Friday, August 18, 2017

Escalation Clause? What Is That?

Have you heard the term escalation clause?  Chances are you haven’t unless you’ve been involved in a bidding war as either a buyer or seller in the last few years.  Today we are going to discuss the controversial subject of escalation clauses and what you should know.

What Is An Escalation Clause?
An escalation clause is a clause in the schedule of an offer which is designed to defeat competing offers by automatically increasing the Buyer’s purchase price by a pre-set amount over the highest offer.  Usually there will be some sort of cap placed on the escalation clause where the buyer won’t go over that amount should the best offer exceed it.

When Would An Escalation Clause Be Used?
An escalation clause would be used in a multiple offer situation (bidding war), where the buyer wanted to ensure they have the highest offer price.

How Would An Escalation Clause Work?
An escalation clause would state that the buyer agrees to pay a certain increment over the highest offer received.  For example, say there were 5 offers on a listing and one of them had an escalation clause, stating that they would pay $5,000 more than the highest offer received.  Suppose then that the highest offer was $500,000.  The buyer with the escalation clause would then agree to increase their offer to $505,000.  The logistics of how to accept the escalated offer vary, but the most common way would include the seller countering the buyer’s offer at $505,000 and having the buyer accept.

Why Is This Subject Controversial?
There are a few inherent conflicts with the inclusion of escalation clauses in bidding wars:

  1. It hurts the confidence of buyers when submitting an offer.  Feeling that dealing with this sort offer is unfair, buyers may decide not to participate in these competitive situations.  That could affect the confidence of the market overall.  Some of these bidding war practices already have buyers feeling discouraged, so it feels like piling on.
  2. There is a privacy issue.  The only people in a multiple offer situation who are supposed to see the contents of buyer’s offers are the listing agent and the seller.  In an escalation clause situation, inherently the price of the highest offer is disclosed to the buyer with the escalation clause – this really cant be avoided.  And this contradicts many RECO rules.

What Is Happening In The Market Because of Escalation Clauses?
Although not illegal, the escalation clause use has been frowned upon in the market in our experience.  Generally, we are seeing listing agents and sellers deciding not to deal with offers that include these clauses, and stating so right in the listing.  This eliminates the potential unfairness to prospective bidders and increases the confidence in the offer process.

What Do We Think Will Ultimately Happen To Escalation Clauses?
We think they will eventually be banned by the governing bodies.  The cons seem to far outweigh the pros in the market.  And real estate professionals have been banning them from their listings for a while now.

So there you have it readers.  Do you or anyone you know have any experience with escalation clauses?

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