Summary: If you’ve been investing in real estate over the last few years, you’ve probably encountered a “hot home” on Redfin. These are the properties that are highly desirable and likely to receive multiple offers. When faced with competition from multiple buyers, one way to increase your chances of beating out the competition is to include an escalation clause.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Over the last several years, members of our community have been investing in a red hot market. They’ve often found themselves in bidding wars with multiple other buyers. They have tried numerous strategies to win these deals, sometimes acting quickly, sometimes offering cash and sometimes waiving contingencies.
Another way to win deals is with an escalation clause. In this article, we’ll cover when you would use an escalation clause and how they work. We’ll also share an example of how we used an escalation clause to beat out multiple other offers.
What is an Escalation Clause?
When you buy real estate, you start by submitting an offer to the seller.
This offer is made in writing, usually in the form of a purchase and sale agreement. Normally you’d offer a certain price and the seller either accepts, counters or rejects your offer. In a competitive bidding situation, there may be other sellers offering the same price or higher. If you really want the deal, you need to figure out a way to beat out these other offers. However, without knowing what the other buyers offered, there’s a risk that you offer far more than the next highest offer.
For example, let’s say that the seller listed a property for $200,000. Your agent tells you that there are multiple other offers and some have offered more than the asking price. So how much should you offer in this situation? $205,000? $210,000? $250,000? There’s no way of knowing because you don’t know what the other buyers offered. There’s a risk you offer far more than the next highest offer and you overpay for the property.
This is where an escalation clause comes in.
An escalation clause is an addendum that you can add to your purchase and sale agreement that allows you to offer a predetermined amount above than the next highest offer. This amount is called the escalating factor. The escalating factor is what allows you to put in a higher offer without knowing what the other buyers offered.
For example, let’s say that you’re willing to pay $5,000 more than the next highest offer. If the highest offer is $210,000, your offer would be $215,000.
You might be wondering, what if you don’t want to pay over a certain amount? What if an inexperienced investor, who doesn’t know their numbers offers a ridiculous amount, say $275,000? In this situation, you don’t want to win the deal at $280,000 ($275,000 plus the after $5,000 escalating factor). Based on your analysis, you would never pay $280,000 for this property.
In order to protect you from overpaying for a property, escalation clauses also include a cap. This allows you to pre-determine how much you’re willing to pay for the property.
For example, you can cap your escalation clause at $225,000. So if someone offers $275,000, you’d be out of the running for the deal but you won’t be in a situation where you pay more than you’re willing to pay.
In addition to the escalating factor and the cap, one other important protection you’ll want to have in your escalation clause is evidence of the competing offer. This is important because you don’t want to take someone else’s word that there’s a higher competing offer. You want to see that it actually exists. If you did take someone’s word for it, this is what we would call a “newbie mistake.”
Example Contents of an Escalation Clause
Escalation clauses can differ depending on the location of the property. However, we thought it would be helpful to show you the language used in an actual escalation clause to further illustrate the escalating factor, cap and evidence of the competing offer. This example is pulled directly from the Northwest Multiple Listing Service:
- The escalating factor: “If the Seller receives a Competing Offer for the Property prior to accepting this offer, with a Net Price equal to or greater than the Net Price of this offer, then the Net Price of this offer shall be increased to $______ more than the Net Price of the Competing offer.”
- Cap: “In no event, however, shall the new purchase price of this offer exceed $______.”
- Evidence of the competing offer: “Seller’s escalation of this offer shall not be effective unless it is accompanied by a complete copy of any Competing Offer used to escalate the purchase price, including any escalation provision.”
When Do You Use an Escalation Clause?
An escalation clause is something you turn to selectively. It’s a tool in your toolkit but not something that you use with every purchase. When you use it also depends on what you’re buying.
If you’re buying a primary residence, you might turn to an escalation clause if there’s a lot of competition and you REALLY want the home. The escalation clause protects you from paying way more than the next highest offer.
For an investment property, it’s different. You don’t have an emotional home buyer who will drive up the price. Instead, there’s usually a cap on the price. Investors won’t want to pay above a certain amount because the numbers stop making sense. Because of this cap, escalation clauses aren’t used if the property is priced too high. Instead, they’re generally used when the property is priced low. Your goal as an investor is to beat out the other offers but not overpay. So the cap you use is really important.
How to Use an Escalation Clause to Win More Deals
So how do you use an escalation clause to win more deals? To answer this question, we’d recommend starting with the goal. The goal is to be the winning offer at a price you’re willing to pay.
In order for you to win the offer, you really need to understand what the seller wants. Sometimes they want to sell for the highest price but not always.
If the seller only cares about price, then you’ll probably win if your cap is the highest. The escalating factor is probably not as important. For example, let’s say your escalating factor is $500 and your cap is $225,000. If the next highest offer is $210,000, your offer is $210,500. Even though the price difference is only $500, the seller will probably choose your offer.
However, price isn’t the only thing that matters to sellers. There are so many other things they care about. For example, certainty of close is hugely important to sellers. So if you offer all cash, sellers often will take far less than the highest offer. If you can promise to close quickly, this is also attractive to many sellers. When there are other factors involved, the amount of your escalating factor can make a difference.
For example, if your escalating factor is $10,000. Then your offer is $10,000 more than the next highest offer. So from the seller’s perspective, even if there are other factors involved, they may be tempted by the higher dollar amount.
As you can see, you really need to understand what’s important to the seller in order to help you determine the escalating factor.
When it comes to the cap, this is all up to you. If you’re a homebuyer, you’ll want to think about your budget and how much you’re willing to pay. If you’re an investor, it all comes down to your analysis. How much you can offer and still make the numbers make sense.
Example of an Escalation Clause in Action
While escalation clauses can be useful at times, we have generally been able to avoid using them. I’d say that most of our transactions DON’T involve escalation clauses. With that said, there have been a few times where an escalation clause was the key to winning a deal. One of these times was for a short-term rental we bought a few years ago.
This property was in a great location right on the river so, we knew that there would be multiple interested buyers. On top of that, the property was underpriced. In the end, there were about 8 or 9 other buyers competing for the property.
We knew that to win the deal, we would have to bid up the price significantly. We did our numbers using our short-term rental cash-on-cash (COC) calculator and came up with a cap – the maximum we were willing to offer for the property.
[Easily & effectively analyze the profit potential of a short-term rental with this FREE cash on cash calculator. Don’t put in an offer without it!]
We also put in $5,000 for the escalating factor. We didn’t choose something low like $1,000 because we wanted to be sure that the seller was financially incentivized to choose our offer over the next highest offer.
In the end, we beat out all of the other offers but ended up paying $85,000 over asking price. While this was a significant amount over asking, we were comfortable with this number because 1) the property was underpriced, 2) based on our COC analysis, we felt confident that the property would cashflow well 3) we were confident we could raise the value of the property significantly by doing smart renovations
In fact, after we bought the property, we remodeled the kitchen and did some cosmetic upgrades. These changes raised the value of the house by $250,000 to $300,000 over what we paid for the property. Not only that, the property has been cashflowing multiple five figures over the last two years.
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Key takeaways
Escalation clauses can be used to help you win deals in certain settings. They can also help protect you from overpaying for a property when you don’t know the amount of the other offers. Using them effectively requires you to know how to choose the correct escalation factor and cap. Getting this wrong can mean losing out on deals or overpaying for properties.
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