Escalation Clauses in Your Contracts: Yay or Nay?

It’s been said, “Good judgment comes from experience and experience comes from bad judgment.” My first experience with cost escalation clauses in home sales contracts was through bad judgment, but it provided a valuable first-hand lesson of what not to do that has stuck with me ever since.

Checklist: Do You Need an Escalation Clause in Your Contracts?

As builders today face rising costs, nearly half have either considered or started using escalation clauses to help balance them, according to recent research from the National Association of Home Builders (NAHB). Here’s a checklist of lessons I learned, which you can use to help determine whether using an escalation clause is a good business decision:

1. Never intentionally be in a position to have to defend the indefensible.

2. Explanations to buyers’ objections must be understandable and believable.

3. (From Stephen Covey) Begin with the end in mind. What’s the objective of the exercise? To sell homes or to be totally risk adverse?

4. (Also from Covey) Seek first to understand, then to be understood. View it from the customers perspective.

5. Consider unintended consequences. An escalation clause will probably trigger appraisal and requalifying issues when you can least afford them—when a home is built and needs to close. And the legal challenges won’t be pleasant, either.

6. Never allow your attorney or accountant to drive your business strategy.

7. If the amount you use in an escalation clause is based on good judgment and within your comfort zone, use it as a part of your pricing strategy. In the midst of other builders using escalation clauses, you be the one who pronounces, “We guarantee our prices!”

RELATED

• A Look at Lumber Prices From the Supply Side
• Home Building by the Numbers
• Help for Getting Home Appraisals to Reflect Rising Costs
• Lumber Prices Hit Record High, Threatening Housing's Momentum

Front-Line Stories of Using Escalation Clauses

I have the privilege of working with Ashley Kent, a rising star in our industry. Selected for Pro Builder’s 2018 40 Under 40 class while VP of sales and marketing for Kent Homes, in Wilmington, N.C. (at the age of 27, no less), she is now president of that company.

Faced with rising construction costs, Kent started using an escalation clause in her company’s sales contracts and asked me what I thought. I asked if I could tell her a little story, which I’ll share it with you, too.    

Living in South Florida in the mid-1970s, I was recruited as a salesperson by a big-time developer/home builder from California, starting up a major project. Ross Cortese’s Rossmoor brand of active adult communities were popping up in California and in the Midwest, and were expanding into Florida; Rossmoor at Coconut Creek (just north of Ft. Lauderdale) was to become a condominium community of 5,250 homes in 133 mid-rise buildings on 457 acres.

The objective was to begin presales just after essential land development activities began. A Hollywood set designer was engaged to create the sales arena in a triple-wide trailer, with all of the elements to establish the developer’s credibility, stability, and integrity in the market.  

The goal was to attain 30 sales per month, or approximately 12 buildings in the first year. Because of the pent-up demand arising from two years of poor market conditions, coupled with a three-month big budget advertising blitz, nearly 150 units were pre-sold.

But then, the hammer dropped. The corporate project manager, a CPA from California, called an emergency meeting. Concerned about rising costs, he was immediately introducing an “escalation clause” to our purchase agreements. We were assured it was developed by very smart attorneys and would protect the company. It turned out to be a perfect example of hastily developing a “tactic” in the absence of a well thought-out strategy.  

For perspective, the homes were priced between $17,000 and $25,000. We were told to develop a story to present to potential buyers to explain or justify the escalation clause, which was limited to a 5% potential increase in the final sales price. Of course, we were still expected to meet the sales goals.

Recognizing an opportunity, I took a big chance: I crossed out the escalation clause and raised the price on the purchase agreement by 5%.

The first month was a disaster. Less than 10 sales, each a difficult encounter. The manager asked what the problem was, and I boldly asked him to explain the rationale for the new clause. His answer was simple: if we need to cover increased costs we have the right to raise the final price 5% to protect our margins.

A few days later, I met the one buyer who would make all the difference. A referral from the first group of sales, he was ready to purchase but had a real issue with the new escalation clause. I tried my best to explain it was not our intent to raise the price and I gave him the reasons we might have to. He looked at me and softly said, “Mr Schultz, I want to trust you. But do you expect me to believe a company of your size will not raise the price if you contractually have the right to? You obviously have been successful in your grand opening. Why don’t you just raise the prices 5% now and be done with it?”  

Recognizing an opportunity, I took a big chance: I crossed out the escalation clause and raised the price on the purchase agreement by 5%. He agreed and accepted. Round one of the battle was done.  

Round two was presenting the signed agreement and deposit check to the manager. I recapped what he had told us: that “if” needed, we could raise the price by 5% and both buyer and seller would be obliged to close. With that confirmed, I told him I thought I’d solved the problem of lagging sales and buyer pushback. His eyebrows rose as he read the agreement with the crossed-out clause and a deposit check. From then on, my way became our standard procedure.  

Back to the Future

I asked Ashley to consider that experience and use the checklist above to determine her best course of action. Here’s what she concluded ...

Due to the robust market and skyrocketing lumber and materials costs, Kent Homes has continued to raise prices to protect our margins.

We also control the number of homes we build annually to approximately 80 units, ensuring an excellent building experience for our homeowners and delivering high-quality homes. We also maintain a six-month backlog before we start construction, allowing us to keep prices as low as possible without eroding our profits.

Networking with builders locally and nationally, I discovered many were using or thinking about implementing escalation clauses in their sales contracts. Having seen templates for such clauses offered by NAHB, and with intent to keep prices as low as possible while providing the ability to raise our prices if needed, I conferred with our attorney to discuss crafting an escalation clause that would be easy for the customer to understand and also protect us.

Thinking about something is one thing; thinking it through creates an entirely different story.

After explaining the details of the escalation clause and how we would present this to potential buyers, I began requiring every contract to include it.

Despite those efforts, the initial reaction from our sales team, as well as potential buyers, was skepticism, uncertainty, and confusion. The sales team said the clause would not sit well with potential buyers and would be one more hurdle to building rapport and trust with our potential buyers. Having to go back to clients prior to starting their home to tell them the price is going up X percent would not be well received and will only sour their experience just as we were starting their home. In essence, they would be making the same sale twice, while taking their attention and efforts away from other potential buyers.

They asked when we planned to introduce the clause to potential buyers, whether other builders were doing it, where to include it in their presentation, and how to best explain and defend how we were determining the escalated amount.

The retorts from potential buyers were as they predicted. They wanted to know how, exactly, the escalation percentage would be determined, whether prices would go down if materials costs went down, if we could raise the price up to X percent, then why wouldn’t we increase that entire amount, regardless of how it related to actual cost increases.

From March 18 to April 7, 2021, the escalation clause was mandatory in all Kent Homes contracts. In that time, we made four net sales with the clause in effect. Due to the ongoing questions and hesitation from potential buyers, I scheduled a video conference with Bob Schultz. He listened to my story, told me about his experience with this issue, and walked me through his checklist. My instincts told me that with the skills my sales team had developed in selling value over price, potential buyers would be willing to pay more for their home initially if they knew their price was guaranteed. I pivoted and withdrew the escalation clause from our contracts.

After raising the price by the same percentage of the escalation clause previously required, we sold 10 homes and received four home-site reservations for a total of 14 net sales in the next three weeks. That’s 14 net sales at the higher price, more than tripling our sales pace within the same time frame as we had the escalation clause in place.  

And, I learned a valuable lesson: Thinking about something is one thing; thinking it through creates an entirely different story—and result.