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Escalator Clause

DEFINITION

Provision in a lease that grants the landlord the right to raise lease payments typically based on an index or market changes.

EXPLANATION

Most leases include what is known as an escalator clause, which allows the landlord to increase the rent after a given period. Price increases change as a result of local real estate market conditions, such as the price per square foot, cost in living increases, inflation, and other factors which are determined by the landlord.

An escalator clause permits the rental rate of a property to go up or for the price of goods to go increase.  This term applies to a few wide-ranging topics including rental rates, offers on a real estate purchase, and the prices of goods.

In the context of rent prices, a landlord might decide against a long-term lease due to the thought that rental rates may increase in the future. To avoid getting bogged down in a long-term lease without the ability to increase rental rates, the landlord will instead opt to have a short-term lease or month to month rental agreement. Having an escalator clause permits the landlord to increase the rental rate on a specified period or by the occurrence of a certain event. Escalator clauses typically have a cap on the maximum the landlord can increase the rental rate.

Escalator Clause for a Real Estate Purchase

One of the common references for an escalator clause is an offer to purchase a property. An escalator clause in a real estate purchase is a provision that tells a seller that a prospective buyer will pay more for the home than their original offer assuming another party puts in an offer that surpasses the buyer’s offer. An escalator clause however is not a blanket amount. In the clause, the buyer will put the maximum amount they are willing to pay or the cap rate for the amount they would consider going up to.

For example, a buyer might make an offer for $500,000 with an escalator clause up to $540,000 committing to pay up to $5,000 more than the second highest offer. If another buyer puts in an offer of $520,000, the escalator clause would permit the original buyer’s offer to go to $525,000. If however the a competing offer comes in at $548,000, the escalator clause would not go up to $553,000 because that would surpass the maximum $550,000 amount.

Do Seller’s Permit an Escalation Clause on an Offer

Many buyers will do not permit escalation clauses on purchase offers. Oftentimes such an offer might not even be beneficial for the buyer because of the potential conflict of interest or impartiality as a seller might claim than an offer has taken place or submit a fraudulent offer simply for the sake of increasing the buyer’s purchase amount.

One benefit of an escalation clause for a buyer is that it states the maximum amount a buyer would pay for a property in addition to the fact that it might create a bidding war between prospective buyers.

Detriment of Escalator Clause to Buyer

One negative aspect of an escalator clause for a buyer is that they are essentially giving away all leverage in the transaction by stating how much they would be willing to pay. A transaction that uses this type of clause forces a buyer to state all their cards in a given transaction thereby reducing the chance that they could get a good deal on the purchase.

In the event that the buyer’s offer is the only one, the original price will remain, however of course the seller does not need to accept it. This presents a problem for the buyer. Because the seller already committed and stated the maximum they would pay for the property, the seller has the opportunity to increase their price because they know the buyer would pay more as this was made clear in their escalator clause. Of course the buyer does not need to accept the higher price that the seller asks for, it does take away the buyer’s negotiating power in this situation.

Escalator clauses benefit buyer’s when they really wish to purchase the property in question and believe there will be competing offers on the property. There is no guarantee that there will be additional offers on the property, therefore the buyer should be sure that prior to submitting an offer with an escalator clause that this is the property they really wish to purchase and that there will likely be competing offers to ensure that the escalator clause is worthwhile.

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