The escalation clause is used by home buyers who are competing with other buyers in a multiple offer situation.
In the Greater Washington DC area, buyers are competing for houses on the market near a Metro station, shops, and restaurants. In Arlington Virginia, where the Amazon headquarters will soon be located, the competition is tough. Last week, we submitted a contract on a one bedroom condo in Arlington and ours was one of twelve offers! We included an escalation clause which looks something like this;
Sales Price $350,000 with an escalation factor of $1000 and a cap at $365,000
This means the buyer will pay full price and beat out any other offer by $1000 up to $365,000.00 In addition to the escalation clause, the buyer has to decide if they should keep the appraisal contingency in place or if they have the money to waive the appraisal contingency.
The appraisal contingency protects the buyer in the event that an independent appraiser says the house is not worth the agreed upon sales price. Here's an example:
Sales Price $350,000 (this is the agreed upon price by seller & buyer)
Appraiser, sent by the lender's office, evaluates the property and appraises its value at $325,000.00
The lender will only lend the amount of money the appraiser says the house is worth
In this situation, if there is an appraisal contingency in place, the buyer can go back to the seller and say lower the price or the seller and buyer may agree to split the difference or any combination they agree on. If they do not come to an agreement, the buyer can get out of the deal, using the appraisal contingency.
If the buyer has waived the appraisal contingency, they would have to make up the difference ($25K in the above example) in cash. To be clear, a buyer should never waive the appraisal contingency if they do not have the cash!
One of the pitfalls of an escalation clause is the fact you are showing the seller how high you are willing to go with your offer.
In most contract negotiations that include an escalation clause, the seller and listing agent counter the buyers agent and buyers offer by showing the competing contract that triggered the escalation. Here's an example:
Offer 1 Sales Price $200,000 with an escalation factor of $1000 and a cap of $225,000
Offer 2 Sales Price $200,000 with an escalation factor of $1000 and a cap of $230,000
Seller chooses Offer 2 since during negotiations Offer 1 capped at $225,000 and Offer 2 escalated to $226,000 ($1000 factor over other offer)
This is a basic example showing how the escalation clause works. However, some sellers and listing agents will ignore the escalation clause and counter a buyers offer with their escalation cap. In a recent negotiation, the listing agent said there was another buyer who would go higher but did not prove this statement by showing the other offer. This scenario creates
A Bitter Buyer
If this happens, you have a couple of options.
- As the buyer, you can accept their counter, knowing that you will have to make up the difference between the appraised value and the sales price.
- Counter their counter offer with a lower sales price (lower then your cap) and make up the difference between the appraised value and the sales price
- Or counter with the escalation clause and say, "if you have another offer that will go up to our cap, then prove it."
In our recent contract negotiations, the seller and listing agent did not have another offer that would go as high as our cap. Our buyer got the property fair and square, using the escalation clause and paying $1000 over the other offer.