Escalation Clauses - Potential Pitfalls for Sellers

An escalation clause is a clause in a purchase and sale agreement that, under certain circumstances, automatically elevates the offer price so as to beat any other offer. The offer will contain the buyer's initial offering price. If the seller receives another offer with the same price, an escalation clause will raise the first offer's price in specified increments until it beats the other offers, usually up to a maximum amount. In other words, escalation clauses act as de facto bidding wars, except that the bidding happens automatically by comparing the competing offers.

So what's the downside? Before going further, I must note: interpretation and use of an escalation clause is clearly the practice of law. I have long believed that consumers benefit when lawyers provide the legal services needed when buying or selling a home. So I've launched Quill Realty, where every buyer client and every seller client is paired with an attorney to protect their interests from start to finish.

In this hot housing market, it has been common for sellers to market their home so that they receive multiple offers. This is often accomplished by listing the house with a comment indicating that all offers will be considered on a particular date. The house may be slightly underpriced as well in order to attract more buyers. Buyers, recognizing that they are probably in a competitive situation, will often include an escalation clause in their contract. Thus, sellers are able to generate competitive bidding that drives up the final sales price.

If you are selling your home and hope to receive multiple offers, it is important that you know how to interpret escalation clauses. If there is a misunderstanding as to how they work, then you will not obtain the best possible sales price. If you are relying on your agent, make sure your agent has a solid understanding of this issue. I note that, in Washington, agents are not allowed to practice law -- they can only complete pre-printed legal forms. I question whether the interpretation of multiple escalation clauses constitutes the practice of law and thus should only be done by lawyers.

It is also important to understand the subtle differences that may exist in competing escalation clauses. Usually, the language is fairly straightforward: the offer price automatically escalates above a comparable competing offer. If the seller accepts this offer, the agreed price for the sale is determined by the escalation clause. For example, assume a seller receives two comparable offers, each offering to purchase the home for $400,000. Offer "A" contains an escalation clause that escalates the purchase price in increments of $2000, up to a maximum of $410,000. Offer "B" contains a similar clause that escalates the purchase price in increments of $2500, with no maxiumum amount. When the seller accepts Offer "B," the agreed purchase price will be $412,500 ($2500 above the competing offer's maximum price).

However, some buyers will write the escalation clause a little differently. For example, rather than automatically escalating the price, the clause may require that the final escalated amount be presented to the buyers as a counteroffer. Thus, when the seller signs and returns the offer as a counteroffer, the buyers retain the right to accept or reject the escalated purchase price.

This can cause problems and, if not handled correctly, lead to a less-than-optimum sales price. Returning to the example above, assume that Offer "B"s escalation clause required the escalated amount to be presented as a counter offer. Assume further that the seller did not appreciate this difference. Accordingly, the seller simply signed and returned the offer with the new purchase price of $412,500, thinking that he had sold his house for significantly more than the asking price. However, after receiving the signed offer (which was really a counteroffer), the buyers reconsidered and decided they did not want to pay that much. Accordingly, they decline the counteroffer. The seller is then left with only a single offer of $400,000 and has lost the advantage associated with the escalation clauses.

If the seller had appreciated the subtle differences in Offer "B"s escalation clause, he could have handled the matter a little differently. The seller could have encouraged the buyers to make a counter-counteroffer, if the price of $412,500 was too much. If these buyers had in fact come back with a counter-counteroffer, say $405,000, then Offer "A"s escalation clause would have escalated off of that amount to a price of $407,000. In other words, by handling the situation correctly in this case, the seller could have obtained an additional $7000 from the sale.

To gain the benefit of escalation clauses, it is important that sellers understand how such clauses work.