Monday, March 7, 2011

Beginner's Guide to the Strategy of Escalation Clauses

Gone are the days of overpaying for a property only to see it appreciate and realize a profit at closing thirty days later. Nowadays, overpaying can mean cutting your profits by thousands....sometimes without even knowing it!

What is an escalation clause? In short, an escalation clause is an addendum to an offer to purchase a property. It gives permission to increase your offer to an amount you specify in increments you also set forth in the event another offer exceeds yours.

In the current recession, you can harness the strategy behind escalation clauses to increase your profits, while helping to keep from overpaying for a property.

Here's an example:

A house priced at $360,000 suddenly drops to $300,000. After seeing the house, you decide it's a deal and begin writing up an offer. Persons B and C are also writing up offers. All persons know there will be multiple offers. All offers will be reviewed together. (sound familiar?) much should you offer?

This situation is actually a common-value auction. Here, each person can only estimate the true value of the house; all they know is their own valuation of the property. If each person knew exactly how much the house was really worth, no one would offer any more than that amount, and a multiple-offer situation would never occur in real estate.

Let's say individual valuations are as follows:

YOU (Person A): $340,000
Person B: $310,000
Person C: $325,000

If each person makes an offer equal to what they believe the house is worth, you would end up overpaying by $15,000. Instead, you can avoid the "winner's curse" by asking a fundamental question:

"If no other offer will be higher than mine, how much should I offer if I think this house is worth $340,000?"

It is advantageous for you to "shade" your offer to avoid overpaying. Since you can never know how much B and C value this house, you must assume you value the house the most. If you don't, you are likely to overpay.

You can always write up an offer for $300,000. After all, an offer like that would be immediately rejected by the seller, and it is far below what you think the house is worth. To "shade" by this much is not necessary, especially if you believe Persons B and C value the property over asking price.

By using an escalation clause in your offer, you can offer $300,000 and automatically raise your offer by specified increments (let's say $1,000) until you reach your valuation of $340,000. This ensures you do not overpay.

In this scenario, you would actually have bought the house for $326,000, thereby making $14,000! You won, and you won big.

You're probably wondering, "Sure, but what if someone else ends up offering more? I'll lose the deal!" That will happen....a lot. In fact, it is not likely that you will have the highest valuation. More often than not, your offer will not be accepted in a multiple offer scenario. But remember, your valuation is the maximum amount you should be willing to pay. Convincing yourself to pay more than your valuation means you may win the deal, but you will end up paying the very most to get it. Not a great feeling is it?

Not all real estate deals involve multiple offers, but by using escalation clauses to "shade" your offers and keep you from overpaying for a property is a great strategy when faced with such a scenario.

Happy strategic investing!

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