How To Use Real Estate Options Contract To Make Money and Lower Risk

There are several paths to get started in real estate investing. However, lesser-known real estate option contracts might give you additional flexibility and opportunities to meet your financial goals.

Real estate options contracts can give potential buyers flexibility – but not the obligation – to buy a property at a specified price. They are preferred by many real estate professionals who want to buy a property at a fixed price but aren’t yet willing to make a 100% commitment.

Whether you are an experienced real estate investor looking to dig deeper into options contracts or a new investor just learning the ropes, understanding what goes into a real estate options contract can help ensure that your next deal is legally sound. And all parties involved understand their rights and obligations.

Let us dive into a comprehensive breakdown of real estate options contracts, exploring everything from why they are essential to how they work practically. We’ll also provide some tips for using this powerful tool wisely as part of your investing strategy to protect yourself while still taking advantage of lucrative opportunities when they present themselves.

What Is a Real Estate Options Contract

A real estate option contract gives a potential buyer the exclusive right – but not the obligation – to buy a property or piece of land at a future date at a predetermined price. 

Contracts are ideal when a prospective buyer may be interested in buying a property but want to wait. If they work out an options contract with a seller, they can have the exclusive right to buy the property in the future.

Options contracts can be used for various real estate dealings, from home purchases to commercial development projects. They offer flexibility for both buyers and sellers and can be an effective way to hedge against market volatility. So, whether you’re a seasoned investor or a first-time homebuyer, understanding the implications of an options contract can be a valuable tool in navigating the real estate market.

How Does an Option Contract Work in Real Estate

A real estate option contract works similarly to a stock options contract and has three components

1. Premium
2. Sale Price
3. Duration of the contract

Real Estate Options Contract Premium

After entering into a real estate options contract, a seller may not sell the property to anyone else during the contract period. As such, a contract may place a seller at a handicap when selling a property. However, this exclusivity isn’t for free.

A buyer will pay a premium or option fee to keep the opportunity open to buy anytime during the length of the contract. The premium is paid upfront by the buyer. Even if the buyer does not ultimately purchase the property, they will NOT get the premium back.

Real Estate Options Contract Duration

It is important to note that most real estate options contracts are not held for an indefinite period. A property buyer may use option contracts when willing to pay a premium to retain the right to buy for a fixed period, also known as the expiration date or the option period. This may be as short as a few months or as long as many years. This agreed-upon time frame is settled before the option contract is signed. This way, both the potential buyer and seller understand precisely how long this option will be available to a potential buyer.

Real Estate Options Contract Sale Price

Furthermore, options usually set an agreed-to sale price. If a buyer chooses to execute their option, they will pay the price already agreed to with the seller. This can save significant time and expense, as the price has already been agreed upon. 

It is possible for an option to have a changing price depending on local economic conditions or the state of the current market. Still, the requirements and criteria must be explicitly written out in the contract.

What Is an Example of an Option Contract in Real Estate

The buyer and seller sign a real estate options contract to buy a property in 12 months for $3 million with a $50,000 options premium. The four possible outcomes are

Buyer buys the property in a year

The buyer secures the funding for a $3 million loan and has completed her due diligence on the feasibility of turning a profit on the property. She exercises her option to purchase the property at the agreed price of $3 million, and the seller will receive this amount in addition to the $50,000 option premium paid earlier.

Buyer does due diligence and doesn’t want to buy the property

The buyer found environmental issues which could plague the development of her apartment building investment. Not wanting to deal with the Environmental Protection Agency, the builder doesn’t exercise the option and loses the premium of $50,000.

Although it is a loss, the builder avoided the possible loss of $3 million if she had directly bought the property. The seller received the premium and can now start looking for another buyer.

Buyer doesn’t want to develop but wants to benefit from the appreciation

The buyer is busy with other commercial real estate investments and no longer wants to invest the time and energy to develop this property.

Since the property’s price has risen from $3 million to $3.5 million within six months, the builder can exercise the option, buy the property, and sell it for a profit of $500,000. The property owner will receive the $3 million selling price plus the $50,000 option premium. 

Why Use an Option Contract in Real Estate

There are many scenarios in which a prospective buyer may use a real estate option contract. 

Lack of Funds

Real estate developers frequently use options contracts. In a typical scenario, a real estate developer may be interested in developing a piece of land for future residential or commercial development. However, they may need more funds to complete this development at the time, or other circumstances may prevent them from completing the contract. 

If they want to hold onto the ability to develop the land in the future, they may seek to use a real estate option contract to ensure they get access to this land before anyone else does. When this contract is in force, a developer could pursue other items necessary to purchase and develop the property, like obtaining financing using real estate crowdfunding options.

