What’s an escalation clause, and how do you avoid getting burned by it?

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In a competitive real estate market, some buyers will use an escalation clause when a apartment they want is likely to get into a bidding war. Even though we're in a buyer's market, that's not necessarily true for lower-priced apartments, where there's still often multiple buyers interested. The purpose behind the clause is to automatically increase an offer each time someone makes a higher offer, so the first buyer has a better chance of winning the bid.

It gives buyer one the comfort level that they’ll get the apartment, "assuming a higher offer doesn’t exceed their maximum offer,” says Elise Kessler, a real estate attorney with Braverman Greenspun P.C. “There’s less stress for certain buyers who are concerned about competing in a hot market and having multiple offers.”

It essentially eliminates the back and forth of offers and counter offers. (Read more about ways to reduce apartment-buying stress here.) But there are risks involved, for both buyers and sellers. It's particularly important to keep in mind that a top offer might exceed the appraisal value, and a buyer might not be able to get financing at the higher price. 

How escalation clauses work

Escalation clauses usually 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 would then recommend that the buyers include an escalation clause with their offer.

“The key here is getting the seller’s agent on board, as they will be the one that has to pitch it to the seller,” says Carson Alexander, a salesperson with Keller Williams NYC.

If the seller is willing to accept one, it will get added to the real estate contract and usually states 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.

The risks to sellers

There are reasons why it may not be in your best interest to accept an escalation clause, if you're the 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 the offer [with the escalation clause] will never really know how high buyer one might have bid on the property. Maybe that buyer would have gone up to $1.2 million,” Kessler says, adding that it may have been in the seller’s best interest to make counter offers, or where you change the sales price or to start the bidding all over again.

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. It’s a gamble, Kessler adds.

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.

The risks to buyers

Our example at the top sounds great if you’re the buyer—you just bought a place for $15,000 less than the asking price. The downside is that once you suggest an escalation clause, 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 in effect up the price. Then you could lose out on the property because technically you gave up your negotiating power, Kessler explains.

It’s also important if you’re using an escalation clause to know when multiple offers come whether they’re legitimate. “For the buyer’s protection, the clause should specify the type of proof the seller should provide with respect to multiple offers,” Kessler says.

That proof should be in writing, and can include copies of the offers, stating who the potential buyers are and what prices they’re willing to pay.