Real Estate Escalation Clauses
Buyers are often looking for any slight edge that may give them an advantage in getting an offer accepted. One strategy that has worked for many is what is referred to as an escalation clause. Sometimes these are also referred to as “sharp” or relative bids. These are all the same.
The following comments and examples are applicable in CA and may not reflect common practice in other states or your specific situation so it is best to consult a local Broker or attorney with questions before trying this strategy.
Why Are Escalation Clauses Used?
If you’ve ever received a seller counter offer asking for your “best and final” purchase price you most likely felt like you were asking to bid against yourself. Sure, you can offer a crazy high price and hope to get into escrow, but you’ll never know by how much you overpaid. One way to insulate yourself from that outcome is to use an escalation clause.
Escalation clauses in real estate contracts stipulate that the buyer will pay a fixed amount above the otherwise highest offer a seller has received. Utilizing an escalation clause can make your offer competitive and when successful also save you money. This is a great strategy to be the winning bid but only by the minimal amount to beat out everyone else.
You might reasonably ask why, if this is such a great strategy, everyone doesn’t use it and that will be discussed in this article.
The Escalation Clause Format
The basic format is very simple and can read as follows:
“Purchase price shall be $1,000 higher than the highest competing offer.”
For luxury Real Estate in very competitive markets, most likely just going $1,000 above the highest competing offer is probably not enough. In Manhattan Beach, for example, where the median sales price is currently in the mid two millions, a Buyer might have to be $20K or higher than the next highest offer but in Redondo Beach which is also expensive but lower priced than Manhattan Beach or Hermosa Beach, and escalation of $5-$10K higher might be more appropriate. A good rule of thumb in many situations is that the escalation clause to be effective should be around 1% of the purchase price depending on the price point in the market (but no less than $1,000).
The example is the simple version of the format and there are many variations including that the clause is only applicable for “bona fide competing offers disclosed to the Buyer”.
Verification of Next Highest Offer
Trust but verify.
A buyer or their agent should be able to verify that the offer or offers upon which the escalation clause is premised, were real or bona fide offers.
The clause might include language such as: "Seller shall provide buyer with a copy of the highest offer received.”
In some instances, there might even be a language such as “Buyer has a right to contact the competitive purchaser making that offer, or their agent, to verify the validity of that offer.” Going that far is most likely a good way to not have your offer with an escalation clause accepted.
An intermediate step might be to include language to protect a Buyer such as “final purchase price shall be at the sole discretion of the Buyer.”
Many listing agents don’t like sharing competing offers because they don’t want to have the reputation of “shopping” offers. However, unless there is a confidentiality agreement in place, offers themselves are not necessarily confidential. In fact, it is the listing agent’s job to get the highest possible price for their Seller as long as the means they employ are legal and ethical.
You are also likely to see a competing offer with the Buyer name and Agent name redacted. In that instance, you are relying on the honesty of the Seller or their Broker.
Should There Be a Ceiling and a Floor?
Yes to both. You definitely want to have a maximum price or ceiling and to stay in the negotiations, stating a price you will pay can only help.
Let’s look at the ceiling or cap first.
The purpose of the cap is to set a maximum price the Buyer is willing to pay. In some regards this can defeat the purpose of the escalation clause because the idea is to get the offer accepted and not lose out on the home you want because of let’s say a $10K differential that you otherwise would have paid.
Often, however, when the Seller sees the maximum, they might counter with that price.
If two buyers each offer $5,000 over the next highest offer, then in theory the purchase price is infinity. So a good practice is to state the highest price that the Buyer would be willing to pay.
“Purchase price shall be $5,000 higher than the highest offer but no greater than $1,750,000”
Likewise, Sellers like to know a minimum a Buyer is willing to pay. And arguably without a stated price there may not be a valid contract. Hence the concept of a floor.
One of the risks with the floor, or minimum bid, is that if no other price matched or exceeded the floor price, then the Buyer would wind up paying more than necessary. One of the objectives of using an escalation clause is to prevent that.
“Purchase price shall be $1,740,000 or $10,000 higher than the highest competing offer”
When in the Negotiation Process is the Escalation Clause Used?
Sometimes they are included in the offer (R.P.A) but it is more common to see the escalation clause used when a Buyer receives a Seller Multiple Counter Offer (SMCO). If the Buyer receives a single counter offer, (S.C.O.) then by definition there is no competing offer.
If the plan is to include it in the initial offer, that should only be done when it is certain that there are multiple offers.
Are Escalation Clauses Legal?
Per the California Association of Realtors (C.A.R.) “generally yes, when drafted properly. Escalation clauses can be used to create a binding contract.”
That being said there are brokerages that have adopted policies discouraging the use of escalation clauses or in the instances they are allowed agents may not draft them and the buyer may be advised to use their own attorney to draft such clauses. As a best practice, whenever language is used that substantially deviates or changes the pre-printed C.A.R. forms that agents are trained in, it would be wise to consult with a Real Estate attorney.
What You Need to Know
If you are a buyer losing out in multiple offer situations while watching prices go up and inventory shrink, using an escalation clause may help you get the home you want but they don’t always work because:
Another Buyer may have have a higher escalator or floor than you do.
The listing Agent or Seller may be reluctant to disclose competing offer.
The listing Agent or their brokerage may discourage use of these clauses.
The final negotiation to accept the escalation requires more time and another step in the process delaying opening escrow.
Unless you ask for written verification of the competing offer you are escalating from, you are taking the risk that you will pay the maximum in your cap.
Putting It All Together
“Buyers best and final purchase price shall be $2,000,000.
However if Buyer’s Best and Final is not the highest offer, Buyers shall pay $25,000 more than the highest bona fide competing offer disclosed in writing to the buyers with a final purchase price not to exceed $2,050,000.
Verification of the validity of the competing offer is at the sole discretion of the Buyers.”
In Closing
If you are thinking of using an escalation clause as a Buyer you should discuss it with your agent or where appropriate a Real Estate attorney.
The purpose of this article is educational and to provide “food for thought” and you should not rely on this information as your situation might be very different than what is depicted here.