One of the National Association of Realtors “30 Under 30” real estate agents, serving the Del Mar and San Diego luxury residential market.
As the pandemic stretches into 2021, so does the hot seller’s market fueled by limited inventory and historically low interest rates. However, as economic and employment uncertainty complicate bidding wars for both buyers and sellers, it’s important to understand all of the tools available to you. You should also know when (and when not) to use these tools in order to make the best investment for your future.
One of the strategies buyers are using to win in this hyper-competitive market is an escalation clause. In short, an escalation clause says, “I will pay x price for this home, but if the seller receives another offer that’s higher than mine, I’m willing to increase my offer to y price.” This allows serious buyers to get a leg up on the competition by putting all of their cards on the table.
For example, if you want to submit an offer of $2 million on a home, but you know there are 10 other bidders, you might write an escalation clause that says you’re willing to pay up to $2.1 million if you’re outbid. Though escalation clauses are relatively simple and straightforward on paper, there are many nuances to consider in practice.
Can you use an escalation clause?
Some states, such as California, allow escalation clauses, while others, such as Texas, do not. In states that allow escalation clauses, individual sellers can decide whether or not they will accept them. While many sellers prefer escalation clauses because it encourages buyers to outbid each other and streamlines the counter offer conversation, your agent should first confirm that the seller will review escalation clauses.
An experienced real estate agent will help you determine whether using an escalation clause makes sense, depending on your unique situation and the seller’s review process. This will help you retain your negotiating power and avoid overpaying for a property.
When is an escalation clause advantageous for buyers?
In a hot market, sellers may choose to go through one or multiple rounds of counteroffers. Escalation clauses are particularly well-suited to buyers submitting an “all-or-nothing” offer for a one-day review process. On the flip side, putting all of the buyer’s cards on the table in the first round of a multistage review process may disadvantage the buyer in subsequent rounds.
How high should you go?
If you’ve decided to write an escalation clause, the next thing you need to determine is how much you’re willing to pay to secure the home – knowing that an escalation clause only carries weight if you waive your appraisal contingency.
Typically, an appraiser determines a home’s value based on recent sales of comparable properties, current market trends and a visual inspection of the home, as well as its features, floor plan and square footage. An appraisal contingency allows buyers to cancel or renegotiate the deal if the home doesn’t appraise for the amount they agreed to pay, which would effectively negate the attractiveness of an escalation clause.
When you write an escalation clause and waive your appraisal contingency, you’re saying that you see the value in a home and you’re willing to pay for it – whether or not the bank sees the same value. With as much competition as we’re seeing in the market today, it’s not uncommon for a home to sell for more than its appraised value; this is known as a shortfall.
If the buyer is using financing and there is a shortfall, they will either have to pay the difference between the appraised value and purchase price to satisfy lender requirements or walk away from the deal and lose their deposit. So when crafting your escalation clause, make sure that the top number doesn’t exceed what you’re able to cover if there’s a shortfall in the home’s appraisal.
What is the home worth to you?
Even though residential real estate is an investment, it’s a home first. Many people don’t realize how much psychology and emotion influence these transactions.
A litmus test for determining the value a home has for you is asking yourself, “If someone else outbids me on this house at (x) dollars, will I be disappointed or relieved?” Determining how much you’re willing to pay for a home is a balance between the personal value you attach to it and setting yourself up for a purchase price or monthly payments that aren’t outside of your comfort zone – because if a life event happens, you don’t want to be forced to sell.
Even if you’ve carefully written an escalation clause that aligns with your financial situation and your personal appraisal of the home, your automatic reaction might be to worry that you overpaid if your offer is accepted. An experienced agent will prepare you for this response so that you’re better equipped to handle any reactionary buyer’s remorse.
It’s been a year since the pandemic hit, and while many feared the real estate market would sink into a recession like it did back in 2008, we’re seeing one of the most competitive markets in years. In a fast-moving, high-stakes market, understanding how and when to use tools like an escalation clause is essential whether you want to buy the right home or sell your home for the highest price possible.
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