Agents Decoded: Escalation clauses are not a magic bullet
A practice that became common when the market heated up may have run its course, observes veteran broker Phil Faranda.
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During the pandemic, escalation clauses became more common as the real estate market overheated, and they remain a frequent practice in most places where inventory is low — which is to say they are seen virtually everywhere.
The idea is that a buyer can present a stronger offer by indicating they will increase their offer amount if they are outbid by a competing offer. For example, an escalation clause might state that if a bona fide offer comes in higher than the offer submitted, the buyer will raise their offer automatically by $5,000 over the higher offer.
Sometimes they are clever due to the confidential nature of highest and best bidding wars, but they are not the cure-all some agents think they are.
When escalation clauses can help
The first escalation offer I can recall was a sale I made in 2012. The house was a rare offering, the market was finally recovering, and the winning bid promised to be $2,500 higher than any superior offer. The listing was sold for about $40,000 over asking, and that clause made the difference for the buyer who ended up getting the house. That buyer was also paying cash, so it was a particularly strong proposal.
When the market heated up around 2020, escalation clauses were added to offers far more often. Not many listing agents understood them well enough to convey the message to their seller clients as effectively as they could have, but by 2021, most agents grasped the mechanics.
Unfortunately, some of us know them a little too well. Yes, escalation clauses are no longer viewed as obscure or a gimmick, but they aren't always the answer.
… and when they can't
Here are three scenarios where escalation clauses may not be as effective as the presenting agent expects:
There is more than one offer with an escalation clause. If a property has multiple offers and more than one has an escalation clause, it can create too much noise for the seller. Yes, one escalation clause can promise $10,000 more than the competition whereas others are $2,500 or $5,000, but that does not negate other terms. Speaking of other terms…
Other terms are not as competitive. If the seller of an $800,000 house has an $825,000 cash offer, and a competing offer has an escalation clause of $10,000 over best — but their down payment is only 5% or 10% — that bump up may not help, because the certainty of a cash buyer is superior to that of a highly leveraged loan contingency. To say nothing of…
The house may not appraise. If the appraised value comes back low and the buyer is cash-poor, they may want the seller to eat the difference. The lower the down payment, the less punch the escalation clause will pack.
Some sellers are wary of escalations
It has gotten to the point where some listings will state that no escalations will be entertained because other aspects of an offer are seen as more compelling.
We recently had a multiple-offer situation on a listing where the winning bid was chosen because it had a high down payment and waived the appraisal contingency. An offer with a VA mortgage came in with an escalation clause, but VA mortgages are 100% financing, or zero down. That might have gotten the seller an additional $5,000, but the risk of going to contract with a buyer with no cash to cover an under-appraisal was not palatable for the seller.
The buyer agent was unhappy about this, and I do appreciate the uphill battle VA buyers face, but that agent did not have an answer for the possibility of an appraisal problem.
Contingencies and other terms can carry more weight
Terms are the achilles heel of escalations. While escalations can virtually guarantee the highest price if they don't have another clause to compete with, the terms are still tricky. A high down payment, flexible closing date, and appraisal and other contingencies are still crucial to sellers, and the devil in those details can't be made bulletproof just because a buyer adds an automatic price increase.
Moreover, that higher price can exacerbate the terms question, especially in high loan-to-value purchase mortgages.
Escalations can indeed make a difference for a buyer competing with other offers. But they aren't a panacea, and agents need to educate their clients and explain that the clause isn't a magic wand.
J. Philip Faranda is a manager and associate broker at Howard Hanna | Rand Realty serving Westchester and Putnam Counties, just north of New York City. He was previously a broker-owner at J. Philip Real Estate, the top independent brokerage in the two counties by transaction sides, which he founded in 2005. He also writes a real estate blog which has been cited by major media outlets. The views expressed in this column are solely those of the author.