What is an Escalation Clause?
In a hot real estate market like Denver, home buyers have to occasionally take that extra step to get a leg up on the competition. For some, that means adding an escalation clause to the offer sheet.
Prospective homeowners in Denver who are looking to buy in the $400,000-$599,000 price range discover low inventory and/or properties that go under contract quickly. According to the Denver Metro Area Realtors statistics, the average price for a home in April 2021 (both single-family homes and condos) was $526,000 and stayed on the market for an average of 13 days.
In other words, if you find a house you like, be prepared to act fast.
Including an escalation clause in your offer has become commonplace as buyers vie to gain favor with the home seller. It’s important to understand how an escalation clause works and what your comfort level is when it comes to the final offer.
How to Increase Your Chances of Getting Under Contract
When do you use an Escalation Clause: When a house is expected to receive multiple offers, an escalation clause is often enacted by a homebuyer.
What is an Escalation Clause: It is a statement included in a purchase offer for a home that’s intended to ensure the buyer is the highest bidder. The key to the escalation clause working properly is the likelihood of multiple offers.
There are typically two parts to an escalation clause: the amount to which you are willing to increase and the increments by which you are escalating.
For example, Buyer 1 will increase the bid by $1,500 over the highest offer up to X amount. Two prospective buyers could have the same maximum bid but whoever has the highest designated increment increase will win the bid.
The downside of using an Escalation Clause: if the contract price becomes higher than the home’s appraised value, the home might not appraise. Keep in mind, your mortgage lender will only loan you the amount for which the home appraises. As a result, you may have to bring cash to closing to cover the difference.
The good news for the buyer is this tactic eliminates the back-and-forth of counteroffers; the bad news is it may put more money in the hands of the seller since they’ll know your top price.
Home Sellers Need to be Aware of the Risks
The escalation clause can also work against the home seller.
For example: A house is listed for $400,00 and there are three bidders. One Buyer offers $380,000. The Second Buyer offers $385,000 with an escalation clause that could go up to $410,000 in $5,000 increments. Buyer 3 offers $390,000. In this scenario, the seller would get $395,000 from Buyer 2 since the $5,000 escalation clause kicked in with Buyer 3’s offer.
But, had the seller not relied on the escalation clause and instead asked the bidders for their best and final offers, he/she might have sold the house for more than the asking price. Buyer 2 showed their hand with $410,000 and the seller is now getting $15,000 less than if they had opted for counter-offers or a flat-out highest bidder.
Be Aware of How an Escalation Clause Will Impact Your Finances
Before considering an escalation clause, it’s important for the potential buyer to have a budget. Knowing how much of a loan you can secure and at what interest rate may limit your offer. By escalating the offer, you may end up risking your chances of qualifying for a loan or may be required to produce a larger down payment. Furthermore, you must have confidence that the appraisal of the home will match the offered price.
If you offer an unlimited escalation clause, keep in mind it’s a very aggressive tactic. It requires the listing agent to come back and speak to you even if there are dozens of offers. They may counter your offer with a new list price so you won’t be under contract until you sign a counteroffer. But if you have extra cash to spare, utilizing an escalation clause can be a fruitful way to get under contract.
Make sure you sit down with your Usaj Realty broker and discuss the pros and cons of escalation clauses. Your broker should get a bead on the seller and make sure this provision will work in your favor. Lastly, the language in the escalation clause should be very clear and indicate when it will be enacted.
Research Comparable Sales in the Neighborhood
It goes without saying having access to comparable sales of homes in the neighborhood is crucial to making a solid offer, much less one with an escalation attached to it. Your Usaj Realty broker is well versed in multiple offer situations and will help navigate the best strategy for you.
Usaj Realty is a boutique real estate brokerage firm specializing in Denver’s most popular neighborhoods. We help our clients find everything from the classic vintage home to a more modern condo. For more information about buying or selling a home in Denver, please contact us at 720-398-2999.
(Editor’s note: This blog was originally published in January of 2020. It has been edited and updated to provide current information).