An option contract in real estate is a crucial part to any seller-to-buyer property transaction. However, few people understand how it works, its pros and cons, and how to apply it when buying or selling properties. Option contracts are a unique buying or selling strategy involving the buyer and seller without including any third party. Essentially, it’s a contract that allows the buyer to place an “option to buy” on a property within a specified period of time.
Continue reading to understand more about real estate option contracts and whether it’s a good investment strategy in the real estate business.
What Is a Real Estate Option Contract?
A real estate option contract is a unique legal agreement between the buyer and the seller that allows the buyer to have exclusive rights to buy the property when they are ready. The seller enters into a unilateral contract with the buyer, providing them with an “option to buy” the property within an agreed-upon timeframe.
Once the option contract is in place, the seller can’t offer the property to other buyers until the agreed buyer time frame elapses. So, if the real estate option contract is set to last six months, the seller can’t offer the property to other potential buyers until the 6-month period is over..
It’s worth noting that while the buyer has entered into a legal agreement to buy the property, they are not obligated to do so. The buyer simply puts a hold on the property, but they don’t have to buy it in the end.
From the seller’s perspective, they have to wait until the option to purchase clause runs out or the buyer makes it clear they are not interested in the property. If the agreed-upon time expires before the buyer makes up their mind, the seller can make the property available for purchase in the market.
You might wonder, “What’s in it for the property seller?” Essentially, an option to buy usually involves a buyer paying for the option. The property buyer pays for the predetermined buying price, and the option to buy lasts for six months to a year. If the buyer doesn’t purchase the property within the specified time frame, the seller gets to keep the money.
Characteristics of a Real Estate Option Contract
Here are some of the features of a real estate option contract.
Grant of Right
The option to buy contract gives the buyer the right to purchase the property at an agreed-upon price within a specified time frame. The agreement provides the buyer with exclusive rights to buy the property.
Time-bound
Option contracts have an expiration date. The buyer should exercise their exclusive rights to purchase the property before the expiration date elapses. If the buyer doesn’t exercise their rights to buy the property on or before the agreed-upon time frame, the seller gets to keep the money used to buy the option.
Non-obligatory
While the option contract gives the buyer exclusive rights to purchase the property, they are under no obligation to buy it. The buyer can simply hold on to the property as long as they wish while waiting for their preferred price movements. If the buyer is no longer interested in the property while the option contract is still active, they can choose not to buy.
Consideration
Option contracts require the buyer to pay the strike price. This is the pre-agreed price of the property.
Transferability
The option to buy the property can be transferable to another party in a manner subject to the agreed terms of the option contract.
Exclusive
One of the main interesting aspects of real estate option contracts is that it provides the buyer exclusive rights to buy the property within the agreed-upon time frame.
Termination
Option contracts feature a termination option. The termination option refers to a legal clause allowing the property buyer or seller to back out of the agreement before the option-to-buy time frame expires.
Specific Terms
Real estate option contracts also feature specific terms of the agreement, including the purchase price, option period, option consideration, and other relevant terms.
Benefits of Real Estate Option Contracts
Here are some of the benefits buyers and sellers enjoy from real estate option contracts.
Flexibility in Real Estate Investment
Property buyers are at a great advantage when using real estate option contracts. Option contracts provide them the flexibility of investing in properties likely to generate profits. The buyer doesn’t have to pay the complete value of the property to invest in it.
Reduced Risk
Another major benefit of option contracts is that investors can secure profitable investments at relatively reduced risk. Consider this example; an investor identifies a piece of land located in a prime location near a town, college, or university. Instead of buying the land, the investor secures the land through an option to buy.
Now with the option contract in place, the investor markets the land to potential investors and developers at a higher price than the agreed-upon option price. If an investor agrees to buy the property, the seller can resell the option or flip the land and pocket the profits earned from it.
So, one of the main perks of option contracts is that it allows property buyers to invest in properties with reduced risk. In the above example, if the property buyer doesn’t find the land profitable, they can back out of the contract before the time frame expires.
Lock in a Future Purchase Price
Option contracts also allow buyers to lock in a future sale price of a specific property. If an investor identifies a land that can increase its value over the next few months, they can lock in the future buying price through an option to buy. The best part is that they don’t have to pay the whole price for the property.
Improved Negotiating Power
A buyer can also benefit from an option contract as it gives them better negotiating power for a specific property. For instance, if you want to purchase a property to build your home, you can use an option contract to ensure the property is available until you have the required funds.
