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:
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.
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?
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.
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.