Difference between the escalation clause and highest-and-best offers

When trying to buy a home in a multiple offer situation, you already know you will have to compete and come in with a strong offer. It is very unlikely that you are going to get the home for the list price. There are a number of ways to structure your offer to improve your chances of winning the bidding war and that includes whether to come in with your highest and best offer or whether to use an escalation clause.

How you structure your offer may depend on the number of competing offers and will also depend on what is common practice for your local real estate market. For the Seattle area, for example, in a hot market, about 80% of buyers will use an escalation addendum.

So, what exactly do the highest and best offer and the escalation clauses mean, how do you use them, and what are the potential pros and cons of going either of these routes?

What does Highest And Best Offer mean?

In real estate, the highest and best offer means that the buyer is making their absolute best offer on a home. This includes the maximum price they are willing to pay combined with the contingencies they are willing to remove from their offer. Essentially the buyer is saying "This is everything I have, and this is the full extent I'm willing to go to buy the home". It's like going all-in in poker!

On the plus, if the buyer misses out on a home, then they can at least feel good that they didn't lose because they weren't willing to go up a little higher. The buyer went to their maximum and still get still didn't get the home there's not much they can do about that. 

The main downside of submitting your absolute best offer is that you may potentially pay way more above the next competing offer when they didn't need to. You might be second-guessing yourself as to whether you overpaid for the home. The seller is under no obligation to share with you how much the competing offers were. 

If a buyer ends up being the only offer, and they came in with their highest and best offer then they have potentially overpaid for the home if they went well above the list price. An escalation addendum would have protected a buyer from the situation.

The highest and best offer is like going all-in in poker, except you don't lose any money if you don't win the home...

Reasons Sellers use a Highest and Best Offer Strategy.

After speaking with their real estate agent, there are a few reasons why a seller may decide to go with the highest and best offer strategy. The sellers are telling potential buyers up front that they must submit their best offers and not use an escalation addendum.

Note that the homeowner's decision may be based on the personal bias of their Realtor and how they like to conduct their business. People don't sell homes very often, so they are going to be relying on advice from their listing agent and certain listing agents like to do things their way. However, it should always be the seller's decision as to how to handle offers on their home.

One advantage of this strategy is that reduces the amount of back-and-forth negotiation with multiple different offers. If buyers are willing to submit their highest and best offer, then there it increases the chances of a clear winner that stands out from the others. The sellers will feel like they should speed up the offer review process.

By requesting "best offers only",  the sellers will feel like they can weed out the tire-kicker buyers who are not going to make strong offers.

A drawback of going this route is that it could scare away some potential buyers who might think the home will go for well over the asking price whereas previously they may have made an offer on the home.

What is an escalation clause in real estate and how does it work?

The escalation clause, aka escalation addendum, is part of an offer on a home that protects the buyer from overpaying for a home while at the same time keeping their offer competitive in multiple offer situations. The clause states that if the seller receives a competing offer that is higher than the buyer's offer then the buyer will match and beat the other offer by a stated amount of money up to a set maximum price ceiling.

Here's an example of how an escalation clause works:

• Say there are two buyers, Bob and Andy competing for a home listed for $500,000.
• Bob is offering $500,000 and is willing to escalate all the way to $550,00 in increments of $5,000.
• Andy is offering $520,000 and is willing to go up to $535,000 in $3,000 increments.
• All other things being equal, who gets the home?
• Bob has his offer accepted for $540,000 = $535,000 (Andy's escalator max) + $5,000 (Bob's escalator increase).
• Bob gets the home without having to pay the $550,000 he was willing to go to.  With the highest and best offer, he would have paid $10,000 more for the home.

Note that the maximum in Andy's escalator ($535,000) is used as the starting point to raise Bob's offer and is not based on Andy's starting price of $520,000.

 If the seller leverages the escalation clause to increase a buyer's purchase price, then the seller must provide the buyer with a full, unredacted copy of the competing offer. This protects the buyer from the seller just making up and pretending that they have a higher offer.

 Note that if you know that you are the only offer or making an offer on a home that has been sitting on the market then there is no point using an escalation addendum since you are not competing for the property.

The pros and cons of the escalation addendum.

Advantages of using an escalator.

The main benefit of using an escalation addendum when buying a home is that it prevents them from overpaying for a home in bidding wars.  With an escalator, the buyer only has to pay one increment above the next best offer and may not have to go all the way to their maximum budget for the home.

