What Is An Escalation Clause?
Today’s real estate market in many areas could be described as tight, meaning that inventory is low and demand is high. This is exactly how it is in many areas of Birmingham, AL where I appraise.
New listings are not staying on the market long before buyers write a contract. The old adage that if you snooze you lose couldn’t be more true.
Because inventory is low and buyers are fighting over what’s available, one tactic that agents are using is the escalation clause. An escalation clause states that the buyer will increase their offer by a certain amount, up to a set maximum, if another offer is received on the property that is higher than theirs.
The escalation clause states how much the price will be escalated by and the maximum amount that the purchase price can reach before the buyer bows out of the deal.
I am not a lawyer or a real estate agent so I cannot comment on the details of how an escalation clause works but if you would like to learn more check out this article by real estate agent Bill Gassett – What is an Escalation Clause and How Do They Work?
What I would like to discuss here is how the escalation clause might affect the deal when the appraisal is performed.
There are two issues that should be addressed when buyers are considering the use of an escalation clause. The first relates to the market value of the property and the second relates to what the plan of action should be for a property that has a contract for more than its market value.
Know The Value
The main purpose of an escalation clause is to make sure the buyer gets the contract. It does not guarantee that the offer will not be over market value.
The strategy the buyer’s agent uses should focus on winning the contract but at the same time striving to make sure the contract is not over market value or if it is what plan of action should be taken.
The best way to do this is to know the true market value of the property in question. A thorough market analysis, such as a CMA, will help the agent to determine this value.
When the market value is known, the agent and buyer can develop an escalation clause strategy. The strategy will help determine how much the offer should escalate to and how high the offer should go before abandoning the deal.
If the market value is not known it is possible that the escalation clause could increase the contract amount over the market value of the home. If this occurs there will be a gap between the two numbers and it is quite possible that the deal may not work out which brings us to the second issue.
Over Market Value Strategy
So if the escalation clause worked and you won the contract is this a good thing? It could be if the contract does not push you over the market value of the property, but what if it does?
If your offer has pushed the property over its market value you run the risk of the property not appraising. You have several options available to you.
The first option should be part of the strategy the seller’s agent came up with when making the initial offer. Including a contingency within the contract that allows the buyer to back out of the deal if it does not appraise should always be done.
The contingency will give the buyer more options. If they still want to purchase the home, another choice would be to bring money to the closing table in the amount of the difference between the appraisal value and the contract amount.
Something I recently read about that a buyer could add to their offer is an appraisal gap guarantee clause. It is similar to what I described above about bringing money to the table but it is included in the written offer so that the seller knows the buyer is serious.
Having a strategy to address all potential outcomes will help the buyer get the home they want without any surprises.
Conclusion
The most important thing the buyer and their agent should keep in mind is that there is no guarantee that a home will automatically appraise for the higher offers we are currently seeing. An escalation clause may help you win the contract but you need to formulate your strategy for how you will handle the possible difference between the contract amount and the appraisal value. This strategy begins with knowing the accurate market value of the property before you make the offer.
If I can answer any further questions you have about an escalation clause and how they relate to appraisals feel free to contact me and as always thanks for reading.
Good article Tom, I know we have received escalation clauses when I truly believe they are just trying to “win” the position and if it doesn’t appraise then the sellers will more than likely compromise to the appraised value. So, the reason is the sellers have the time invested now along with the buyers and most do not want to start the process over but occasionally it does happen.
Thanks, Amy. I think I have felt the same way about high offers on some deals. I guess it is a tactic that has been successful for some people. From an appraiser’s perspective, these are some of the jobs that we dread as we may end up being the “bad guy” and the “deal killer” in the eyes of some, however, we are just doing our job.
Thanks Tom. It gets tricky when we’re in a market with offers over list price as the norm. I was just contacted this morning about two pending contracts in a neighborhood that are both in contract at higher levels (and they both have appraisal waivers). Where is value? That’s the question both appraisers and buyers need to ask.
I’m glad you mentioned waivers, Ryan. If these sales are priced over market value and no appraisal is done then the comparables used in the future may be skewed. This could be a real problem and result in a flawed increase in perceived values in the area. I’ve heard that there should be a new field in MLS systems that show whether a waiver was obtained so that this can be studied.