Escalation Clauses

At the time of this writing, in April 2015, our local real estate market is the hottest I’ve ever seen it with record low inventory levels. Here are some charts showing you what I mean:

Fort Collins All Price Ranges 6 Months Versus 12 Months

Loveland All Price Ranges 6 Months Versus 12 Months

Windsor All Price Ranges 6 Months Versus 12 Months

So, with inventory at historic lows, very attractive financing with low interest rates, and strong demand for properties, we are seeing lots of situations when looking at homes where the Seller is receiving multiple offers.

When you are a Buyer competing directly with other offers all coming in at the same time you start thinking hard about the price you need to offer to actually get the property. What often comes to mind as you start to consider this is an offer where the purchase price increases automatically to beat out other Buyers’ offers. This, in theory, allows you to make an offer where you’re not over paying but will beat the next highest Buyer’s offer by some reasonable amount.

Here’s an example:

Let’s say you are considering buying a home listed for sale for $300,000. You go to see the property and find out there are 10 other Real Estate Brokers with their clients in line waiting to get into the house to see it. As each one comes out, the Brokers and their Buyer clients all seem to be discussing what they need to do to make an offer. When it is finally your turn to go inside the home, you notice 50 or so business cards of other agents that have gone before you with their clients. It is pretty clear that there will be more than one offer on this property.

While it is not true all the time, one could speculate that the first offer on a property could be below asking price. If the second Buyer knows about the first offer, they are much more likely to bid at least asking price on the property. A third offer, knowing of the first two, probably thinks it is reasonable to bid above asking price. Those making offers after that are often left wondering how much above asking price they will need to offer to be competitive.

This is an obvious over simplification. There are lots of other factors that go into whether an offer will be the winner like the financing being used to purchase, closing date, requests for due diligence documents, inspection contingencies, appraisal contingencies and many others. Simplification or not, it does bring up an interesting dilemma of how much you need to offer to purchase a property and possible ways to avoid over paying but still give yourself a greater chance of getting your offer accepted.

ENTER STAGE LEFT: Escalation Clauses.

Escalation clauses, also called trump clauses, allow you to make an offer and have it automatically increased based on other offers that might be made.

Standard Escalation Clauses

Before we get too far ahead of ourselves, I will tell you that while the Colorado Department of Regulatory Agencies Division of Real Estate provides us with a good number of documents to be used in real estate transactions including a Contract to Buy and Sell Real Estate, to the best of my knowledge, they do not have a standard Escalation Clause.

Furthermore, it is my understanding that Real Estate Brokers should NOT write Escalation Clauses for their clients since doing so might be considered practicing law without a license.

So, to use an Escalation Clause to make an offer, it means you (as the Buyer) are probably writing the Escalation Clause yourself, trying to find one off the Internet (strongly not recommended) or paying an Attorney to draft one for you. All three of these solutions are less than ideal in my opinion.

Escalation Clause Example and Potential Pitfalls

Getting back to our example of a $300,000 home, a typical Escalation Clause might say that the Purchase Price will increase by $1,000 over any other verifiable offer.

Here are a couple of things to consider with that type of offer.

Starting Purchase Price

In this example, we said that the house was listed for $300,000. So, what initial Purchase Price will you offer as a starting point? Will you offer the asking price of $300,000? Or, will you offer below or above asking price? In theory, your offer will rise to be $1,000 over the next highest offer from another Buyer. So, your starting point shouldn’t matter, but it probably does. If for no other reason, psychologically it has an impact on how the Seller perceives you.

If you offer $200,000 ($100,000 below asking price), but have an Escalation Clause to be $1,000 above the next highest offer you will probably lose credibility with the Seller.

Capping Your Escalation Clause

Are you worried that someone else will offer $400,000 for that $300,000 property and cause you to pay $401,000 with your Escalation Clause? You should be. Another thing to consider with Escalation Clauses is whether or not to put a hard limit on your maximum offer. Maybe you say, I’ll go $1,000 over any other legitimate, verifiable offer but not to exceed $325,000. This could protect you from an unlimited Purchase Price.

Multiple Offers With Escalation Clauses

What happens if you have two offers each one with its own Purchase Price changing provisions? How do you determine who has the highest offer and what that offer amount actually is? If both Escalation Clauses did not have a limit, where does it end? Many people will choose to put a limit or maximum on their Escalation Clause so it might just end up being above some other Buyer’s maximum, but what if there is not a maximum on two?

Comparing Apples to Oranges

With no standard way to create these, not all of these types of clauses will be written the same. Some may compare Purchase Price to Purchase Price. Some might try to use a calculation of Net Purchase Price. Some might include things like Seller Concessions and who pays for what as part of the offer in its comparison. Others won’t.

