The Real Estate Escalation Clause And What It Means For Investors

Key Takeaways

  • The escalation clause is a unique strategy every real estate investor should at least consider.
  • When executed properly, an escalation clause can mean the difference between missing out on a deal and landing your next payday.
  • Escalation clauses are just one of many ways to help investors secure the deal they want.

Today’s greatest investors are well aware of the escalation clause real estate deals may have the potential to exercise; it’s perhaps one of the most advantageous contract clauses known to real estate entrepreneurs, but did you even know it existed? Are you aware that there are a few key phrases that, when added to a contract, can actually make it more attractive to homeowners looking to sell their property? If you answered yes, I commend you, as you are ahead of the game. If, however, you are racking your brain for a simple explanation, you are not alone. Through no fault of their own, far too many new investors are unaware of what an escalation clause is, let alone what it can do for them.

At the very least, a properly executed escalation clause may serve as a tool to strengthen an offer. At its pinnacle, an escalation clause can be the single most important factor in separating your offer from the rest of the competition. Let me explain.

What Is An Escalation Clause?

As their name would lead you to believe, real estate escalation clauses are just that: clauses contained within a contract that allow respective parties to escalate their existing offers. Otherwise known as an escalator clause, escalation clauses are commonly found in the underwriting of offers, indicating that the buyer is willing and able to increase their original offer in the event subsequent, higher offers are submitted. In other words, escalation clauses offer prospective buyers a safety net—of sorts—in the event they are outbid by another party.

More often than not, escalator clauses will convey two very important messages: that the offer is not only serious, but also just how far they are willing to go. That’s an important distinction to make, as escalation clauses will typically include a cap—exactly how high the potential buyer is willing to go. Perhaps even more specifically, a good escalator clause will indicate how much they are willing to beat subsequent offers by—up to a point, of course.

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Escalation clause real estate

How Does An Escalation Clause Work?

Escalation clauses are relatively simple to understand; they essentially allow prospective buyers to offer slightly more than any additional offer that is submitted after their initial offering. If, for example, an investor submits an offer of $400,000, they could supplement their offer with an escalation clause that specifically states they are willing to beat any additional offers by a specified amount, up to the maximum amount they are willing to spend. Therefore, in the event a $405,000 offer is submitted after their initial offer, an escalation clause will make it possible to beat the competing offer by a predetermined amount. As a result, the investor needs to clarify how much they are willing to beat subsequent offers by, and up to a maximum price point. That way, the escalation clause will incrementally beat out any subsequent offers, up to a designated price point.

When Should I Use An Escalation Clause?

Escalation clauses are commonly used when a lot of interest has been expressed in a particular property; in other words, when multiple offers are expected to be submitted on the same home. In a scenario where you can image a property to receive multiple inquiries, it may be in your best interest to submit an offer complimented by an escalation clause. That way, your offer won’t automatically be ignored if—and when—it’s beat out. At the very least, an escalation clause is best exercised when an investor wants their offer to remain relevant. That said, it only makes sense to submit an escalation clause with an offer when you are absolutely confident in the property and its ability to make up for any additional spending the clause may lead to.

Pros Of Using An Escalation Clause

Using an escalation clause has many apparent advantages, not the least of which combats the possibility of becoming an afterthought. If for nothing else, the single most important reason investors include an escalation clause in their initial offer is to remain relevant. In suggesting you are willing and able to increase your offer when necessary, it’s a lot less likely to be relegated to the trash bin. Of particular importance, however, is the ability of an escalation clause to keep an interested buyer in the running. An escalation clause is nothing less than a rebuttal to the most recent offer, and it could be the one decision that lands you the property of your dreams.

Outside of the obvious, the inclusion of an escalation clause in real estate deals may result in the following additional benefits:

  • Escalation clause real estate contracts provide peace of mind for buyers who really want the subject property.
  • Done correctly, including an escalation clause in real estate deals may prevent the buyer from overpaying. Provided the verbiage is up to the task, the clause should escalate the offer just enough to land the deal without going to far over.
  • An escalation clause works heavily in favor of sellers, as they are almost always guaranteed a higher offer under the right circumstances.
  • Prospective buyers won’t be left out of negotiations or overlooked in the event they provide an escalation clause.
  • Sellers my look at offers with an escalation clause more seriously, giving the edge to anyone who is willing to include one.

