There is no doubt that investing in real estate is a great way to increase your wealth over time. Real estate investing comes in many forms – from basic home buying or as a larger investment in commercial properties. There are even Real Estate Investment Trusts (REITs) that you can invest in without having to put up extensive capital.
For savvy investors who want to utilize real estate to increase their wealth, options are a great solution. A real estate option is a contract between the buyer and seller. The contract has specified terms laid out that give the buyer the option to purchase the property at a predetermined price during the contract holding period.
How Do Real Estate Options Work?
Real estate options allow buyers to get all their ducks in a row before agreeing to the sale. The option contract has 6 main parts: seller, potential buyer, option consideration, holding period, specified price of property, and exercise of option. The exercise of option is how the buyer signifies in writing that they are ready to move forward and complete the transaction.
Within the contract, the seller offers the buyer a fixed price to purchase the property within a predetermined time frame. The buyer pays a consideration (a premium to the seller) for the right of the option, then has the contract period to decide whether or not to buy the property.
What Does It Mean to Option a Property?
When the buyer enters a real estate purchase option, they have the exclusive rights to purchase the property within the allotted time frame. They pay a premium to the seller, who agrees to not sell the property to anyone else during the holding period. At any time throughout the hold period, the buyer can choose to purchase the property at the agreed-upon price.
As an investor, real estate options are used to secure high-profit investments for relatively low risk. This creative investing transaction is called a unilateral contract since the seller is the only one bound by it. The buyer has the exclusive option to purchase during the holding period, but is not obligated to do so.
How Much Does a Real Estate Option Cost?
There is a fee that is paid to the seller through the contract called a consideration. Typically, this premium is somewhere between 3% and 10% of the property’s market value. This is one of the main things that attracts sellers to real estate options. In the event that the buyer chooses not to purchase at the end of the contract term, the seller still retains that initial lump sum payment.
The buyer will want the consideration to be as small as possible, but the seller will obviously want it more favorable in their terms. There is no set amount, and it is entirely dependent on the agreement made between both parties.
When Should You Buy Real Estate Options?
No matter if the market is hot or not, utilizing an option to purchase real estate can be a powerful tool before you fully commit to buy a property.
Residential Real Estate
If you are interested in purchasing a property but are hoping the market will improve before you commit, you can utilize a real estate option. For example, you might find a property for $300,000 at the current market value. If you believe the price will appreciate to $350,000 or more in the near future, and you are not quite ready to finance the investment, you can create an options contract.
However, if you see the value continue to appreciate, you can purchase the property for $300,000. Lastly, if you see the value depreciate, you can choose to walk away – minus what you have paid into the contract thus far.
Commercial Real Estate
If you are interested in purchasing a parcel for commercial real estate development, you might not want to miss out on the perfect swatch of land. You can utilize a real estate option to purchase the land listed. This allows you time to get financing in order for the development, gain the necessary permits, and stop anyone else from swooping in with a different offer.
Examples of Real Estate Options
Real estate options can be appropriate in many situations. Imagine you want to purchase your neighbor’s home for $750,000 cash to turn into a rental property. However, you have a potential job offer that could move you across the country and you would need to liquify some assets before fully committing. If your neighbor realizes that you are a good, cash buyer, they might decide to offer an option contract.
The terms of your real estate option could include that you have exclusive rights to buy the home within 30 or 60 days, and that you agree to pay the $750,000 cash price. The terms are then set in writing and signed by both parties. The next 30 to 60 days provides you with the time needed to ensure you will not be moving across the country and the time needed to liquify your assets. Your neighbor benefits because they have a good buyer “on the hook.”
Different Types of Real Estate Options
While options contracts seem fairly straightforward, there are actually several types of options to buy.
Holding Period Option
With a holding period option, the buyer pays the consideration premium for the option to purchase the property at or anytime during the holding period. But they are not required to do so.
With a listing option, the buyer uses the option holding period to list the property for sale and make a mark up for it. For example, if you knew a seller was eager to offhand a property, you could enter an options contract to lighten their load.
You would agree upon the price you will pay, pay the consideration premium, then do the work to make the property turn a profit – through marketing or other means. If the agreed upon price was $250,000, and you marketed the property and sold it for $300,000, you would have a $50,000 profit.
1031 Exchange Option
A 1031 exchange is where an investor swaps one investment property for another, and the capital gains taxes are deferred. The name comes from IRS code Section 1031 and has many moving parts. The IRS sets rules on these options, including that exchanges can only be made with like-kind properties.
A 1031 exchange option is when the buyer pays the consideration premium to secure the holding period, then moves forward with their 1031 exchange.
The most common type of 1031 exchange option is called a delayed exchange. This is where the investor sells the property first to buy another property within 180 days. The opposite is a reverse exchange, where an investor buys a property first, then has 180 days to sell another property.
Advantages of Real Estate Options
There are advantages for both the buyer and the seller in real estate options.
Advantages for Seller of Real Estate
The biggest draw for sellers is they immediately benefit from the consideration premium. This non-refundable payment is paid up front in a lump sum to the seller.
Advantages for Buyer of Real Estate
The biggest advantage for buyers is that a real estate option stops the competition for the predetermined holding period. This extra time allows the buyers to sort out everything necessary before moving forward.
It also locks in the property price, so if the market improves, they have the option to purchase the property at the lower agreed upon price. And if the price drops, they can choose to not move forward.
Difference Between a Purchase and Option Agreement
As mentioned above, an option agreement gives the buy the option to buy the property with no obligation. A traditional purchase agreement is more concrete. There are no surprises, and the buyer agrees to purchase the property for the price negotiated with the seller.
Option agreements also include a purchase agreement. That way, both parties know what the agreement is in the event they choose to move forward with the purchase.
Utilizing Real Estate Options to Your Advantage
As an investor, you do your due diligence before placing your hard-earned capital into investments. Real estate options are just another way to ensure you are fully ready to make the investment, before placing your money. By utilizing them to your advantage, you can grow your wealth.
Before you start, be sure to have a knowledgeable attorney, and even your financial advisor, on hand. You will want them to write and/or review the contracts before you enter them.