In an example where the Seller is comparing Purchase Price to Net Purchase Price (after taking Seller Concessions or other negotiated contract terms into account): an offer for $325,000 with nothing in Seller Concessions is better to a Seller than an offer with an Escalation Clause that is $1,000 more but that has $6,000 in Seller Concessions because the Seller would net more with the lower offer.

Adjusting Other Numbers As Price Changes

When making offers where Purchase Price can change, you may want to think about other numbers you list out in your offer. If you’re getting a loan, you may want to discuss what happens to down payment and Seller Concessions. Down Payment amount is a particularly interesting discussion when a property might not appraise for the Purchase Price.

Comparing Offers

How do you verify that an offer is legitimate? Most Sellers are honest, but they could encourage Aunt Susie (who couldn’t even qualify for a loan) to submit an offer to purchase their property for a much, much higher amount just to raise your Purchase Price using an Escalation Clause.

A more subtle and more likely example is measuring and comparing ability to perform. Will you require that the other offer be from a fully qualified Buyer? How do you check this? Do you ask to see a copy of the other offer that raised your Purchase Price? What level of due diligence do you complete on that other offer and how willing do you think that other Buyer will be in cooperating with your due diligence requests?

Other Contingencies

What good is an Escalation Clause if you keep other contingencies in your offer? For example, if you keep the appraisal contingency in your offer and use an Escalation Clause you can terminate if the property does not appraise for the higher Purchase Price. On the other hand, if you remove the appraisal contingency you need to be prepared to pay any amount above the appraised value plus your down payment and closing costs.

They Confuse Many Sellers (and Their Real Estate Brokers)

A confused mind tends to say, “no.” Some Sellers will outright ignore offers with Escalation Clauses because they don’t understand them. Some Real Estate Brokers may advise their clients to talk to an attorney about them since they may not feel qualified to interpret all the intricacies and nuances of custom written trump clauses. We do sometimes see properties listed in the MLS that explicitly state “No escalation clauses.”

The Kill Pill

While I’ve never seen it done, I’ve considered encouraging my Buyers–especially ones that have made significantly above asking price offers–to remove their offer from being used as a tool to raise the Purchase Price for someone else using an Escalation Clause. For example, I might encourage them to have their attorney write up something like this to put into the Additional Provisions section of the contract:

“1. When comparing this offer to another offer that has an Escalation Clause or any other device that changes the price of their offer based on other offers received, the Purchase Price of this offer is to be considered $0.”

How would this play out? I’m not sure. Maybe an attorney would like to comment below.

Conclusion

In conclusion, at first glance, using an Escalation Clause to help you be more competitive on very desirable properties with multiple offers seems like a good idea. Beware! There are no standard Escalation Clauses put out by the Colorado Department of Regulatory Agencies Division of Real Estate — so you’ll need to have an attorney draft one for you. They’re complicated and nuanced and some Sellers just plain don’t like them and will set aside your offer from consideration if you use them.

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Stats

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Northern Colorado Real Estate Inventory Update April, 2015

As a Real Estate Broker that helps buyers buy homes and sellers sell homes in Fort Collins, Loveland, Windsor and other cities in Northern Colorado I’ve seen first hand that the Northern Colorado Real Estate Inventory is very low. But how low is it really?

That’s what I plan to address using some charts I just made using data from the our local MLS, IRES.

Before I get deep into the data and my commentary, I want to talk about what indicators we could use to talk about inventory and why I chose the one I did. To discuss our local housing inventory, we could use sheer number of homes listed for sale or even the raw numbers of homes that sold by month and by city. And I have that data that I could share with you, but I think there is a better indicator and I will be focused on sharing charts of that data and discussing that. The indicator that I think is best? Months of inventory also commonly referred to as absorption rate.

Months of Inventory and Absorption Rate

Months of inventory is a calculation that takes into account both the number of homes for sale and also the number of homes that are typically sold each month to give you a number that tells how how long it would take (in months) for the current inventory of homes for sale to be sold.

Let’s walk through a basic example.

Let’s say there are currently 8 homes for sale in the $250,000 to $300,000 price range in Fort Collins. Let’s also say that over the last 6 months, we’ve sold 6 homes in that price range or about 1 per month. How long would it take us, knowing that we’re selling 1 per month, for use to consume the 8 homes that are currently for sale in the price range? We will ignore the fact that there are probably new homes coming on the market each month. It is pretty easy to see that if homes are selling at 1 per month and if we have 8 homes available that it would take 8 months for all those homes to sell. So, we say that we have 8 months worth of inventory available at that price point.

