There are several ways to invest in real estate. For many Americans, the most basic real estate investment comes in the form of a family home or rental property. Investing in a single real estate property can be a large, lucrative investment with multiple possibilities for usage. Versatility, longevity, and appreciation are often top reasons that make single property investments relatively safe, reliable, and profitable over time.
A rise in online crowdfunding and mortgage lending has also broadened many of the possibilities and opportunities for direct real estate investors. Platforms like Lending Club, Prosper, SoFi, LendingOne, LendingHome, Groundfloor, Money360, and more, offer faster, easier, and more efficient ways to get a mortgage loan, increasing the potential for buyers to be more versatile in their investments.
As the real estate market evolves, new offerings are being introduced regularly. With these introductions, real estate investors now have a range of choices spanning from real estate investment groups, real estate mutual funds, real estate investment trusts, and crowdfunded retail offerings like Fundrise. However, direct real estate investments still offer a way to make significant profits for those investors with the right mix of financial stability and risk tolerance. For these investors, real estate options may be a possibility that when exercised can add to the gains or reduce some of the risks of a direct real estate investment.
Real estate options aren’t available on exchanges, they don’t have fluctuating prices beyond the premium, and they don’t usually cover multiple units. Real estate options are most heavily utilized in the commercial real estate market but they can be used by regular investors too. Typically, real estate options are used for targeted situations in which a buyer will benefit from an option but not a requirement to buy real estate by the end of a holding period.
- A real estate option is a specially designed contract provision between a buyer and a seller.
- Real estate options are negotiated between buyers and sellers, usually offering the greatest advantage for the buyer.
- Holding period real estate option provisions are the most common but options can be drafted with a multitude of variations.
What Is a Real Estate Option?
Direct real estate investments come with many unique considerations that usually don’t apply as strictly to the variety of other real estate alternatives. For interested or advanced investors, a real estate option as a provision to a contract to buy a real estate property directly may be a potential opportunity. Real estate options come with an additional level of complexity as well as their own unique parameters.
Broadly, a real estate option is a specially designed contract provision between a buyer and a seller. The seller offers the buyer the option to buy a property by a specified period of time at a fixed price. The buyer purchases the option to buy or not buy the property by the end of the holding period. For the right of this option, the buyer pays the seller an option premium. If the buyer decides to buy the property (in other words, exercise the real estate option), the seller must sell the property to the buyer according to the terms of the pre-existing contract.
You may have encountered the concept of options when purchasing stocks. Options provide some additional choices to a buyer with terms based on the underlying asset. Options in general can be exercised early, held until option expiry, or possibly sold to a second buyer before expiration. Real estate options are most commonly used by property developers and investors in commercial or high-end residential property deals. Real estate options provide more flexibility and potentially a greater investing opportunity to buyers, with limited benefits to sellers.
There can be a multitude of drafted real estate options incorporated as part of a real estate purchasing contract agreement. Some of the most common include:
- Holding period option: buyer pays a premium for the option to buy the property but is not required to
- Listing option: buyer uses the option to list the property and potentially profit from a markup
- 1031 exchange option: buyer pays a premium for the option to obtain a holding period then makes a like for like real estate property exchange at the time of the purchase
The real estate option premium, negotiated holding period, and final selling price are often the most important components negotiated in a real estate option agreement.
Example of a Real Estate Option
Here is a comprehensive analysis of risk and reward for a real estate option scenario. Assume a builder has $500,000 and wants to purchase land listed for $2 million. The builder is unsure of a few things:
- Can the builder raise $1.5 million through bank loans or other sources?
- Can the builder gain necessary permits for residential or commercial development or further subdivision of the property?
- Can the builder raise money and obtain permits before another builder buys the land?
In this situation, a real estate option is appropriate. For a defined non-refundable cost (called the real estate option premium) of say $25,000, the builder can enter a real estate option contract with the seller. The real estate option allows the builder to lock down the property sale price at $2 million over a period of six months.
The real estate option contract could include the following conditions:
- Property details (location, size, and other specifics)
- Duration of the contract (six months from agreement date)
- Option premium or consideration amount ($25,000 non-refundable premium paid by the buyer to the seller in a lump sum)
- Agreed purchase price if the option is exercised during the contract ($2 million)
For the six-month duration of the contract, there may be four possible scenarios.
Scenario 1: The builder is approved for a $1.5 million bank loan. He also confirms he can obtain necessary permits for development. He exercises his real estate option to purchase the property at the predetermined price of $2 million. The seller receives $2 million plus keeps the additional $25,000 option premium.
Scenario 2: After two months, the builder discovers he will not be able to obtain a development permit. In the next four months, the builder manages to find another party willing to buy the property for $2 million. The builder sells the real estate option to the new party for a new price of $30,000. The new party replaces the builder in the original option contract. The new party exercises the option and purchases the property for $2 million. The seller receives $2 million from the new party plus keeps the $25,000 option premium from the builder. The builder sold the option for $30,000, so he makes $5,000 and is not saddled with a property he cannot use.
Scenario 3: The builder is simply an option buyer looking to benefit from price appreciation of the property. If the demanded price of $2 million increases to $2.2 million in five months, the builder will benefit by exercising the option to purchase the property and selling the property for a profit. At the end of the transaction, the property owner gets $2 million plus the $25,000 option premium. The builder earns a profit of $175,000 from the sale of the property.
Scenario 4: The builder is not able to secure a loan or permits. He also cannot find any other interested buyers. The builder lets the option expire and loses the option premium. However, the buyer was able to avoid a potentially bad $2 million investment by paying the $25,000 premium (1.25% of the actual deal value). The seller benefits by $25,000 and continues to search for a buyer.
In all cases, once a real estate options contract is put in place, the seller no longer has a choice on whether to sell the property or at what price during the option holding period. The seller must wait six months for the buyer’s decision. This is why the seller receives and keeps the option premium regardless of what the buyer ultimately decides.
The Bottom Line
Real estate options offer an alternative method to trade, invest, and profit from real estate investments. They can be considered a type of over-the-counter contract between two individual parties. There is no exchange market for these types of options but there can be creative provisions that could potentially allow a buyer to sell the option while still in an active holding period. In general, the involved parties must ensure that the option contract provisions are appropriately written, fair, and adhered to by those involved.
Real estate option contracts can offer some alternative ways to make money but generally one of their biggest advantages is the diversion of large risks. Real estate developers could benefit from holding multiple real estate option contracts and potentially only exercising a selected few based on evolutions during the holding period. A contract holder may also choose to forego an option if changes occur during the holding period like a new busy highway or increase in crime.
Holding periods for these options can vary, which also varies the risks. A seller is usually locked into a set price. A high probability of exercise though can provide them with some time to make better choices or arrangements. A buyer is usually required to pay a specified premium over the life of the holding period. The premiums may help in lowering the purchase price. They may also allow the buyer to obtain better mortgage financing terms, which lower the overall costs. Over the life of the holding period, a real estate property may also appreciate in value with a purchase price that remains the same.
Default by the option seller can be one of the major challenges in real estate option agreements. In such cases, the buyer’s only recourse is usually a lawsuit. Lack of publicly available information and past records on real estate option participants is another challenge. Real estate option investors may also need to consider additional expenses like fees for legal services such as drafting and registering the contract.