Should we use an escalation clause in our purchase offer?

Question of the week: Should we use an escalation clause in our purchase offer?

Answer:  This question came up yesterday in a monthly real estate networking group that consists of lenders, brokers, attorneys, accountants and other professionals in the industry.

To answer the question of the week we must first answer, “what is an escalation clause?”

Raise your hand if you have ever purchased or sold something on eBay or other on-line auction sites {raises hand}. If you have, you are aware of the “auto-bid” function. If you have not, here is how it works.

I want to purchase a baseball autographed by all members of the 1980 World Series Champion Philadelphia Phillies. The current bid is $1000 and the auction is open until Saturday at 6:00 PM. I’m tied up tomorrow at that time so I won’t be able to sit at my laptop and keep hitting refresh to see latest price and deciding to make a higher bid. I use the auto-bid feature by entering my bid of $1010, indicating that I will increase my bid by $10 increments to a maximum of $1100** Before I turn off my laptop Saturday at 10:00 a.m. I am the highest bidder at $1040. Before I go to bed at 9:15 Saturday night I check the auction and see that the baseball went for $1120, either someone was waiting until the last second to bid, or they had an auto-bid that was $20 more than the highest bid with a higher maximum.

**I love the Phillies but would not spend this much for a signed baseball, if I were to do so I would not put the transaction in a communication that is sent to over 600 people, many of whom know my wife…who may tell her, since she is one of the more than 600 people on the e-mail list but admittedly does not read the WR&MU weekly.

An escalation clause in a real estate purchase contract is similar to the auto-bid feature on eBay. 1980 Phillies Place goes on the market for $535,000. There is a lot of activity and your agent informs you that there appears to be several offers and the deadline to get an offer in is Monday at noon. You have written offers on a few houses, going above the listed price, and have lost out to higher offers. You really like this house and want your offer to be accepted. You and your agent sit down to write the offer and feel because of the market, the house itself and its location that it will likely sell for around $560,000. Your agent suggests you write your offer for $545,000 with an escalation clause. In this clause you write that you will pay $2500 more than the next higher legitimate offer up to $565,000.

Is this a tactic you should use to better your chances of having an offer accepted?

Possibly, but before you decide to use an escalation clause here are just some of the factors you should consider.

Look, I have two pair. Would you announce that if you were playing poker? When you write an offer with an escalation clause you have told the seller that you have two pair, giving them the advantage. Why should they take less than your maximum offer? Imagine you are the seller; you have four offers from your list price of $535,000 up to $559,900. Your expectation is the seller will counter you at a price of $562,400, but the seller sends you a counter-offer for $565,000. Do you accept the counter-offer? Well, before I accept the counter-offer I would want to see the next highest offer. Why would the seller show you? You said you were willing to pay $565,000, the seller is agreeing to your price.

That is one scenario. Another scenario is the listing agent knows your maximum price. There are multiple offers on the property and some of the agents representing other buyers, possibly including the listing agent, have indicated their buyers are willing, and able, to increase their offers. The listing agent advises the seller to issue counter-offers for $575,000 and see if anyone bites, or counters the counter-offer at a price higher than $565,000. Your escalation clause has possibly helped the seller get a higher price.

It isn’t always all about the money. The California Association of Realtors Residential Purchase Agreement is ten pages. The first page includes the price and the buyer’s financial terms for purchasing the property. The other nine pages are filled with terms, contingencies and clauses for who agrees to do what and when. You have an offer to purchase 1980 Phillies Place for $545,000 with the above escalation clause. You also disclose that you will put $10,000 into escrow upon acceptance of your offer by the seller, that you intend to purchase the property with a loan covering 80% of the purchase price, and that you want to have a contingency for 15 days to receive and approve an appraisal report, and wish to close in 35 days from the date an agreement is made. These are normal terms and conditions for most real estate purchase transactions.

Steven Carlton offers $555,000 for the property, will deposit $75,000 into escrow upon acceptance of his offer, will provide the rest of the purchase price in cash within fifteen days of the offer being accepted. His only contingency is a twelve-day physical inspection contingency.

Your escalation clause indicates you would pay $557,500 for the property—but the seller can counter your offer to $565,000 which you would probably pay.

If you were the seller, which offer would you take?

Is it worth $10,000 more to you to accept an offer that has several factors that could result in your home going back on the market, and delaying your receipt of the funds in two weeks as opposed to five?

What if the other competing offer is the same price as yours, but the buyer has eliminated all contingencies and puts a $25,000 deposit into escrow?

