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.”

Another Housing Bubble?

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Trulia quoted me in Warning Signs: Another Housing Bubble Is Coming. It opens,

Signs show another bubble coming. Some experts have a different opinion.

When the housing market crashed in 2008, it caused what came to be known as ”The Great Recession.” When the bubble burst, it ”sent a shock through the entire financial system, increasing the perceived credit risk throughout the economy,” according to a report published in The Journal of Business Inquiry.

The crash caused homes to lose up to half their value. People became underwater, owing more than their home was worth. And who wants to pay on a mortgage that’s larger than what the home could sell for? Although some people did just that, many more opted to short sell their homes or to simply walk away and have the bank foreclose.

Present Day

Fast-forward to 2016, and we are seeing hot, even ” overheated,” housing markets; bidding wars; rising home prices; and house flippers – all the signs of a housing bubble that’s about to burst. Are we repeating the mistakes we made before? Yes and no. Let’s explore four reasons the housing bubble burst and whether we’re experiencing the same conditions today.

1. Easy Credit

Before the 2008 crash, credit was easy to get. Pretty much, if you were breathing, you could get a mortgage loan. This led to people getting mortgages who ultimately couldn’t afford to pay them back. They lost their homes, and this contributed in large part to the housing crisis. Today the situation is different. ”Credit is still much tighter than it was before the financial crisis,” says David Reiss, professor of law at Brooklyn Law School. ”This is particularly true for those with less-than-perfect credit scores.” He explains: ”There are almost no no-down-payment loans as there were in the early 2000s. Those defaulted at incredibly high rates.”

But what about Federal Housing Administration (FHA) loans? They feature ”low down payments, low closing costs, and easy credit qualifying.” Those are the very features that should sound some warning bells. But before you get too alarmed, keep in mind that the FHA has been making loans to people who do not qualify for a conventional mortgage since 1934. ”While there are low-down-payment loans available from Fannie, Freddie, and the FHA, their underwriting standards appear to be higher than those for low-down-payment products from the early 2000s,” says Reiss.

2. Low Interest Rates

Mortgage rates have been low for so long that you might not realize that was not always the case. In 1982, for example, mortgage rates were 18 percent. From 2002 to 2005, the rates stayed at about 6 percent, which enticed people to take out mortgage loans. And in 2016, we’re seeing historic lows of under 3.5 percent. If rates go up, we might see housing demand and housing prices fall.

3. ARMS

Before the housing crash when home prices were rising fast, many people were priced out of the market with a fixed-rate mortgage because they couldn’t afford the monthly mortgage payments. But they could afford lower payments that were possible with an adjustable-rate mortgage – until that rate adjusted up. In 2005, 38.5 percent of the mortgage market was ARMs. But in 2015, that amount has dropped considerably to 5.3 percent.

4. A Buying Frenzy

There’s an old story that before the stock market crash of 1929, Joseph Kennedy, Sr., sold his shares. Why? Because he received a stock tip from a shoeshine boy. Kennedy figured, the story goes, that if the stock market was popular enough for a shoeshine boy to be interested, the speculative bubble had become too big.

Before the housing crash, this country saw a home buying frenzy similar to what happened before the stock market crash. Everyone from lenders to rating agencies to investors (foreign and American) to investment bankers to home buyers was eager to get into the mortgage game because house values kept rising. Today, we are seeing a similar buying frenzy in some markets, such as San Francisco, New York, and Miami . Some experts think that the price increases of homes in those areas are not sustainable. They say that because heavy foreign investment in those areas is part of what’s driving up prices, if those investments slow or stop, we could see a bubble burst.

So what do some experts think?

David Ranish, owner/broker for The Coastline Real Estate Group in Laguna Beach, CA, says: ”There are concerns about another housing bubble, but I do not see it. The market could stabilize, but a complete collapse is highly unlikely.”

Bruce Ailion, an Atlanta, GA, real estate expert, says,” ”Five to six years ago, I was a buyer of homes. Today I am a seller.”

David Reiss says, ”It is probably a fool’s game to predict the future of the housing market or whether we are in a bubble that is soon to burst.”