It has been a year-and-a-half since US home prices surpassed their previous peak from July 2006, and they’ve only continued to move higher since. Earlier this week, we reported that home prices in two-thirds of US cities climbed to record highs during the fourth quarter, according to data from the National Association of Realtors.
This advance has continued even as prices in the ultra-high end of the market – where homes go for $ 10 million or more – have climbed to such elevated levels that buyers are beginning to disappear.
And today, at a time when investors are worried that rising 10-year yields and the affects of the Trump tax plan could trigger a shakeout in the housing market, the Wall Street Journal highlighted a practice that is being widely embraced in some of the US’s hottest housing markets, like Seattle and San Francisco.
Essentially, these clauses are attached to offers, and stipulate that the buyer will increase his or her offer by a given incremental amount if the seller can prove that a higher, verifiable bid has been made.
Typically, this tactic is employed for homes in the middle-level of the market – because if a buyer is bidding on an ultra-high end home, the increments would be so large they would warrant review by a human.
And as one professor pointed out, some buyers see it as a way to have their cake and eat it to: That is, a way to ensure that the price they would pay should they win the bid is the lowest possible in their price range.
However, there are obvious concerns that, in our view, make this a terrible tactic.
“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.”
Since a seller would know that an escalation clause has been attached to an offer, they could easily orchestrate “verifiable” bids by coaxing a third party to make a dummy offer, knowing with certainty that it will not be filled. Automating the process of price discovery is, as every flash crash and blowup in equity, bond or currency markets has demonstrated, fraught with risk that many of the parties involved don’t fully understand.
Whether the use of these clauses has had a material impact on prices would be difficult to confirm. Already, mortgage applications are tumbling as mortgage rates spike to their highest levels in more than four years. The real question is, how long after demand evaporates will sellers be able to abuse these “escalation clauses” to ensure they sell at the highest price possible.