The Dangers of Using An Escalation Clause
Updated: Mar 12
During a seller's market, buyer's have to make offers that will set them apart from their competition. Some prospective buyers may choose to have their agent add an escalation clause to their offer to purchase contracts in order to present a more attractive offer to sellers. What is an escalation clause, exactly? In real estate, this is when a buyer notes their willingness to pay a particular amount more than the highest competing offer to purchase. The escalation clause may or may not specify a maximum price that the buyer would pay.
This is a risky strategy for the majority of buyers and understandably, many real estate agents advise against it, as well. Escalation provisions are even discouraged by the Real Estate Commission, although they are not prohibited. According to Commission Rule A.0115, “a broker shall not reveal the price or other material terms contained in a party’s offer to purchase, sell, lease, rent, or option real property to a competing party without the express authority of the offering party.” In the uncommon occasion that a buyer agrees to enable a broker to disclose the price and terms indicated in their offer with another prospective buyer, the broker may do so then and only then. The odds are slim that the competing offeror will knowingly allow that information to be shared, but it does happen. That's where things can get muddy of everyone involved.
How it can become a messy situation
At the height of the sellers market in 2021, we saw a ton of risky behavior from buyers, from abnormally large due diligence monies and an increase in escalation clauses - often added by an agent, rather than a legal professional. If a buyer submits an offer with an escalation clause without knowing the price and terms of the other offers or without stating a limit price, they may end up paying far more than anticipated for the property. If the property doesn't appraise for that amount, that's even more money that the buyer must come up with in order to cover that gap.
If a buyer specifies a maximum price in the escalation clause, the seller will know the buyer’s top price right away, thereby jeopardizing the buyer’s negotiation position. Everyone involved in the transaction may not be the most honest. For a buyer who applies an escalation clause, the seller may construct a phony bid in order to drive up the sales price.
Real estate brokers should not attempt to prepare escalation clauses, because in doing so it may be considered the unlicensed practice of law. It is advised that the buyer hire an attorney for these types of contracts, however this will increase the buyer’s fees. Again, this becomes an even more pricey transaction. Likewise, to safeguard the seller’s rights, an offer with an escalation clause should be reviewed by an attorney. Real estate professionals should never advise their clients to accept any legally binding language that they themselves may not understand.
The local market is sometimes adversely affected when we start to see these additions to offers. For instance:
Bidding wars often ensue when purchasers include escalation clauses in their contracts.
Escalation clauses can lengthen the negotiation process - a disadvantage for both sellers and purchasers.
Market prices become inflated and comparative analyses can become skewed.
Unaccepted offers may bring a rise in complaints against the brokers involved in the transaction, especially when offer price is shared without clearly expressed consent.
The Commission may take disciplinary action against a broker who reveals the price/terms of an offer without the buyer’s approval or otherwise provides one party an unfair advantage over another.
In a multiple offer situation, rather than employing an escalation clause, a listing agent’s best approach is to ask all purchasers to submit their highest and best offers. Real estate transactions can be even more frenetic in hot markets with minimal inventory. Confusion, angst, buyer pessimism, and fraud increase and escalation clauses are seen as an unfair advantage. For these reasons, the Commission discourages their use and the disclosure of competitive offer terms, even when buyers have given permission.