June 20, 2017
What Is an Escalation Clause?
There’s recently been a bit of a war of words between the Ontario Real Estate Association (OREA) and the Real Estate Council of Ontario (RECO), the industry’s regulatory body, over a little-known sales technique called an escalation clause.
Here’s a primer on what escalation clauses are, and how they can affect buyers and sellers of homes.
What is an Escalation Clause?
An escalation clause, also known as an elevator clause, is something written into a would-be buyer’s offer that says they will automatically pay a pre-set amount of money on top of the highest price submitted by any other offers. So in a situation where multiple offers are submitted, whichever offer comes in highest will be trumped by the one with the escalation clause.
These clauses will almost always also include a cap on how high they’re willing to go. So if two (or more) offers include escalation offers, the bid with the highest cap will be the one that makes the highest offer.
That’s not to say that it will necessarily be the offer that ends up buying that Toronto condo or house, just that it’s the highest in monetary value. More on that in a moment.
RECO vs. OREA
No one seems to be tracking how often escalation clauses are used in Ontario real estate transactions, but with bidding wars being the norm in many markets, on May 31, 2017, RECO posted an article on its website advising agents and brokers how to handle these clauses.
OREA president, Ettore Cardarelli, posted an open letter to RECO saying the organization is “quite concerned with RECO implying that escalation clauses are permissible in Ontario.”
Cardarelli argued that escalation clauses violate the Real Estate and Business Brokers Act and Section 26 (1) of the Code of Ethics regulations that sellers’ agents and brokers “shall not disclose the substance of the competing offers.”
RECO then countered with a revised article that states, “there is nothing in the Real Estate and Business Brokers Act, or its regulations that prohibits the use of escalation clauses.” That said, the organization “does not endorse the use of escalation clauses” and advises that “representatives must act carefully and conscientiously when advising their clients and customers about the use of an escalation clause, to ensure that they are making a well informed decision.”
In short, they’re legal, but controversial. Here’s how they can impact you, depending on which side of the table you list.
If You’re the Buyer
The goal of a including an escalation clause is to ensure you don’t “lose” out on – yet another – bidding war. As mentioned above, it is however essential to include a cap on the maximum price you’re willing to pay. (Without one, you could get locked into an offer you truly can’t afford.)
Buyers must also be aware that if they put an escalation clause in their offer and it ends up being the winning bid, their offer is irrevocable if the seller accepts it. So there are no back-and-forth negotiations and no backing out. (You could, but you’d lose your deposit and likely face a costly legal battle.)
You will also be relying on the honesty of the seller’s agent on the price the second-highest offer was at. (As per OREA’s point, brokers are prohibited from disclosing the value of competing offers. You can do the math to figure it out, but they’re not allowed so show you the written offer.)
If You’re the Seller
From a seller’s perspective, anything that ensures prices continue to escalate is a good thing. Juggling multiple offers and multiple escalation clauses can be a bit cumbersome on offer night but in the end, it should be clear which offer is highest.
Keep in mind that, as the seller, you’re under no obligation to accept any offer.
The highest monetary offer may also include conditions or requests for additional inclusions that you might prefer to avoid by accepting a lower-priced “clean” offer (i.e. one with no conditions that the offer is pending financial approval and/or a home inspection, for example).
Related Read: Should You Ever Drop Your Offer-to-Purchase Conditions?
If you do accept the escalation clause offer with the highest price cap, once you’ve signed it the deal is done. (Congratulations, start packing.)
Given the relative rarity of these situations and some competing opinions on their legality, RECO advises agents with multiple e offers including escalation clauses to keep a copy of the second-highest bid in the event of a legal challenge.