What is an Escalation Clause?
How do you legally define it?
What are the essential elements you should know!
In this article, we will break down the definition of the Escalation Clause so you know all there is to know about it!
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Table of Contents
What Is An Escalation Clause
An escalation clause, also called an escalator clause, is a contractual provision allowing the contracting parties to increase, adjust, or alter the price when certain conditions are met.
For example, a contractor may enter into a contract to build a property by including an escalation clause allowing it to increase prices should the cost of material goes up or for inflation.
Another example could be escalation clauses included in commercial lease contracts.
In a long-term commercial lease, the landlord may want to include an escalation clause allowing the rent to be adjusted based on an escalation rate or price increase factor.
Having an escalation clause allows for the contracting parties to aim for a much longer contracting term and ensure that the contract fees, prices, rates, or other financial considerations remain fair over the entire span of the contract.
When the “escalation” conditions are met, the contract price will automatically get adjusted to the required rate.
In some cases, to avoid a perpetual increase in prices, the contracting parties will agree to an escalation cap or a maximum limit beyond which the escalation provision will no longer take effect.
Once the cap is reached, the price will no longer get adjusted or get increased over time.
Escalation Clause Definition
According to Investopedia, an escalation clause is defined as follows:
A provision allowing for an increase in wages or prices.
As you can see from this definition, the escalation clause is a type of contractual clause allowing the parties to:
- Increase wages
- Increase prices
In other words, the contract provides a mechanism allowing the contract price to be adjusted if certain conditions are met.
Escalation Clause Example
What are some price escalation clause examples that we can consider to better explain the notion of escalation provision.
Depending on the nature of the contract, escalation provisions can take many different forms.
Let’s look at a few different types of agreements.
In a lease agreement, the lease escalation clause or rent escalation clause can stipulate that the tenant will pay the landlord a higher amount of rent, starting from the anniversary of the agreement, adjusted for inflation plus 3%.
For example, if the tenant agrees to pay $10,000 in rent this year, then next year, the tenant must adjust the rent by inflation (say inflation was 3%) and an additional 3% totaling a 6% adjustment.
This means that the rent for next year will be $10,600.
Then, the year after, the same exercise will be done.
Collective Bargaining Agreement
Labor unions can use the escalation clause to contractually provide for the increase of the employee wages during the term of the bargaining agreement.
In other words, if the labor union and the employer agree that the employees’ wages will increase by 5% every year, we can consider this to be an escalation provision allowing for the increase of the employee wages.
Long-Term Construction Project
A contractor looking to work on a long-term construction project may want to include a clause to escalate price in the event of volatility or fluctuations in the cost of the material.
In other words, if the contractor has estimated the project cost based on today’s material cost, he or she will put an “escalation” clause allowing it to charge the client more to reflect the increase in the price of the material.
In construction projects where the purchase of the material represents a significant factor, this clause may end up saving the contractor in case of wild fluctuations in costs.
Escalation Clause Real Estate
What Is An Escalation Clause In Real Estate
An escalation clause in real estate works in a slightly different way than in general contracts.
An escalation clause in real estate is a type of clause a buyer may include in a purchase offer informing the seller that he or she is prepared to pay a higher purchase price should the seller receive another competing offer.
Typically, the real estate escalation clause will establish by how much the buyer will want to increase the offer should a competing offer be received by a seller and there is usually a maximum cap that is established.
The maximum cap represents the highest price the offeror is willing to pay to purchase the property when there are multiple bids.
Real estate escalation clauses are quite useful in sellers’ markets as you will have many buyers competing for the same property.
When that happens, the buyer who really wants to acquire the property (or win the bid) will need to find an expedited process to have the offer price “escalate” to match and even slightly exceed the highest bidder.
How Does It Work
The real estate escalate clause will generally include:
- An escalating factor
- A cap
- Disclosure of information
- The number of escalations possible
This means that the offeror will include in the purchase offer a provision allowing the offered price to be escalated by a certain factor or based on a certain formula.
For example, the buyer can say that he or she will match the highest bid and increase it by $5,000.
The second element is the escalation cap establishing the highest possible price at which the buyer is willing to buy the property.
The third element is the seller’s disclosure of a bona fide third party offer.
This means that the seller cannot just claim that another person has made an offer but will have to disclose or prove that a competing offer has been received (proof of a bona fide offer).
The fourth aspect is the number of times the buyer is willing to trigger the escalation factor.
In some cases, the buyers will only want to escalation provision to get triggered only once while in other cases they may allow for multiple escalations.
There is no doubt that in hot and booming markets, a buyer may find it useful to leverage escalation clauses to increase the odds of winning a bid, particularly when 10, 15, 20 other bidders are all engaged on the same property at the same time.
There are many benefits and drawbacks in using legal tools such as an “escalation clause”.
Here are some of the key factors and considerations you should keep in mind:
- Will the seller accept an escalation clause or reject your offer?
- Are there multiple offers on the property requiring that you use an escalation provision?
- By including an escalation factor, will your offer stand out?
- Do you have the funds necessary to purchase the property if the price is escalated?
- Do you have enough cash to fund the appraisal gap?
- Will your escalation clause keep you within your anticipated budget?
Escalator Clause Takeaways
So, what is escalation clause?
How does an escalation clause work in real estate?
Let’s look at a summary of our findings.
Define Escalation Clause
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