Seller’s Markets, Buyer’s Markets and Balanced Markets

Typically, we consider 5 to 7 months or so of inventory to be a balanced market. Any market with lower than 5 months of inventory means there is more demand from buyers for the small number of properties available for sale and therefore it is a seller’s market. Any market with higher than 7 months of inventory and there is probably more homes for sale than there are buyers and that means that it is a buyer’s market.

In my charts, I expand it a little to show 4 to 8 as a balanced market instead of the typical range of 5 to 7. Here is a sample chart that I’ll be discussing shortly showing you the seller’s market (in light red), balanced market (in light yellow) and buyer’s market (in light green).

Fort Collins Historical Months of Inventory Up To 300K

NOTE: You can click on any of the images of the charts to see a much larger version.

Seasonality To Real Estate Inventory

While this article is not intended to be a discussion relating to the fact that there are typically more homes that come up for sale during the summer months and fewer during the winter months, you can clearly see that trend in the chart I just showed. You can see the peaks and values showing up each year.

One thing I will point out relating to seasonality is that in recent years the seasonality effect has significantly diminished. The peaks and values we’ve seen are getting smaller and smaller in the last couple of years.

All Price Bands Summary

The following charts show the historical months of inventory for ALL PRICE BANDS at the same time for the primary cities I cover as a real estate broker in Northern Colorado.

Fort Collins Historical Months of Inventory - All Price Bands

Longmont Historical Months of Inventory - All Price Bands

Loveland Historical Months of Inventory - All Price Bands

Wellington Historical Months of Inventory - All Price Bands

Windsor Historical Months of Inventory - All Price Bands

High Priced Homes versus Low Price Homes

As you might imagine, the higher price houses tend have a much higher number of months of inventory that the lower price ranges. While there may be some exceptions to this rule, we tend to see the most demand for homes in the lower price ranges.

Fort Collins Historical Months of Inventory - High Versus Low Price Band

Longmont Historical Months of Inventory - High Versus Low Price Band

Loveland Historical Months of Inventory - High Versus Low Price Band

I’ve included Wellington and Windsor below, but realize that because they have far fewer transactions (especially in the higher price bands) the charts are less than ideal.

Wellington Historical Months of Inventory - High Versus Low Price Band

Windsor Historical Months of Inventory - High Versus Low Price Band

Inventory Levels in the Meat of the Market

The majority of transactions happen in what I refer to as the “meat of the market” or the prices between $100K and $300K. I wanted to show you how the number of months of inventory in these prices in particular have done over time.

Fort Collins Historical Months of Inventory - 100-300K

In the chart of Fort Collins above, you can clearly see that the inventory started to get tighter in 2012 and was significantly tighter in 2013. 2014 was even tighter than 2013 and so far in 2015, it is–as unbelievable as it may seem–even tight than it was last year. We’ve lost a good amount of the seasonality that we’ve seen in many years because the range has narrowed. We are at all time low inventory levels for as far back as I have data for.

Longmont Historical Months of Inventory - 100-300K

Just like Fort Collins, Longmont in recent years has had record low inventory levels.

Loveland Historical Months of Inventory - 100-300K

I feel like a broken record, but Loveland started getting tighter in 2012, continued to get tighter and tighter and is now showing record low levels of inventory in the meat of the market.

Wellington Historical Months of Inventory - 100-300K

Wellington is hotter, but with fewer data points since it is a much smaller market, it is not as obvious look at the full data set. Let’s glance at the zoom of data since January 2012 in Wellington to see the trend down a little clearer:

Wellington Historical Months of Inventory - 100-300K - Zoomed 2012 - Present

I think it is easier to see in this zoomed view of the Wellington chart that overall trend is that we are in a tighter market of inventory even in Wellington.

Windsor Historical Months of Inventory - 100-300K

And, to round out the perfecta… Windsor has super tight inventory and has continued to get tighter to present.

What Does This All Mean When Looking At Homes

So, what does all this mean if you’re considering buying a home?

First, it means that you need to be prepared to move immediately if you see a home that you’re interested in. Demand is high. Supply is low. Be prepared to act quickly.

Second, it means that you’re likely to have more than one person interested in the same property and that means that you’re likely going to want to make your strongest offer possible and be prepared to be competing against other offers simultaneously.

Third, expect challenges with appraisals. As prices are forced up, the property may not appraise for the price you offer. Prepare yourself in advance for that and discuss what might happen if it does not appraise and how to deal with that.

What Will The Future Bring?

No one has a crystal ball, but I expect our market to remain strong for the next 5 years or so. Will it remains as hot as it is right now? I’d guess not. We can watch the months of inventory charts to see if there is any softening of the markets to adjust as we move forward.

If you have any questions, contact me and we can discuss your specific situation and how this will likely affect you specifically.

See also…

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