The Little-Known Escalation Clause

The Wall Street Journal quoted me in Escalation Clauses: A Little-Known Bidding-War Strategy. It opens,

For home buyers locked in a heated bidding war, there is one weapon that may help ensure victory: an escalation clause.

It’s an addendum to a real-estate contract, typically when the offer is made, in which a prospective buyer says, “I will pay X dollars for this house, but if another buyer submits a verifiable bid that’s higher, I will raise my offer in increments of Y dollars to a maximum price of Z.”

These clauses are particularly useful in a competitive real-estate market where homes typically get multiple bids. If a bidding war erupts on a home, the escalation clause will automatically raise the buyer’s offer on the house by the predetermined increment, up to the maximum amount the buyer authorizes. It eliminates the back and forth of offer and counteroffer and helps the buyer avoid paying too much for a house by getting caught up in the frenzy of a bidding war. But they can be risky for buyers who use them.

“A buyer can think of an escalation clause as a ‘have your cake and eat it, too’ clause,” says David Reiss, a Brooklyn Law School professor who specializes in real estate. “But in real estate, as with cake, it is hard to have it all.”

One concern is that the buyer is tipping his hand to the seller by using an escalation clause, Prof. Reiss says.

By indicating the maximum amount he will pay for the house, a buyer is revealing important information—that he’s willing to pay more. For example: Seller lists the house for $1 million. The buyer bids $950,000 with an escalation up to $975,000. The seller can counteroffer at $975,000, knowing that the buyer can both afford it at that price and is willing to pay it.

“Sellers get more money than they ever thought they would have,” says Carrie DeBuys, a real-estate agent with Realogics Sotheby’s Realty in Seattle. In her market, it isn’t uncommon for a seller to receive “10, 15 or 20 offers on a property.”

On the flip side, an escalation clause may not be in the seller’s best interest, explains Prof. Reiss.

Say a house is listed for $1 million, and there are three bidders. Buyer A offers $950,000. Buyer B offers $975,000 with an escalation clause that could go up to $1 million in $5,000 increments. Buyer C offers $980,000. In this scenario, the seller would get $985,000 from Buyer B after the initial offer escalates over Buyer C’s offer. But, had the seller not relied on the escalation clause and instead asked the bidders for their best and final offer, he might have sold the house for $1 million. “We know that the buyer was willing and able to go up that high,” Mr. Reiss says. “Thus, the seller is likely getting $15,000 less in the escalation-clause scenario.”

Assessing RESPA

image by Yoel Ben-Avraham

The Consumer Financial Protection Bureau issued a Request for Information Regarding 2013 Real Estate Settlement Procedures Act Servicing Rule Assessment. The Bureau

is conducting an assessment of the Mortgage Servicing Rules Under the Real Estate Settlement Procedures Act (Regulation X), as amended prior to January 10, 2014, in accordance with section 1022(d) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Bureau is requesting public comment on its plans for assessing this rule as well as certain recommendations and information that may be useful in conducting the planned assessment. (82 F.R. 21952)

This is certainly a pretty obscure initiative, albeit one required by the Dodd-Frank Act. But it is worth determining what is at stake in it. The Request includes some additional background:

Congress established the Bureau in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).1 In the Dodd-Frank Act, Congress generally consolidated in the Bureau the rulemaking authority for Federal consumer financial laws previously vested in certain other Federal agencies. Congress also provided the Bureau with the authority to, among other things, prescribe rules as may be necessary or appropriate to enable the Bureau to administer and carry out the purposes and objectives of the Federal consumer financial laws and to prevent evasions thereof. Since 2011, the Bureau has issued a number of rules adopted under Federal consumer financial law.

Section 1022(d) of the Dodd-Frank Act requires the Bureau to conduct an assessment of each significant rule or order adopted by the Bureau under Federal consumer financial law. The Bureau must publish a report of the assessment not later than five years after the effective date of such rule or order. The assessment must address, among other relevant factors, the rule’s effectiveness in meeting the purposes and objectives of title X of the Dodd-Frank Act and the specific goals stated by the Bureau. The assessment must reflect available evidence and any data that the Bureau reasonably may collect. Before publishing a report of its assessment, the Bureau must invite public comment on recommendations for modifying, expanding, or eliminating the significant rule or order.

In January 2013, the Bureau issued the ‘‘Mortgage Servicing Rules Under the Real Estate Settlement Procedures Act (Regulation X)’’ (2013 RESPA Servicing Final Rule). The Bureau amended the 2013 RESPA Servicing Final Rule on several occasions before it took effect on January 10, 2014. As discussed further below, the Bureau has determined that the 2013 RESPA Servicing Final Rule and all the amendments related to it that the Bureau made that took effect on January 10, 2014 collectively make up a significant rule for purposes of section 1022(d). The Bureau will conduct an assessment of the 2013 RESPA Servicing Final Rule as so amended, which this document refers to as the ‘‘2013 RESPA Servicing Rule.’’ In this document, the Bureau is requesting public comment on the issues identified below regarding the 2013 RESPA Servicing Rule. (Id., footnotes omitted)

The Bureau will be evaluating servicer activities such as responses to loss mitigation applications and borrower notices of error. It will also be evaluating fees and charges; the exercise of rights by consumers under the rule; and delinquency outcomes.

The Bureau is requesting comment on some technical subjects relating to the assessment plan itself. But if you think you have something to add, you should submit comments by July 10th here.