Escalation clauses can put dream homes out of reach

January 11, 2013

Escalation clauses are back.

Sellers are delighted to get offers sometimes thousands of dollars higher than their initial listing price, but buyers are often frustrated when they lose out on their dream home to a higher bidder.

How does escalation work? Let’s take this example: Sellers list their three-bedroom house for $450,000. Their real estate agent has done her homework and believes it is a fair price. There is an open house on Sunday, and 20 people show up. Two couples express an interest, and each submit an offer. In the Washington area, it is customary for a buyer to submit an offer; the seller has three options: accept the offer, reject it or counter the offer with different terms.

Couple No. 1 in this scenario fill out an “Escalation Clause” form. The document, supplied by the Greater Capital Area Association of Realtors , is used by buyers interested in raising their bid in a potential bidding war.

The first couple offers $450,000, with a contingency for obtaining an 80 percent loan, but adds in the escalation form that they are prepared to increase their offer by $1,000 over any other offer, but in no event shall the offer exceed $460,000. The seller then gets an offer of $451,000 from the second couple.

What happens if the seller — based on the escalation clause — accepts the higher price from Couple No. 1? The form provides three options for the buyers. First, the 80 percent loan will remain the same, but the buyers will pay the increase in cash at settlement. Second, the loan will automatically increase to be 80 percent of the new sales price. Or third, the loan will increase by a smaller amount and the buyers will pay the difference in cash.

Here are some suggestions buyers should consider when confronted with any real estate transaction — especially one which involves a possible escalation:

●Make sure you have proof that there is, in fact, another contract offer higher than yours. While rare, I have heard of unscrupulous sellers falsely claiming higher prices without producing sufficient documentation.

To avoid breaching the privacy of the people making the competing bid, typically all personal information on the copy of the sales contract will be redacted.

●Make sure you will qualify for a higher loan if you have to escalate your offer. It is a good idea to get a preliminary assessment from a mortgage lender before you even start your house hunting, so that you will know the range of your potential purchase. But, for example, if your lender tells you that you can qualify to buy a $500,000 property, don’t let anyone know about that until after you sign a contract. I have seen too many overanxious buyers tell the potential seller (or seller’s agent), I can qualify to buy a house up to $500,000. Clearly, with the information, the seller will want to push the buyer up to that dollar mark.

●Make sure you have a contingency giving you the right to back out of the contract if the lender’s appraisal is lower than your contract offer. Currently, appraisals are coming in quite low and lenders are reluctant to challenge any erroneous valuations.

●You must have a contingency for a home inspection. Brokers may tell you that the seller will not accept such a contingency. If that’s the case, walk away. I know of too many buyers who did not have the home inspected, only to discover thousands of dollars of needed repairs after they went to settlement. A home inspection contingency benefits the seller also. Should a buyer complain about a problem after settlement, the seller usually says, “You had an inspection and could have walked away from the contract. If you have a problem, sue your inspector.”

●You must have a contingency for obtaining financing. While mortgage rates remain historically low, lenders have become very cautious and are requiring credit standings (FICO scores) to be much higher than in the past in order to commit to a loan.

Lawyers are taught in law school that real estate is unique. That may be true in a court of law, but in the real world, if you can’t buy that escalated home, you will soon find another one that you may even like better. When you buy a car, you usually have a three-day cooling off period. Unless you include the contingencies recommended here, once you have a signed real estate contract, it is difficult — if not impossible — to cancel.

Don’t get caught up in the frenzy of the escalation process.

Benny L. Kass is a Washington lawyer. This column is not legal advice and should not be acted upon without obtaining legal counsel. For a free copy of the booklet “A Guide to Settlement on Your New Home,” send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036.

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