Escalation Clauses: A Little-Known Bidding-War Strategy

For home buyers locked in a heated bidding war, there is one weapon that may help ensure victory: an escalation clause.

It’s an addendum to a real-estate contract, typically when the offer is made, in which a prospective buyer says, “I will pay X dollars for this house, but if another buyer submits a verifiable bid that’s higher, I will raise my offer in increments of Y dollars to a maximum price of Z.”These clauses are particularly useful in a competitive real-estate market where homes typically get multiple bids. If a bidding war erupts on a home, the escalation clause will automatically raise the buyer’s offer on the house by the predetermined increment, up to the maximum amount the buyer authorizes. It eliminates the back and forth of offer and counteroffer and helps the buyer avoid paying too much for a house by getting caught up in the frenzy of a bidding war. But they can be risky for buyers who use them.

“A buyer can think of an escalation clause as a ‘have your cake and eat it, too’ clause,” says David Reiss, a Brooklyn Law School professor who specializes in real estate. “But in real estate, as with cake, it is hard to have it all.”

One concern is that the buyer is tipping his hand to the seller by using an escalation clause, Prof. Reiss says.

By indicating the maximum amount he will pay for the house, a buyer is revealing important information—that he’s willing to pay more. For example: Seller lists the house for $1 million. The buyer bids $950,000 with an escalation up to $975,000. The seller can counteroffer at $975,000, knowing that the buyer can both afford it at that price and is willing to pay it.

“Sellers get more money than they ever thought they would have,” says Carrie DeBuys, a real-estate agent with Realogics Sotheby’s Realty in Seattle. In her market, it isn’t uncommon for a seller to receive “10, 15 or 20 offers on a property.”

On the flip side, an escalation clause may not be in the seller’s best interest, explains Prof. Reiss.

Say a house is listed for $1 million, and there are three bidders. Buyer A offers $950,000. Buyer B offers $975,000 with an escalation clause that could go up to $1 million in $5,000 increments. Buyer C offers $980,000. In this scenario, the seller would get $985,000 from Buyer B after the initial offer escalates over Buyer C’s offer. But, had the seller not relied on the escalation clause and instead asked the bidders for their best and final offer, he might have sold the house for $1 million. “We know that the buyer was willing and able to go up that high,” Mr. Reiss says. “Thus, the seller is likely getting $15,000 less in the escalation-clause scenario.”

While escalation clauses are commonly seen in competitive markets like San Francisco and Seattle, they are less common at the top end of the market. “They’re not really happening at the ultrahigh end because the X amount—the increment—has got to be pretty significant,” says Billy Rose, president and co-founder of the Agency, a brokerage in Beverly Hills. “If you’re talking about a $15 million house, the X amount needs to be substantial enough to be material. A $2,000 increment is not going to make a difference.”

Escalation clause tips

Here are some things to consider if you’re thinking of using an escalation clause.

• Be aware of the mortgage. If an escalation clause is invoked, buyers may need additional cash on hand for a larger down payment. The escalated price can also affect the type of mortgages available to the buyer—as well as the appraisal, which may not match the escalated price.

• Feel out the seller first. “Some agents and sellers do not react favorably to escalation clauses because they think they are unfair,” says Michael Nourmand, president of Nourmand & Associates, a brokerage in Los Angeles. “You should know their position before blindly using this strategy.” Otherwise, the seller may not consider your offer.

• Get it in writing. Buyers should specify the type of documentation the seller must provide before the escalation clause kicks in. For example, the escalation clause could specify that the seller must provide a copy of the highest offer received.