer was $309,000. So you were willing to pay up to $320,000, but you are selected for $310,000 and the sellers provide you a copy of the competing offers that show that there was another offer in hand that will escalate yours to $310,000.
Ryan Renner [00:06:03]:
Now, the reason an escalation clause is so useful is, let's say you didn't use an escalation clause and you just said, My offer is going to be $320,000. So you love the house, you don't use an escalation clause, you're gonna spend $320,000 and let's keep all the other offers the same. So your offer gets accepted for $320,000 because you're under the impression there are other offers, 3 other offers. You want to beat them out. You want to be selected. But you might have overpaid because the next highest offer was 309,000. And you put in an offer for 320,000 when you had an opportunity to use an escalation clause and pay potentially $310,000. Now, we are making some assumptions in the scenario that all of these offers are equal, meaning they're all, you know, let's say they're all cash or they're all financed or something like that.
Ryan Renner [00:06:59]:
Because we'll we'll talk about this a little later. Just because you're the highest offer doesn't mean you're going to get selected because not all offers are the same. Every offer is different. The contingencies, the different things that are included, the amount of down payment, cash versus finance, will dictate partly what offer gets accepted, not just the purchase price. There are some potential downsides to an escalation clause. For 1, when you use an escalation clause, you are, in essence, telling a seller just how much you're willing to pay for a home. Now that might not necessarily be a bad thing, but a listing agent could see that number and try to negotiate that you pay that number without providing any evidence of competing bids. Now, Realtors are bound by a code of ethics that forbids them from lying about offers, but that doesn't prevent a real estate agent from using vague, flowery language that implies that there are multiple offers.
Ryan Renner [00:08:00]:
So it's important to work with an experienced real estate agent that knows how to navigate this type of situation. Now here's a real world example of a situation like this. Now this was about a year ago or two, so the details aren't exact. I had a listing that had a fair bit of activity and interest, and we received an offer. That offer had an escalation clause in it. So let's use some round numbers and say that the house was listed for $300,000 and the buyer was willing to pay 300 and escalate to 310, so beat any other offer, by 1,000. We had no other offers. This was our only offer.
Ryan Renner [00:08:42]:
And so I talked to my seller, and we decided to go back to the buyer's agent and say, Listen, we don't have any other offers. I'm being told by other agents that they're planning on writing, which was true. But we like your offer. The offer's clean. And my seller is sick of having to round up the kids, round up the dogs for showings, and just wants this to be over with. Your buyer is interested in escalating to 310. How about we send you a counteroffer for 305,000, which is 5,000 more than the list price, but it's 5,000 less than your seller is willing to pay? And if the buyer agrees, we'll stop the showings and we'll be under contract. And the buyer agreed.
Ryan Renner [00:09:26]:
We got the home under contract for $305,000. And the home closed. Both parties were happy. Now, did the buyer potentially overpay? Maybe. But we might've gotten an offer 2 hours later that would've escalated them higher or kicked them out of contention completely. And then you can ask yourself, well, did the seller get less than what they could've gotten if they waited for more offers? Maybe. Maybe not. I educated the seller about the situation and explained all the hypotheticals.
Ryan Renner [00:10:00]:
And they were hypotheticals. And the seller was ultimately comfortable with the decision. The second risk is some listing agents just don't like seeing offers with escalation clauses. A lot of agents wanna see a clean offer with no additional addendums that just lists what the buyer is willing to pay and not, you know, willing to pay this, but escalate to this. So let's go back and take a look at another scenario. Similar scenario. The house is listed for $300,000 and we know there's 3 other offers. Let's say on that $300,000 home, you love it so much that you're going to put in an offer that escalates to $400,000 because you have a preapproval letter from your bank that says you're approved to $400,000.