Locking In Exclusivity

Options contracts can create exclusivity and lock out other buyers. An option to purchase a contract may be ideal when one buyer wants to stop anyone else from potentially buying a property. This can be a tricky proposition, as creating an options contract has to be agreed to by the property owner. In this case, the owner would have to determine that the options fee was the best financial course for them to take. 

Need More Information

Keep in mind that these contracts are expensive. Not only does a potential buyer have to pay a premium to hold the option, but there are other ancillary costs, like contracting with a law firm to draw up the contract. That’s why these contracts are often used by higher than average net worth developers who can afford to pay a premium to hold an option on the land. 

They are also commonly used by real estate investors interested in a property but want to wait to finalize the purchase.

Accredited investors often need more information before agreeing to a capital raise for a real estate project. Developers can use the time after signing the options contract to complete market studies indicating the potential rents for the developed property. Developers can use the time to hire the workforce necessary to complete the development of the property since skills needed for jobs in real estate are in high demand. All these details need to be fleshed out as part of the real estate syndication private placement memorandum.

Pros of a Real Estate Option Contract for the Buyer

The benefits to the potential buyer of an options contract are significant. 

Flexibility for Buyers

An options contract gives the buyer the right – but not the obligation – to buy a property over time at a pre-agreed-upon price. As such, an options contract is ideal for certain buyers interested in finalizing a residential or commercial property purchase but has yet to do so. Thanks to an options contract, a buyer maintains flexibility. In this situation, the buyer decides if and when to finalize the purchase of a contract and actually buy a property.

Lowers Cost for Buyers

Real estate options contracts are a great way to lower initial investment costs for buyers. Buyers can gain control of a property without having to purchase it immediately. This allows them to benefit from any potential appreciation in value that may occur over the option period without incurring upfront costs or taking out a loan.

Upfront Negotiation of Terms

The buyer can also negotiate favorable terms such as low rent payments and other concessions during this time. Furthermore, since the seller is only required to transfer the title after the sale has been completed, there is less risk for both parties than with a traditional real estate transaction. With these benefits in mind, it’s easy to see why real estate options contracts have become increasingly popular among savvy investors and buyers alike.

Several 1031 Properties Identified

The 1031 exchange option allows real estate investors to defer paying capital gains tax. The advantage of tax deferral is the stepped-up basis for heirs resulting in generational wealth creation.

One of the biggest challenges of the 1031 exchange is closing out the “like-kind exchange” within a specified period. A real estate options contract allows the buyer to pay a premium for the right to buy a property within a specific period. They can then conduct the 1031 exchange based on several pre-identified properties.

Pros of a Real Estate Option Contract for the Seller

Income for Seller

A seller can monetize their land without ever transferring ownership, having someone living on it, or developing it. A real estate options contract is a legally binding document. While an options contract is enforced, the seller still maintains property ownership, and they can use their property to generate passive real estate income in the form of the contract premium during this period. 

Avoids Non-Serious Buyers

Selling a commercial property can be difficult because location, market, and size can make it challenging. In some cases, the property could remain vacant for years. Instead of waiting for a sale, a real estate option contract can offer reassurance that the buyer is committed to meeting the sale terms and buying the property.

Thanks to options, a seller and a buyer may be able to enter into a contract that allows both the maximum degree of flexibility. 

It is also worth noting that options can extend the status quo. A buyer pays for the ability to buy land later, even if both parties aren’t ready to cut a deal at that moment. This gives each buyer and seller time to get financing or manage other considerations. 

Cons of a Real Estate Options Contract

A real estate option contract can provide flexibility for buyers, but that’s not to say that they are for everyone or come without real risks, concerns, or potential problems.

Premium Expenses for the Buyer

From a buyer’s perspective, real estate option contracts come with major expenses. Yes, it does give a buyer a chance to purchase real estate, and it ensures that no one else can buy the real estate on which they have an option. 

However, a buyer will have to pay a premium to lock that land up and ensure they are the only ones who can buy it. Furthermore, there is never a guarantee that the buyer can position themselves to buy the property. For example, a buyer may take out an option on a property and give themselves time to get their finances in order, get the equipment necessary, or ensure that certain contracts are executed. All of this is done before they actually purchase real estate.

However, if the finances to buy this real estate asset fall through, a buyer may be unable to execute a contract. In that case, they will have wasted significant money trying to obtain actual ownership over a property.

Additionally, there is always the potential for unforeseen issues to arise during the option period, such as title disputes or zoning changes.

Also, if the market shifts unfavorably after entering into an options contract, investors may lose money rather than profit.

Loss of Flexibility for the Seller

Depending on the specific situation, a seller may be at even more of a disadvantage than the buyer. Yes, a seller can monetize property while still retaining ownership, just like a rental property.