Cons Of Using An Escalation Clause

While I can wholeheartedly argue that including an escalation clause in your next offer has inherent benefits, it’s not without its flaws. Namely, an escalation clause requires interested buyers to lay all their cards out on the table; as an investor, that’s not a good thing by any stretch of the imagination. You see, by including an escalation clause in your offer, or more importantly a cap, you are identifying the maximum amount you are willing to spend. And while a seller may appreciate your honesty, it all but destroys your chance of negotiating a better deal. What’s more, a poorly calculated escalation clause can really eat into your bottom line. Sure, it could help you land a deal, but at what price? If you aren’t careful, an escalation clause could have you spending a lot more on a property than you should have.

In addition to disclosing the amount investors are willing to pay, there are a few other downsides to including an escalation clause in real estate deals:

  • Their inclusion downplays one of an investor’s greatest advantages: negotiations. By including a clause that discloses the amount someone is willing to pay, thee’s less room to negotiate profit margins.
  • While the real estate industry has come a long way, there’s still a great deal of people that don’t know what an escalation clause is. In the event a listing agent doesn’t understand what an escalation clause is, for example, the inclusion of it may cause some confusion and delays.
  • Select sellers may be put off by the inclusion of escalation clauses. While they are most likely welcoming of the idea of investors paying more, they are usually mad at the original intent to undercut impending offers.
  • There are times when the inclusion of an escalation clause can cause issues with bank appraisals.
  • While rare, some sellers don’t want to deal with the inclusion of an escalation clause.

Real estate escalation clause

Escalation Clause Example

If the concept of an escalation clause has still avoided you, perhaps this escalation clause example will shine a light on the handy little contract addition:

Let’s say, for example, Molly finds the perfect home for her next investment deal, and proceeds to offer the owner $100,000. However, in addition to the initial offer, Molly has her Realtor include an escalation clause that states she is willing to pay more in the event a higher competing offer is submitted in the interim. Her escalation clause will not only identify that she is willing to pay more, but also the increments she is willing to beat out other buyers by—up to a maximum offer, of course. In other words, Molly could include an escalation clause that specifically increases her offer by $2,000 more than the latest competing offer. More importantly, she will cap her escalation clause at $110,000. That means if another offer is submitted after Molly’s initial offer, let’s say at $105,000, the escalation clause will automatically bump up Molly’s offer to $107,000, and will continue to do so until the cap is hit. Of course, if no other offers are submitted, Molly will get the house for her initial offer, provided the owner accepts it.

Real Estate Escalation Clause Language

Few things are more important to the real estate escalation clause than the language used to enact it. As with just about any other contract, how you word your escalation clause can make all the difference, so you will want to be as specific and deliberate as you can. Sometimes a single word can convolute your entire statement, so be sure to get the right point across.

To be clear, this is what the average escalation statement will look like:

The buyer in a respective deal offers to pay $____ for the property, but in the event the seller receives a bona fide offer that exceeds the initial offer, the buyer is willing and able to increase the price to $____ above the amount of the other offer, up to $____.

It is worth noting that some words carry more weight than others. The emphasis of a bona fide offer, for example, stresses the importance of initiating the escalation clause only in response to a legitimate and enforceable offer. Otherwise, illegitimate offers may cause the owner to increase your offer without a reason to do so. Not surprisingly, it’s of the utmost importance that you carefully calculate the language of your own escalation clause.

Are you aware of the escalation clause real estate deals may contain? Perhaps you use one whenever you get the chance. Whatever the case may be, feel free to let us know what you think about escalation clauses in the comments below.

The post The Real Estate Escalation Clause And What It Means For Investors appeared first on FortuneBuilders.

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