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Escalation Clauses

Video transcript: Escalation Clauses

Escalation clauses are a standard contractual tool for any broker helping a buyer through a competitive market. In the event of more than one offer, an escalation clause allows a buyer to make their offer amount dependent on the offer of others.

Buyers may be interested in making high offers with an escalation clause, and it's the job of the listing broker to ensure that offers submitted can provide some documentation of the buyers ability to meet the promise to pay the top amount listed in the escalation clause. Multiple offers create a bidding situation, where buyers may be inclined to offer more than they know they can handle. For example, consider a buyer who can comfortably afford $750,000. When submitting an offer for a competitive property, they choose to add an escalation clause that tops out at $810,000. In this case, the buyer may not be able to financially handle the amount. It's the job of the listing broker to verify funds.

A listing broker can obtain proof of financial ability by either a proof of funds document or through a letter or pre-approval from the buyer's mortgage broker. There's a reason we did not mention a pre-qualification letter since it lacks significant clarity because it doesn't require any documentation be provided to the potential lender. Even with the paperwork provided to the seller, the listing broker should also follow up with a phone call to the lender to verify the veracity of the letter.

Let's look at how an escalation addendum works and evaluate what each of three offers really are after triggering their escalation addendums. First, an escalation addendum will start with an initial offer amount. That's the amount the buyer is willing to pay regardless of any other offer. Second, the buyer will list an amount of money they are willing to pay more than any other offer. For example, a buyer's escalation addendum may say they are willing to go $5,000 more than any other. Lastly, the escalation addendum will list a maximum amount the buyer is willing to pay for the property, regardless of other offers.

Now to the three offers for us to consider:
Initial offer $505,000, $500,000 and $510,000
Escalation amount $4,000, $5,000 and $2,500
Maximum offer $560,000, $545,000, and $548,000

The easiest way to determine the actual value of more than two escalation clauses is to identify the highest maximum offer. In our case, the highest maximum offer is $560,000. The reason this is helpful is that any offer with a lower maximum value can be simplified. We can immediately ignore the initial offers and escalation amounts of those less than the highest maximum offer. We're able to do this because when an offer doesn't have the highest maximum value, the actual offer requires no calculation, since they will be maxed out due to a higher competing offer.

So in our case, both offer 2 and offer 3, will have actual offer amounts equivalent to their maximum offer, $545,000 and $548,000 respectively.

What seemed like a complicated problem is now much easier, we only need to determine the value of offer 1, the offer with the highest maximum. We can do this by starting with the second highest maximum, offer 3, at $548,000, and add on top of that the escalation amount allowed by offer 1, $4,000. That leaves us with an actual offer price of $552,000 for offer one.

Thankfully, the state's most often used escalation addendum provided by the NWMLS includes clear instructions and a worksheet portion to help determine the value of an escalation addendum. The following was provided courtesy of the NWMLS form 35E.

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