The challenge is that sellers lose all flexibility when engaging in this contract. They can continue to collect options premium but can no longer sell a property for a higher price. As such, if a better offer were to come along, the seller would be unable to benefit.

Alternatives to a Real Estate Options Contract

Real estate transactions have gotten very creative over the past few decades, enabling buyers and sellers to explore new options as they attempt to determine the best way forward for buying and selling properties. The specific alternatives that a buyer and seller examine ultimately depend on the situation that each finds themselves in.

Seller Financing

In most cases, a buyer may want to pursue an options contract because they cannot secure financing. In that instance, a buyer may want to pursue seller financing.

In this case, the seller of the property only receives a down payment, then gets the rest of the funding over time. There has to be a high degree of confidence that the buyer can make payments in this situation.

There also needs to be strong protections for the seller, ensuring they get their money or property back if the buyer defaults on payments.

Sale-Leaseback Transactions

There are also sale-leaseback transactions. In this transaction, a property is sold to another party, then leased back to the original owner. This provides the original owner of the property cash upfront but allows the new owner to monetize the asset. Such sale-leasebacks are common when a property owner needs to monetize property but still needs access to the property.

It is ubiquitous for cash-strapped governments looking to turn some property assets into money. The challenge is that these methods are expensive over time and usually cost the original owner of an asset more money in the long run. 

Rent To Own

The person renting agrees to lease the property with the added option to buy it. Usually, the renter (lessee) must provide an upfront payment and/or additional money each month that can be used towards the purchase if they decide to exercise the “buy” option.

For individuals who don’t have excellent credit scores for purchase, the rent-to-own model provides additional options for homeownership. Rent-to-own mobile homes are often an option for lower-income individuals.

Assignable Purchase Option Contracts

Assignable purchase option contracts are real estate option agreements allowing one party to transfer and assign the contract to another. This contract assignment is used when one party wants to transfer real estate assets directly. The assignee receives the benefit of the property acquisition under the original purchase terms but also takes on the assignor’s duties, responsibilities, and liabilities.

The original buyer sells the assignable purchase contract at a higher price than the options premium paid, thereby profiting from the deal. The new buyer secures the property at a lower value than the current market value.

Tips for Negotiating a Successful Real Estate Options Contract

When negotiating a real estate options contract, remember a few essential tips.

1. First, it’s essential to identify your goals and priorities before entering negotiations. Know what you want and what you’re willing to compromise on.
2. It is also vital to do your research beforehand, including understanding market trends and the specifics of the property in question.
3. During the negotiation process, maintain open and constructive communication with the other party, aiming for a collaborative rather than an aggressive approach.
4. Don’t be afraid to ask questions and seek clarification on any points of contention.
5. Please make sure to have signatures from all parties involved in the contract, and include identifying information about the property, such as the parcel number. Verifying that one of the signing parties is the legitimate title holder is crucial. Additionally, ensure that the option premium, term, and purchase price is clearly stated on the option contract.
6. In addition to the option premium, duration of the contract, and expiration date, also include the choice of law clause. The clause will determine which rules apply based on the property’s location. Consider state statutes regarding real estate option contracts when creating your contract.
7. Finally, once an agreement is reached, ensure it’s documented clearly and accurately in writing to avoid misunderstandings.

Following these tips can increase your chances of negotiating a successful real estate options contract.

Should You Pursue Real Estate Options Contracts

Real estate options contracts offer opportunity and risk for those engaging in the practice. While understanding the key terms involved is essential to protect one’s interests and ensure a successful outcome from an options contract signing, there can never be complete security when entering a real estate contract.

With this in mind, it is important to proceed cautiously and be proactive about avoiding common mistakes when drafting and negotiating such agreements. Despite the procedures required to ensure a successful deal, the benefits of a real estate options contract could outweigh any potential downsides.

Knowing what you are getting into beforehand is crucial in realizing these benefits while mitigating the potential risks of this type of transaction.

So, are real estate option contracts right for you? Maybe. Ultimately, there’s no set way to answer this question, as the answer depends on what you need out of a purchase price and what your plans are for a property. There is no question that these contracts have real utility and can enable someone to purchase property at a later date.

However, a real estate option agreement comes with actual costs and concerns to the buyer and seller alike, meaning that both parties must be sure about the option period, option fees, and more.

Real estate option contracts are generally meant for experienced investors rather than for individuals looking to invest in real estate with little to no money down. However, depending on your risk appetite, you can explore options with an experienced real estate mentor. If you do not have a mentor, at least ensure you are educated enough by reading some of the best books on real estate investing.

Ultimately, it is your decision, but you should contact an experienced real estate attorney and agent to determine if a real estate options contract is your right investment strategy. Consulting with these experts can ensure you stick to all mandated rules, help you secure funding, and avoid legal mistakes.