Sometimes a home that is expected to get many offers only ends up getting one offer. In this situation, a buyer with an escalation clause in their offer would get the home for the advertised list price. The seller won't be happy but the buyer sure will be!

The great thing about the escalation addendum is that the buyer who does win the home knows that they only had to pay a set amount above the next highest offer. They are not second-guessing themselves as to whether they paid a huge amount above the next best offer. However, they may still have to pay well over the list price to purchase the home but won't feel as manipulated.

Potential disadvantages of using an escalation clause.

I tell buyers in a competitive market that if they do include an escalation addendum in their offer then be prepared to the pay maximum price that's listed in the escalator. When there are multiple offers it is more likely that there will be another offer that can escalate you up to your max price so be prepared to end up there. Do not put in a maximum price that you are either not willing to pay or cannot afford. 

By including the escalator in your offer, you are essentially giving up the opportunity to negotiate the price with the seller. You can still negotiate other parts of the contract but not the price since the escalation will automatically set the sale price based on the competing offer. When an offer doesn't include an escalation addendum the buyer and seller are free to haggle back and forth on the sale price.

Agents often say that a buyer is revealing their cards by using an escalation addendum because it shows their upper price limit. Personally, I don't agree with that because the owner can only get you up there if they have another offer to leverage you all the way up.

And if the home seller tries this tactic...

Buyers need to remember that just because they are escalating above everybody else does not automatically guarantee that they will get the home. Savvy sellers are looking at the complete offer and not just the escalation price. How good is your financing and appraisal contingency, how big is your down payment, and what other criteria do you have in your offer? The best offer is not necessarily the one that goes the highest.

Also, sellers will be aware of super-high offers and the risk of the home not passing an appraisal. Unless the buyer is coming in with 100% cash or waiving their financing, then the owner will be wary of not passing an appraisal and not getting to closing. 

Seller's Offer Instructions says: "Highest and best offers only, no escalation offers please!"

Sometimes the seller and their listing agent will try and control the type of offers that are made on the home. They will post an offers instruction list of the things that buyers should include, (and exclude), in their offers to give them the best chance of getting the home.

Does that mean you as a buyer have to adhere to those suggestions? Absolutely not. You are totally free to submit whatever offer you want regardless of what the seller is requesting.

Could using an escalator in this situation hurt your offer? Potentially, yes but it could also prevent you from overpaying for the home.

 However, if you submit an offer that has an escalation maximum price that is $10,000 above the best "conforming" offer then the seller will probably have a change of heart and be more than happy to work with you. Money talks!

The seller tells the top offers: "Come back with your highest and best offer, remove your escalation".

Sometimes in multiple offers situations, the seller may come back to the top three or four offers and say, "OK, you are one of the top offers. I'm giving the top 3 offers the opportunity to come back with their highest and best offers but do not include an escalation addendum".

And why would they do that? It usually means that they have one offer that is way above the other offers, but they are unable to escalate that offer up to their stated maximum price because the seller doesn't have another offer that is close to the top offer. A high escalator is useless to the seller if they can't escalate the offer up to the maximum.

The seller really wants that maximum (potential) price from the top escalator. The seller is hoping that that top offer will remove the escalation addendum and offer their maximum price as stated in the escalation clause.

If a buyer is in the situation, should they come back with their highest and best offer and remove the escalation? I usually tell buyers to ignore the seller and to keep their offer us is.  Politely inform the seller that you are more than happy to remove the escalation addendum if they show you proof of the competing offer. Of course, it all depends on badly the buyers really want that home and their fear of missing out on the property.

Does the strategy always work for sellers? No! Lots of times the highest offer will not come back with their initial upper price. Buyers do not want to feel like they are being manipulated and way overpaying for the home. If you squeeze some buyers too much, you will lose them.

To summarize the difference between submitting your highest and best offer versus using an escalation clause: there are pros and cons to each, but the escalator provides the buyer greater protection from overpaying for a home. However, local real estate practices will usually dictate the prevailing types of offers that win homes in a competitive market.

Here are some additional resources for home buyers.

Strategies to Improve Your Chances of Getting Your Ideal Home from Vicki Moore including understanding the nuances of local real estate and the importance of getting good buyer representation.

18 Ways to Beat the Competition When Buying a Home from Andrew Fortune provides a long list of ways to improve a buyer's chances of winning a home in a hot market.

5 Things to Know About Escalation Clauses from Sharon Paxon provides advice on when and how to use an escalator and that sometimes you may need to get some real estate attorney advice,