The option contract also ensures the property owner can’t sell it until the agreed time frame expires. It’s worth mentioning that the option-to-buy agreement also provides you buy the property at the agreed price, even if the property value increases during the interim. But this depends on the terms of the option contract.
Overage Agreements
Property buyers and sellers can also benefit from overage agreements in the option contract. Usually, this happens when the developed property increases in value when the option agreement is still active. If the value of the land increases significantly, the overage agreements in place might require the investor to share the profits with the property owner.
Developer Protection
An option contract also protects the developer as they gain exclusive buying rights to the sold property. Once an investor agrees with the property owner and pays the option costs, the owner can’t sell the property.
This means the developer or investor can explore the viability of the property within the specified time frame. If the property increases in value while the purchase contract is active, the investor might end up paying less than the market value for the property.
Seller Protection
The property seller also benefits from the option contract agreement as the buyer incurs the option costs to secure the property. In most cases, if the purchase contract fee is non-refundable, the property owner pays the money if the buyer opts out of the sale agreement.
Moreover, the seller can agree on a price higher than the market value since the developer might increase the property’s value by getting development approval.
Limitations of Real Estate Option Contracts
While a real estate option contract seems like a great investment idea, the following are some of the main limitations you should be aware of.
Complexity and Legal Requirements
Option contracts are legally binding. The buyer and the seller must enter into a contractual agreement for the option contract to work. Generally, this complicates the process of buying and selling property.
In a normal scenario, the seller only mentions their price and negotiates with the buyer before selling the property for an agreed amount. Therefore, option contracts only bring about complexity and so many legal requirements the buyer and seller must meet.
Additional Option Costs
An active option contract requires additional non-refundable costs paid to the seller to reserve the property for a specific period. Option money is paid within 72 hours of entering the purchase agreement.
Time Limitations
Real estate option contracts have time limitations which are a significant disadvantage to the buyer if they don’t take action when the option to buy is still active. Once the option contract expires, the purchasing rights are passed to other potential buyers.
No Guarantee of Sale
For property owners, option contracts can be a disadvantage as there is no guarantee of a sale. Yes, the buyer has the option to purchase the property, but there’s no guarantee they will buy it. This can be a major downside if the buyer backs out of the deal.
Difficulties Finding a Buyer
Entering an option contract limits the property owner from putting the property on the market. Option contracts give buyers exclusive property rights when the contract is active. This is a considerable disadvantage for the property owner as they must wait until the contract expires or the buyer backs out.
Key Takeaways
Option contracts in real estate have pros and cons for both property buyers and sellers. With an option contract in place, buyers have stronger negotiating power and can benefit from the flexibility of investing in real estate. Overage agreements can also mean that the buyer and seller gain something if the property increases in value while the option contract is active.
However, option contracts have time limitations, and there’s no sale guarantee for property owners. Make a smart move today by talking to experienced real estate agents from eXp Realty. We are a phone call away to ensure you make intelligent investment decisions!
FAQs
Below are some frequently asked questions about option contracts in real estate.
What is an example of an option in real estate?
If you want to purchase either a primary home or a rental property for future investment, you can secure it by paying the option price. By doing this, you can hold the property for some time to get the required funds or to speculate whether the property is worth investing in it or not.
What is the purpose of an option contract?
Option contract provides the buyer exclusive rights to buy a property, but they are not obligated to purchase it. The buyer pays the option fees and holds the property for an agreed period. Once the option period elapses, the seller can accept offers from other potential buyers.
Why use an option contract in real estate?
You can use an option contract to attract investors to buy a property for a higher value than the market price. As a result, you can profit from holding the property and finding potential buyers willing to pay a higher price for it.
Who benefits from option contracts in real estate?
The buyer and seller benefit from an option contract in the real estate transaction. The property buyer can secure the land until they find suitable investors and make profits from it. It’s also worth noting that the option contract protects the buyer from losing the land to other investors. As for the seller, the main benefit is the option fees they collect from the property buyers.
What is the biggest advantage of option contracts?
The biggest advantage of option contracts in real estate is that it allows investors to invest in primary houses and rental properties with reduced risk. They can hold a property for some time as they look for potential investors to buy it for a higher price than the market value. This means they can profit from the property without paying its full price.
What are the disadvantages of an option agreement?
Sellers are disadvantaged in an option agreement as they are never guaranteed a sale. On the other hand, buyers must incur additional costs to secure the property for some time.
