Bricktionary

What is an escalation clause and what are the risks?

By Donna M. Airoldi | April 26, 2021 - 12:30PM 

An escalation clause isn’t a common strategy in the current market, but here's what to know if conditions change.

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If you bought an apartment in New York City six or seven years ago, when the market was very competitive, you may have heard of buyers using an escalation clause. This is a creative strategy brokers use to make sure its their buyers that get the winning bid as competing offers come in.

As a buyer, an escalation clause automatically increases your offer by a certain amount, say $5,000, each time another buyer makes a higher bid. It’s the real estate version of eBay and essentially eliminates the back and forth of offers and counter offers. 

It can help get you the apartment you want, assuming a higher offer doesn’t exceed your maximum offer. However, there are risks involved. For example, you reveal your hand to a seller by indicating you are willing to go higher than your original bid. 

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There’s also the risk that a top offer might exceed the appraisal value, and you might not be able to get financing at the higher price. As a seller, you risk selling at a price lower than what might be generated by simply waiting for other offers or asking for a buyer’s best and final offer.


[An earlier version of this article was published in August 2018 and has been updated with new information for April 2021.]


Kobi Lahav, director of sales at Living New York, says he’s never used the strategy although he’s familiar with it’s use in a more competitive NYC real estate market in 2015. At that point buyers were being constantly outbid and he says brokers got increasingly desperate to close on properties. It’s not something he’d ever recommend. “It seems counterproductive to the idea of a meeting of the minds,” he says. 

How escalation clauses work

An escalation clause might come into play when the buyer’s agent tells the seller’s agent an offer is coming, and the seller’s agent says there is interest from several buyers. The buyer’s agent could then recommend that the buyers include an escalation clause with their offer.

If the seller is willing to accept one, it will get added to the real estate contract and state that a prospective buyer has made a bid on a property, but will pay a certain amount above each new bid, up to a capped amount.

Here's an example: Say you’re a seller who has listed your apartment for $1 million. And let's say that a prospective buyer makes an offer of $950,000, with an escalation clause that will raise that bid in increments of $5,000 over any other bids that come in above $950,000, up to a maximum of $1 million.

If someone else were to bid $980,000, the clause would automatically raise the first prospective buyer’s bid to $985,000. If no one else bids above that, the first bidder gets the apartment for $985,000.

Does your lawyer get involved in this maneuver? Only in an advisory role.

“It’s really a brokerage-side strategy,” says attorney Shaun Pappas, partner at Starr Associates. He says he’d advise a client on the procedure and risks, “but ultimately is not something that makes it into the contract and once the contract is signed, the price is fixed.”  

The risks to buyers

The risk of an escalation clause for a buyer is that once you suggest this strategy, you’ve shown your hand and disclosed you’re willing to pay more than you’ve actually offered.

The seller’s broker will know this and can make counter offers to other buyers or tell potential buyers what your top offer is and ask everyone to beat that number, which could up the price. Then you could lose out on the property because technically you gave up your negotiating power.

It’s also important to know whether additional offers are legitimate. “How do we know they don’t have an offer from a relative posing as a buyer?” Lahav asks. 

For the buyer’s protection, the clause might specify the type of proof a seller should provide with respect to multiple offers. That might include an offer in writing stating who the potential buyers are and what prices they’re willing to pay.

Lahav points out there are plenty of other tools a buyer can use before employing a strategy as risky as an escalation clause. 

“If you’re a buyer and you really want the unit, offer more,” he says. You could also waive the due diligence or do an option to show your commitment so you pay $10,000 and if you exercise the option it goes towards the deposit. 

“There are lots of things you can do to make sure you get the deal done and sometimes you have to overbid,” Lahav says.

The risks to sellers

There are reasons why it may not be in your best interest to accept an escalation clause as a seller. In the example above, for instance, you potentially lost $15,000 that you might have been able to make if you instead waited for a better offer, or asked for a best and final offer from the initial prospective buyer, who clearly was willing to pay up to $1 million for your place, and possibly more.

The problem is, the seller who accepts an offer with the escalation clause will never really know how high the original buyer might have bid on the property. Maybe that buyer would have gone up to $1.2 million. Or it may have been in the seller’s best interest to make counter offers, or change the sales price.

The downside is there might not be someone out there willing to pay the higher price, and it stays on the market for more days.

Another pitfall for sellers: For some, price isn’t everything. It might be more important for you to close quickly, so you should think twice about an escalation clause and instead see what other types of offers are out there. You might find getting an all-cash deal with no contingencies at a lower price is more favorable to one with financing at a higher price.

 

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