For many Americans, real estate, in the form of a family home or rental property, is their single largest investment. These investors often perceive real estate as one of the safest and most reliably profitable investments over a period of time. However, real estate investment involves a high cost of entry (usually funded by a loan with interest), a long investment period and great uncertainty. Instead of buying actual property, investors can buy real estate options to invest in real estate at a lower cost and with fewer expenses.
A Realistic Look at Calculating Profit in Real Estate
A novice real estate investor may look at a two-bedroom apartment, see that in five years it increased in value from $100,000 to $300,000 and conclude a tripling of investment value. However, this simple analysis misses routine related expenses, including finance charges for property purchase, monthly interest payments, property taxes, commissions to agents during purchase or sale, monthly association fees, maintenance and repairs, insurance, and other applicable taxes (e.g. capital gains tax on the eventual sale of the property, or a valuation above a certain level qualifying the owner for a wealth tax).
Considering all these factors, the realistic valuation of returns for property is reduced substantially. Developments during the investment period may also lead to difficulty in selling the property later. For example, a noisy new highway or a spike in crime may devalue the property. (For related reading, see: The Most Important Factors For Investing In Real Estate.)
A more affordable way to invest in and profit from real estate is through real estate options.
What Is a Real Estate Option?
A real estate option is a specially designed contract between a buyer and a seller. The seller offers the buyer the option to buy a property for a specified period of time at a fixed price. The buyer purchases the option to buy or not buy the property during that time. 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 preexisting contract.
You may have encountered the concept of options when purchasing stocks. Options provide many choices to the buyer. They can be exercised early, held until option expiry or sold to a second buyer before expiration. Real estate options are commonly used by property developers and investors in commercial or high-end residential property. Real estate options provide more flexibility and a low-cost trading and investing opportunity to buyers, with limited benefits to sellers. (For related reading, see: How Real Estate Options Work.)
Example of a Real Estate Options Trade
Here is a comprehensive analysis of risk and reward of a real estate options 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 nonrefundable 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 will include the following conditions:
- Property details (location, size and other specifics)
- Duration of the contract (six months from trade date)
- Option premium or consideration amount ($25,000 nonrefundable paid by the buyer to the seller on the trade date)
- Agreed purchase price if the option is exercised during the contract ($2 million)
For the six-month duration of the contract, there are 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 and new option buyer purchases the desired property at current market rates.
Scenario 4: The builder is not able to secure a loan or permits. He also cannot find a new buyer for his option. 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. 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 a lower-cost method to trade, invest and profit from real estate investments. However, they are effectively OTC contracts between two individual parties with no outside regulatory oversight. The involved parties must ensure the options contract is fair. Default by the option seller is one of the major challenges in real estate options agreements. In such cases, the buyer’s only recourse is a lawsuit. Lack of publicly available information and past records on real estate option participants is another challenge. Real estate option investors should also consider additional expenses like fees for legal services such as drafting and registering the contract.
(For further reading, see: Invest in Real Estate with $1,000 or Less.)