In markets with shortages of inventory, buyers know that they must aggressively compete for the right properties. Yet purchasers do not want to pay any more than is absolutely necessary to buy the property. Purchasers sometimes submit “escalation” clauses in an attempt to tie up the property without offering much more than the competition. This article explores the pitfalls of escalation clauses and suggests alternatives.
An escalation clause is one in which the offer purports to beat all other offers submitted by a certain deadline. A proposed escalation clause might read as simply as, “Purchase Price shall be $1,000 more than any other bona fide offer submitted to Seller on or before April 15.”
Most buyers identify a maximum price in the escalation clause. A cap, however, reveals the highest price that the buyer is willing to pay. The smart seller, who seeks to avoid all of the uncertainties and complications of an escalation clause, may simply counter the offer from the buyer using the maximum price in the escalation offer as the fixed price in the counter proposal. An escalation clause without a cap suggests a reckless buyer, or worse, a buyer who is intending to use subjective contingencies in the contract, such as the inspection contingency, to kill the deal if the bidding drives the price too high.
The buyer who is concerned about not offering more than is necessary to win the competition needs to address whether the gross or “net” prices in competing offers are used to compare offers. For example, “Contract A” may have a gross purchase price of $300,000, and call for a seller’s concession to buyer of $5,000. “Contract B” might have a purchase price of $298,000 and not call for any concession from the seller to the buyer. “Contract C” contains an escalation clause. What figure does contract C need to beat, $300,000 or $298,000?
If an escalation clause purports to compare the “net” value of the competing contracts, then the clause should address the question “net of what?” One offer might not call for any seller paid concessions, but might require the seller to pay the title insurance. Another offer might call for the seller to pay traditional buyer closing costs, but require the buyer to pay for title insurance. Some deductions from the seller’s proceeds might not be known until closing. Addressing the “net” versus “gross” issues adds complication and uncertainty to the offer.
Price is not the only consideration when comparing offers. For example, the buyer who is able to submit an all-cash offer of $500,000, without any contingency for the sale of other property, might be paying too much by beating a $520,000 offer that had a contingency for the sale of an overpriced property.
The buyer that uses an escalation clause instead of making his best offer should verify that the competing offers are bona fide. A verification process adds complication. What happens with the other deadlines in the contract while the buyer verifies the integrity of the competition? Are the more normal deadlines in a contract stalled while the buyer verifies the integrity of the competing offers? If the buyer must ratify the purchase price to form a final binding contract, is the seller free to accept even higher offers while the buyer considers ratifying? What if the buyer and seller disagree on the bona fides of the competing offers?
Most escalation clauses do not address how the components of the escalating price adjusts among the earnest money, the cash at closing, and any borrowed funds. When two competing buyers submit offers with escalation clauses, how do they interact with each other?
The extra dollars the seller might receive due to fierce competition among buyers might not justify the enhanced risk that the deal might not close at the competition driven price. Residential appraisers primarily rely on previously closed comparable sale data to determine appraised value. In an appreciating market, previously closed transactions tend to understate the market value of the property. Prices driven by auction like frenzies may not be supported by the lender’s appraisal. A cash buyer, for example, at $390,000 might, under some circumstances be a better buyer than a $400,000 purchaser with stellar credit who still needs a loan.
Because of the complications and uncertainties of escalation clauses, sellers should simply counter offers with escalation clauses with offers at a fixed price. Since escalation clauses create unnecessary complications for sellers, buyers can make their offers more attractive to sellers by submitting simple offers with the buyers’ highest and best terms, without an escalation clause. The cleverness of an escalation clause might tend to hurt, rather than help, the buyer’s chances of winning the competition.