What is an escalation clause?

An escalation clause is a clause put into an offer to buy a property by the buyer that says the buyer will pay “X” more than the best offer received by the seller. It usually contains a cap. Are they a good strategy for a buyer? I don’t think so. Here’s why.

The buyer’s agent thinks an escalation clause will narrow the gap between what his client will end up paying and what the next best offer was in a multiple offer situation.

For example, the client has a maximum price in mind of $ 600K but doesn’t want to overpay. An escalation clause indicating that buyer is willing to pay $ 5K above the highest offer would mean that if the next best offer was $ 550K, the client would only pay $ 555K instead of $ 600K. That seems sensible for the buyer, right? Well, I think that’s completely wrong. Instead, the buyer has disclosed their bottom line and a savvy seller will take full advantage of it.

By specifying in the offer itself that the buyer is willing to pay up to $ 600K, the buyer is now negotiating from a position of weakness. Why would a seller ever accept an offer for $ 555K from someone who has clearly stated they are willing to pay as much as $ 600K? The smart seller will either counter the offer back at full asking price, or send all offers back and tell the buyers to come back with their best price.

So then, an escalation clause is good for the seller, right? After all, they now know what that buyer’s top price is, and assuming it is the best offer, they can take advantage of it and get top dollar. What’s wrong with that?

Well, if I am acting for the seller, the escalation clause  adds uncertainty to the buyer’s offer. Instead of being able to accept an offer, my seller has to counter back. That applies even where my client accepts the escalation clause amount , because we have to change the purchase price on p. 1 of the Agreement of Purchase and Sale to reflect whatever calculation resulted from its use, and that’s considered a counter. The buyer can then either reject our counter or counter back, and we’ve now rejected all the other offers as we can only counter back one.

Accepting the buyer’s offer also implicitly tells the buyer that the next best offer was $5K below theirs, which is a breach of our Code of Ethics not to disclose the contents of a competing offer.

If I had a close offer with no escalation clause and one with the clause in it, I’d recommend my clients take the one that didn’t have the clause, particularly if the offer was conditional. One issue I see with accepting an offer that has an escalation clause in it  is that the buyer now knows they were $ 5K ahead of the other buyer (in my hypothetical) and may use that knowledge to try to wrest concessions in price over financing or the home inspection.

Our manager says an option for us is to simply strike out the escalation clause and send the offer back to the buyer with their maximum amount written in as the new purchase price. That gets around any disclosure issues, but it is still a counter and I don’t like counters because they mean we may not have a deal.

Overall, in a multiple offer situation, I think every buyer should come in with their best offer upfront. Now that these clauses are creeping into the business, I  may well get my sellers to sign a Form 244 (Seller’s directions for sale) saying that they will not entertain any escalation clauses in offers and that they do not want to see any offers that contain them. That would force buyers to bring their best offer in from the start and without the uncertainty and ethical issues around the use of these clauses.

(Besides, I can’t even imagine what might happen if you had a whole bunch of offers with each one containing an escalation clause: it would be a real Rubik’s cube trying to sort out whose offer was best. Again, I think I’d send them all back and tell them to come back with their best offer so we can make a decision.)

Our brokerage does not recommend the use of these clauses, by the way, they think they will cause all kinds of problems, and I agree. For our governing body’s position on them, see this link to RECO’s recent article, What you need to know about Escalation Clauses. 

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