Terms often trump price, and even if an escalation clause may put your offer at the highest price, it is not always the highest price that has an accepted offer.

You are buying a property for $30,000 more than an appraiser says it is worth.  Every few years the WR&MU covers what are the options when an appraisal is lower than the sales price (most recently September 2020). In the scenario above, an agreement is made between you and the seller for $565,000 purchase price and you are getting a loan for 80% of the sales amount (80% loan-to-value, or LTV), or put another way, you are putting $113,000 down.

The appraisal report has a value of $535,000—the initial sales price. The seller will not lower the price from $565,000. What are your options? As listed in the WR&MU linked above, the lender bases the loan-to-value on the lesser of the sales price or appraised value. In this case, if you wish to have an 80% loan you must now have $137,000 for down payment, which stretches you very thin. Or, you can still put $113,000 down, have a loan for $452,000, and pay mortgage insurance as your LTV is 84.5%. (Which is what I would recommend.)

If you are writing an escalation clause you need to be consider your options if the appraisal comes in lower than your sales price and be prepared to accept one of the possible options.

I think escalation clauses are a good idea, if offers are being reviewed by a computer, such as with eBay’s auto-bids. Or, if everyone involved is operating above board and ethically—but whose ethics? Is the seller or listing agent being unethical if you tell them the highest price you will pay and they say you can buy your new home at that price?

Unfortunately, in our current real estate market there is no short cut or gimmick guaranteed to have your offer accepted. Preparation, information and diligence are a must to improve the opportunity for you offer to be accepted. Three things we offer to all our clients.

Have a question? Ask me!

A crack starting? Earlier this week the minutes from the Federal Reserve’s Federal Open Market Committee (FOMC in geek-speak) from the April meeting were released. For those who do not peruse economic journals or financial pages, the FOMC is the policy making body of the Federal Reserve. This group is in control of our nation’s monetary policy and actions, including, but not limited to, setting the federal funds rate, and determining whether to buy, sell or hold assets such as mortgages and United State’s Treasury debt.

The minutes revealed that “several members” of the twelve member FOMC are “willing to discuss” reducing the amount of monthly purchases of Fannie and Freddie mortgages and Treasury issues due to concerns about current and pending inflation.

This activity, the Fed purchasing fixed rate assets, is known as Quantitative Easing. Why does this matter? With the tremendous amount of mortgages being funded and debt being issued by the Treasury, a correspondingly tremendous amount of supply should be coming to the markets. As we all know, the greater the supply the lower the price; in fixed rate financial instruments such as bonds (Treasury) and mortgages lower prices mean higher rates. Since last March the Fed has been sucking up over $3 trillion in these assets, the supply on the open market has remained stable, or decreased, which has resulted in interest rates staying very low through the pandemic.

If the Fed reduces its purchases, economic principles show rates should increase, unless is also reduced. Notice the nuance of the language. The minutes did not state that several members are willing to reduce the Fed’s purchasing policy, but are willing to “discuss” such an action. This is the crack. It signals to investors and markets that the Fed is opening up to reducing its purchasing program, or easing the Quantitative Easing. The expected path that is being signaled is the Fed reduces the amount of it is purchasing each month, tapering off purchases until it is no longer making any purchases. As well, the FOMC will begin to increase its federal funds rate. When? How much? How long? These are the questions investors are trying to answer, but their reaction to the minutes show they are anticipating higher rates sooner than later.

Rates for Friday May 21, 2021: As happened last week, a mid-week rise in rates was tempered by hostilities in the Middle East. With the cease fire between Israel and Hamas announced yesterday rates have calmed today and as a result we are flat from last Friday.

FIXED RATE MORTGAGES AT COST OF 1.25 POINTS LOCKED FOR 45 DAYS FOR PURCHASE TRANSACTIONS:

30 year conforming                                         2.75%  Flat

30 year high-balance conforming                   2.875%  Flat

Please note that these are base rates and adjustments may be added for condominiums, refinances, credit scores, loan to value, no impound account and period rate is locked. Rates are based on 20% down with 740 FICO score for purchase mortgages.

Big weekend for the Smith family this weekend as our oldest daughter comes home tomorrow from Boston. She will be with us for two weeks before returning the Beantown for her summer job in a lab on campus before starting her senior year in September. The opportunities for the four of us to get together are diminishing as the girls get older and start their lives of independence; a somewhat bittersweet part of life that has been our goal as parents.

Have a great week,

Dennis

Past Weekly Rate & Market Updates can be found on my blog page at my website www.DennisCSmith.com/my-blog