The Escalation Clause: Should You Use It to Buy a Home? Read This First.

Sometimes a house is a good deal, or it's in a hot neighborhood with few other homes for sale - that's when you might encounter a lot of competition, and some terms you may not be familiar with. The “escalation clause” is a common one. Here’s what you need to know about the benefits and costs of this real estate tactic.

What is an Escalation Clause in Real Estate?

Escalation clauses allow the buyer’s offer price to increase when multiple buyers are competing for a home. In order to avoid getting outbid, the clause allows the buyer's offer to leapfrog over other offers in pre-established increments. The escalation clause also indicates the increments by which the bid will increase (for example, $2,000 or $5,000), as well as a price cap. Escalation clauses are included in the purchase offer for a home.

To recap, the escalation clause lets the seller know:

• The original purchase price offer
• The increments for escalating that offer beyond other bids
• What the maximum purchase price would be

Escalation Clause Example

Say that Buyer A submits an offer of $300,000, Buyer B submits an offer of $305,000 with an escalation clause of up to $316,000 via $2,000 increments, and Buyer C submits an offer of $308,000.

Buyer A’s offer will not impact Buyer B, but Buyer B’s escalation clause will leapfrog them over Buyer C’s offer. Ultimately, Buyer B’s final offer would be $310,000.

Buyer B would likely get the home, but it's not a guarantee (the seller, for example, might opt to go with an all-cash offer even if the offer amount is slightly lower - and that could be A, B, or C). 

Benefits of the Escalation Clause

If you’re a buyer, having an escalation addendum in place can help you avoid losing out on a home by just a few thousand dollars (especially if it’s ultimately a price you would’ve happily paid). In today’s market, escalation clauses can come in handy since buyers are almost always facing competition for homes.

“An escalation clause gives you a competitive advantage when you don't know what other offers are coming in at,” explains Virginia-based buyer agent Muoki Musau. “So if your offer is $500,000, you can escalate to, say, $550,000 in different increments to ensure that if any offers are within that range, that you still remain competitive.”

The escalation clause can also speed up and simplify the home buying process because it’s immediately clear to the seller what the buyers are offering, rather than going back to each buyer’s agent and asking for a new highest bid.

Is the escalation clause a good idea? In a competitive housing market - especially if you want to decrease your odds of getting outbid - this clause can be a good home buying strategy.

Drawbacks of the Escalation Clause

The escalation clause should only be used when the buyer knows they will face competition, because they are revealing to the seller exactly what they’re willing to pay (beyond their initial offer).

“One of the main drawbacks to an escalation is that you give away your maximum number,” explains Musau. “It's essentially showing all your cards, and can drive the price of the home outside of your top number if there's another offer with a higher escalation.”

If you end up in a situation where there’s no competition for the home, the buyer may still counteroffer for higher than your initial bid - since they already know it’s not your maximum number. In today’s hot market, though, a home priced right in an attractive location is undoubtfully going to receive attention from multiple buyers - and you're unlikely to be the only offer.

Does the Seller Have to Accept the Escalation Clause?

Sellers may not opt to allow escalation clauses, preferring instead that buyers submit their best and final offer first. This makes sense because in the example given, Buyer B could have comfortably gone up to $316,000 but the price only escalated to $310,000. Had each buyer submitted only one top offer, then the seller might have received an offer of $316,000. 

Sellers in less competitive areas, where they might receive only one offer on the home at a time, will also be less incentivized to accept an escalation clause.

On the other hand, many sellers like the escalation clause since it gets buyers in a competitive mindset from the get-go and also streamlines paperwork. 

How to Calculate Escalation Clause in Real Estate

There is no set number for clause increments. Realistically you’ll want to go up by fairly large, even increments so that you actually stand a chance of bumping out other offers and looking competitive - not, say, $100 at a time. 

Your price cap should be determined by your existing budget/ideal monthly payment.

“The increments that your offer escalates are up to how aggressive you want to be. In Northern Virginia, $1,500 - $2,000 increments are normal,” notes Musau. “The two most important factors to determine what your top escalation amount should be are, first, a precise CMA (comparative market analysis), and second (and most important!), how many liquid assets you have to cover a low appraisal. So if the list price is $500,000 and you have $25,000, a safe escalation could (not should) be $525,000.” 

How to Structure Your Escalation Clause

Your real estate escalation clause should indicate: 

• The original purchase price offer
• The increments by which the offer escalates (example: $5,000)
• The maximum purchase price - keep in mind your pre-approval letter, because the maximum price should not exceed this (or be prepared to make up the difference in cash)

And your escalation clause should require:

• Proof of a bona fide offer - this means the seller can’t simply pretend there was a higher offer that you needed to outbid. There is no legal requirement for the seller to reveal other offers to you, so it’s important that you ask for this.

Keep in mind that once the seller accepts an offer with an escalation clause, this creates an agreement of purchase and sale - so don’t agree to a maximum price you don’t feel comfortable with paying. As with any offer, you should consult with your agent and mortgage advisor to make sure your offer is based on budget, not emotion.

So: Is the Escalation Clause a Good Idea?

The escalation clause can be extremely beneficial to buyers struggling to land a home in 2021's highly competitive real estate market. Like most offer tactics, however, it has potential drawbacks as well as benefits, and these should be discussed with your Realtor - they will have the most insight as to whether the property will be difficult to obtain without one (and whether it's worth it, if so). Talk to an agent about the escalation clause

Further Reading

• What Does Pending Mean in Real Estate [Everything You Need to Know]
• 6 Strategies for Buying a Home in This Extra Hot Market
• Private Mortgage Insurance: Why Do I Need It, and How Can I Get Rid of PMI?