An Escalation Clause Raises Risk

Although New York City’s housing market has noticeably cooled, there were some buyers inserting escalation clauses into their proposals not long ago. It is useful to understand when the market heats up. While it increases your chances of purchasing the property, the strategy also entails higher risks.

What is an escalation clause?

When you submit your offer, you can add an escalation clause. This contains your bid, but also states that your offer will increase by a certain amount should a higher bid emerge. It is also typical to include how much your offer will go up in case a bidding war arises. There is also a maximum offer you can put in.

For instance, if an apartment is listed at $800,000, you may put in an offer at $750,000. However, you add an escalation clause that automatically puts in a bid $3,000 above an offer that is higher than that amount. Since you do not want this to go on indefinitely and cost yourself a lot of money, you cap your last offer at $795,000.

Why should buyers do it?

It is a preemptive move to get ahead of a bidding war. You do not have to go back-and-forth with the seller since your counter offers are essentially in place already. You have also put in the maximum price you are willing to pay. In theory, this introduces price discipline to your purchase strategy.

With your next steps planned, an escalation clause might place less stress on you.

Risks to the buyers

There are risks involved, though. To use poker parlance, you have essentially given away your hand since sellers know your next moves and how high you are willing to push your offer.

A buyer can shop your offer around, and use it as leverage. You can wind up paying more than you would have, even if the other potential buyers are not serious.

While putting a maximum price in the escalation clause mitigates paying more than the property’s fair market value, you could still end up doing so. A bank will balk if it turns out the loan is more than its appraised value. This means you may have to renegotiate, come up with additional cash, or walk away.

You may still lose out on the property, even if you have the highest offer. There are other things sellers may favor. This includes the ability to pass a co-op board’s muster, a quicker close, or an all-cash deal.

Sellers may balk

Using an escalation controls the process, and sellers may want to make it a more open competition. While the buyer puts in a maximum price, the seller may prefer a less controlled process, where emotions come into play. That way, he or she might sell the property for more than the listing price.

Under an escalation clause, the seller has no way of knowing if the buyer was willing to expend more than his or her maximum price set in the contract.

When to consider it

Keeping in mind the risks involved, you may wish to use an escalation clause if the real estate market is hot, or there are other reasons your exclusive buyer’s agent expects multiple offers on the property.

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