Be wary of escalation clauses, and never, ever skip home inspections

Posted on Posted in Realtors

My wife and I are house hunting. A real estate agent friend told us that the market is hot, and there are very few houses available for a large number of potential buyers. We were advised to consider including an escalation clause in any contract we present to a seller. If we have an escalation clause, how do we deal with the amount of the loan we plan to get? It also was suggested that we decline having a home inspection. What do you think about these issues?

A: Maybe for the first, and absolutely no for the second.

Let’s look at the inspection contingency. Unless you are a professional engineer or architect, what do you know about houses? Is the electricity up to code? Does the HVAC system work? Are the joists that seem to be holding up the basement ceiling adequate? You are investing in what may be the biggest purchase of your life; don’t take a chance that something — possibly something major — could go wrong soon after you take title. If a seller is not willing to let you have 10 to 12 days after signing the sales contract to have a professional inspector carefully go over every detail in the property, my advice is to look elsewhere.

I worked with clients who wanted an expensive house, but the seller was not willing to allow a brief inspection period. Against my strong advice, they bought the house without the inspection. Four months later, they called to tell me they should have listened — they had serious roof damage that cost them almost $100,000 to correct. And there was no insurance coverage, either. Fortunately, they could afford it.

What about the escalation clause? Let’s look at this example. In my experience, in most parts of the country, the potential buyer makes an offer, and the seller has three options: accept, reject or counter. You put in an offer of $450,000. The seller gets another offer with similar terms but a price of $452,000. Sorry, you lose.

How do you try to protect yourself? You include in the offer a statement that you will pay $1,000 more than the highest offer, subject however to a cap of $456,000.

In that case, when the other offer comes in at $452,000, your escalation clause bumps the contract price up to $453,000 and you will be the winner. But be sure to include important provisions in your escalation clause. You want proof that there is a real, higher-priced offer against which you’re competing. I have been involved in a case where an unscrupulous agent indicated — falsely — that there was a higher offer, and my client, without seeing any evidence, increased the offer by $5,000. You should review a copy of the other offer; the buyer’s name and other personal information can be removed.

If you submit the escalation clause and your offer increases, there are three ways to deal with the loan. Typically, your offer lists your loan as a percentage of the purchase price. So, you can pay the difference in cash, and there is no need to change the terms in the contract. Alternatively, you can change the loan amount in the contract to reflect the new price. Or you can partially increase the loan amount and pay the difference in cash.

Bottom line: I am not a fan of escalation clauses, but if this is really your dream house, make sure you include the necessary protections discussed above. And most real estate agents should have a template of an escalation clause that includes these safeguards.

Benny Kass is a practicing attorney in Washington, D.C., and in Maryland. He does not provide specific legal or financial advice to any reader. Readers may email him, but he cannot guarantee a personal response.