Ryan Renner [00:10:51]:
If only it was that easy. In that preapproval, it will say something along the lines of the home is to appraise at or above the purchase price. Any time you are using an escalation clause and financing the purchase, you need to keep in mind the appraisal. The bank is loaning you a bunch of money and it is using the home that you wanna purchase as collateral. They're not gonna give you $400,000 loan on a home that's worth 300,000. Now I'm making this example really extreme just so it's a little bit easier to understand, but the real world cases are not quite this extreme. For example, the bank won't loan you $301,000 on a home that appraises for $300,000. If you have the bare minimum amount of cash needed to close, you're not gonna be able to cover an appraisal gap.
Ryan Renner [00:11:44]:
Now it doesn't mean you can't use an escalation clause. You just can't use it alongside an appraisal gap coverage. So what exactly is an appraisal gap coverage? So in a hypothetical, let's say that you are under contract for a home for $320,000 but the appraisal comes back at 310,000. Now in this scenario, a couple of things could happen. It really just depends on what was included in the purchase contract to begin with. But if I have a listing and it's listed for $300,000 and someone says, I'm going to escalate it to 3.20, my first question is, well, do they have the cash on hand to cover if there is a gap in the appraisal? So before I tell my sellers to accept an offer that with a large escalation, I'm going to check and see, Okay, how much money are they putting down on the property? What does their cash on hand look like? Etc. And also, what is my level of confidence that the home could appraise for that amount? So in this scenario, with a $10,000 appraisal gap, the buyers could bring extra money to the table. The bank will let you purchase that home for $320,000 even though it's only worth $310,000 according to the appraisal if you're putting a bunch of money down.
Ryan Renner [00:13:05]:
You have to cover that $10,000 and also cover the normal down payment and closing costs. If you only have enough money to cover the down payment and closing costs and don't have any extra money sitting around, you're not going to be able to cover an appraisal gap. Now, in an offer, you're going to use verbiage that says something along the lines of, The buyer is willing to cover a gap in the appraisal up to $10,000, something along those lines. This is not exact verbiage. Don't use this exact verbiage, because you also want to say, we'll cover up to $10,000 appraisal gap up to and including the purchase price, something along those lines. So including an appraisal gap coverage addendum verbiage in your offer makes your multiple offer addendum, your escalation clause, stand out if there are other offers? Because it's basically guaranteeing to the seller that no matter what that appraisal comes in at, they're going to be able to sell you the house at a certain amount. Now, I'm going to try to do another video about the appraisal gap coverage, the concept, and what happens. I don't want to spend too much time on it, but know that you cannot just escalate an offer to whatever amount you want.
Ryan Renner [00:14:27]:
You have to keep, certain parameters in mind. Now if you're purchasing the home with cash, you can spend whatever you want. You don't really have to worry about an appraisal. You could put an appraisal contingency in the offer, but most of the time with cash offers, they don't include that. So when should you not use an escalation clause? Don't use an escalation clause if there aren't multiple offers on a property. It's as simple as that. If the home has been listed for a while or had a price reduction or two, you don't usually need to use an escalation clause. Also, if you are the 1st person to get an offer in on a property, I generally don't recommend including an escalation clause.
Ryan Renner [00:15:07]:
Now if the agent calls back and says they have more offers and they're gonna review them altogether, you could then say, we're gonna amend our offer and we're gonna include an escalation Like I mentioned a little bit before, the highest bid doesn't always win. So you need to keep that in mind. Just because you are the highest bid doesn't mean you'll get selected. There are a lot of variables that go into an offer. Every offer is different. No 2 offers are alike. A seller may select a lower offer because they are waiving a home inspection. Or they can close on a preferred date.
Ryan Renner [00:15:40]:
Or it's cash. There are a ton of different variables that go into writing an offer. So it's important that you work with an experienced agent that can guide you on writing the cleanest, most competitive offer that you can. I really hope you found this video useful. Thanks so much for watching, and please reach out if you are in the Omaha area and are looking to buy or sell a home. And please check out my other videos.
