How Escalation Clauses can Drive Up the Purchase Price.
Escalation clauses have become the norm in the Seattle area real estate market, especially in the most desirable neighborhoods. They are are a boon for sellers but can be a bane for buyers. While the offer price is never the only criterion in evaluating an offer, it is the most important. With multiple offers, it is helpful to create a spreadsheet to compare all aspects of each offer.
What is an Escalation Clause?
An escalation clause is an addendum to the Purchase and Sale agreement. The escalation addendum states that the buyer offers an incremental amount over the next highest offer up to a maximum purchase price. For example, a buyer offers to pay $3,000 over the next highest offer up to a maximum price of $550,000. Obviously, the maximum price of the escalation clause is higher than the listing price and higher than the offer price stated in the Purchase and Sale Agreement. Below is a real-world example.
Round 1: Multiple Offers without Escalation Clauses.
For the sake of privacy, the names of the buyers and the dollar amounts have been changed. There were four offers and two had escalation clauses. But what if there had been no escalation clauses? What would have been the outcome? The listing price of the home was $518,000.
Escalation clauses aside, the price isn’t all that matters – closing date, the amount of earnest money, and the downpayment can influence the seller’s pick. With that in mind, let’s pretend you are the seller.
Earnest money was more than average except for one. Offer expiration dates were similar but two sought quicker replies. Closing dates did not vary by much. Three offers specified an inspection report within 5 days (10 days is the default). Garcia waived the inspection because they had done a pre-inspection (good move). Financing was all conventional (no FHA, VA, etc.). All offers included a pre-approval letter from a reputable lender. All had acknowledged receipt of the Seller’s Disclosure and one waived the right to withdraw the offer based on it. Even though Schuster made the highest offer, based on all the factors, Garcia’s offer would have been accepted. With no escalation clauses, Garcia’s purchase price would have been $522,000 – $4,000 over the list price.
Round 2: Two of the Four Offers Included an Escalation Clause.
This eliminated Wang and Schuster. Now it’s just Smith versus Garcia.
Smith was willing to pay as much as $543,000 for the home and offered to pay more than $3,000 than the next highest offer up to that amount. Garcia’s maximum amount was $550,000 with an incremental payment of $2,000 over the next highest offer.
Since Smith was offering a maximum amount of $543,000, Garcia was forced to beat that by the stated $2,000 increment, amounting to $545,000! Playing by the rules, the seller also revealed to Garcia the Smith offer. This gave Garcia the opportunity to see that the Smith offer was not as good as it concerned the terms, such as inspection contingency and appraisal clause. The Garcia offer included language saying that if his lender’s appraisal should come in lower than the offer price, he would make up the difference. The seller liked that a whole lot.
With no escalation clauses among the four offers, the seller may have taken Garcia’s $522,000 offer – $4,000 over the listing price. Since there were two offers with escalation clauses, Garcia paid $545,000 – $27,000 more than the listing price.
What if Garcia’s offer would have been the only one with an escalation clause?
Had the Garcia offer been the only one with an escalation clause, Garcia’s offer would have beaten the highest offer (Schuster) by $2,000 and Garcia would have paid $525,000.
If you concluded that making the right offer in an escalating housing market is not for the faint of heart, you would be correct. An expert real estate agent who deserves your trust can protect you from paying too much. In the above example, I had the better but not necessarily easier role. I represented the seller.
Waiving the Appraisal Contingency
Offers that rely on the financing of part of the purchase price require an appraisal from the lender. The Purchase and Sale Agreement includes an appraisal clause that stipulates among other things that the buyer may rescind the agreement if the appraisal is lower than the agreed-upon purchase price. The seller, on the other hand, has the opportunity to accept the value arrived by the appraiser as the purchase price. In a market with very low inventory, some buyers waive the appraisal clause when making an offer, as Garcia did in the above example. In that case, the quality of the lender and the size of the down payment become even more significant.
What one of Gerhard’s clients said
After my first home purchase with Gerhard, I remarked how he had redefined for me what excellent service meant. Since then, he’s helped me purchase another home. He also sold my Redmond home in record time. His marketing skills are exceptional. Frankly, I don’t understand why he doesn’t list another home every week.