An option contract is one of the most unique ways to purchase property.
It’s a contract that exists between a buyer and seller, and it requires the seller to put their property on hold at a set rate until the buyer decides if they want it or not.
If this sounds like an intriguing investment option (and a way to keep multiple investments balanced at once), then keep reading.
We have the top things you need to know about option contracts in real estate.
1. What is an option contract in real estate?
Option contracts are legal documents that grant a buyer or investor the option to purchase real estate from a seller.
This seller normally offers an option to buy a property within a limited period of time.
An option contract ensures that the buyer has the exclusive right to buy a piece of real estate.
While they have exclusive rights, the buyer isn’t under any obligation to follow through on the purchase.
That said, a seller is not required to reserve the property indefinitely.
An option contract has time limitations, and once those expire, the buyer will lose those purchasing rights, which can then be offered to others.
Option contracts in real estate can also be called “option to buy’ contracts, purchase and sale agreements, or real estate purchase agreements.
2. What is the purpose of an option contract?
An option contract gives the buyer alternatives.
The outcome may change according to the type of buyer, but the option includes early exercise, option expiration, or second-buyer sales.
Real estate professionals most often use option contracts to provide flexibility on specific types of real estate transactions.
Here are the top 6 reasons why these documents exist in real estate.
It attracts high net worth buyers to high-end real estate transactions
It provides stipulations in purchase agreements, land contracts, a deed of trust, and mortgage notes
It lowers the cost of the initial investment
It allows the buyer to fix the price for a certain period of time
It mitigates seller risks on EPA liabilities
In short, option contracts allow buyers to engage in alternative forms of investment, trade, and profit over traditional opportunities.
While an exchange market for options doesn’t exist, their provision can increase the future likelihood of that happening.
When writing an option contract in real estate, it’s most important that it’s enforceable and valid.
3. What should be included in an option contract in real estate?
To ensure it’s a valid and binding contract, here’s what you should include when drafting an option to buy agreement:
The contract should be made in writing (no handshake or verbal contracts are permitted)
Include signatures of all parties
Include the date that the option contract is signed
Include the date when the option contract is expired
Verify that one of the signing parties is the title holder
Include the address of the property
Include the parcel identification number
4. What are two examples?
A common example of how option contracts work in real estate is in development.
If a developer wants to purchase a $3 million building, but can’t secure funding for up to one year, then a real estate option contract may allow the developer to obtain exclusivity rights.
This would occur because there would be no point in obtaining financing on a building that may not be for sale in a year.
Here’s another example for commercial property.
Commercial property can be difficult to sell from a seller’s perspective depending on the location, market size, and other factors.
The building may remain vacant for years due to its unique purpose.
Instead of waiting for a solvent buyer to come along — which is rare — an option contract would provide reasonable assurance that the property buyer is serious about their desire to satisfy the sales terms and transfer the property.
5. What key terms should you know?
As with any niche area of real estate, key terms are essential to understanding the contract and how they work.
Below, we’ll provide a list of key terms, so that you’re clear on the words and phrases you may see when dealing with these types of contracts in the future.
Option fees
These fees are used in the commission of contract enforceability.
To have a valid and enforceable contract, there must be something of consideration exchanged between the buyer and seller.
The option fee cannot be nominal; however, there’s no specific guidance on reasonability.
Note: Option fees are non-refundable.
If a buyer doesn’t exercise their purchasing rights, they generally forfeit the option fee.
However, if they do follow through on the purchase, then the seller will normally deduct the option fee from the sale.
Duration
Real estate option contracts are required to specify a date when they will have to exercise their purchasing rights.
However, there is flexibility in this duration as sellers can allow them to continue for weeks, months, or years.
That said, most sellers follow between one to five years as a general guideline.
During the option period, buyers can purchase the real estate asset.
If the period expires, then the agreement will be terminated, and the buyer loses the option fees that they paid to the seller.
Real estate purchase price
Option contracts in real estate must include the purchase price of the asset.
This value may be based on the property’s current appraisal value.
Especially when the duration is extended, this strategy doesn’t always seem practical.
As such, most sellers will require that the buyer agrees to a reappraisal of the property.
In some other cases, the seller may simply agree to sell at the current market value.
Whatever is decided, it’s most important that everyone agrees and is amendable to the terms.
Choice of law clause
Depending on your state, there may be specific statutes surrounding real estate option contracts.
When your draw up an option contract, make sure that your agreement includes a choice of law clause and complies with the mandated rules.
This clause allows you to specify what rules your agreement will follow based on where the property is located.
6. Who uses real estate option contracts?
Both real estate investors and developers use real estate option contracts.
They provide flexibility and advantages that make them a great resource.
They amplify buying opportunities and limit seller benefits.
Buyers, assignors, and assignees are typically the receiving parties.
These parties will sign them alongside the seller.
7. Are real estate option contracts required to be in writing?
Yes, a real estate option contract must be in writing so that they comply with the Statute of Frauds (SOF).
SOF transactions must contain key elements to be legally binding and enforceable.
We recommend that you seek legal advice from a real estate lawyer in your state when writing a real estate option contract.
Due to their complex nature, option contracts are easy to make legal mistakes on, which can result in unintended and unwanted legal consequences for you in the future.
8. What advantages do real estate option contracts offer the buyer?
Using an option contract allows a buyer to put a property “on hold” for a certain period without the fear of losing it.
This time allows the buyer to secure financing or conduct inspections while knowing the property is secure from other buyers.
Additionally, the price of the property is also secured and won’t change.
An option contract is often highly appealing in a market when the price of property is wildly fluctuating.
The one thing that the buyer should remember is that, regardless of whether they end up purchasing the property or not, the seller will keep the option fee that was paid to them when the contract was enacted.
So, there is a cost associated with having an option contract in place!
9. What advantages do real estate option contracts offer the investor?
As an option contract severely limits the seller’s choices for the time it’s in place, you may wonder, “What’s in it for them?”
And it’s true.
Sellers forfeit their ability to accept any other offers on their property.
They’re required to accept a previously agreed-upon price for their property even if the value of it has increased.
For many, this makes an option contract unattractive.
However, the extended time option can be useful to sellers as it provides them more time to relocate or conduct other business that may need to be done before closing a sale.
Additionally, even if the sale doesn’t go through, they will retain the option fee that the buyer paid to initiate the contract.
This fee can be worthwhile for the seller as they get paid and then can still sell their property to another willing buyer.
Overall, this is a beneficial route to go as long as you’re not in a hurry to sell your property and are okay with encountering a few obstacles along the way.
10. What’s the difference between an option contract and a right of first refusal?
An option contract is a right that the owner of a real property gives to another person to buy a certain property at a fixed price for a definitive duration.
While it doesn’t obligate the potential buyer to purchase, it does bind the seller to sell to that individual.
Throughout that duration, the seller typically cannot revoke or withdraw the option contract without the potential buyer’s consent.
On the other hand, the right of first refusal obligates a real property owner to offer their property to the holder of the right of first refusal on the same terms as the owner is trying to sell the property to another party.
The right of first refusal offers more control over the sale of the property to the owner.
With an option contract, a buyer can force the sale at will.
With the right of first refusal, only the seller can initiate the sale of the property.
Both of these documents must be:
In writing
Signed
Contain a legal description of the property
Have consideration to be legally enforceable
Sometimes they are included in lease contracts.
They may also be drafted as a separate agreement.
11. Why would a seller choose an option contract over a regular sale?
An option contract may appeal to a seller in a variety of circumstances, especially if the property is a non-traditional piece of real estate.
Think of an office building or a piece of land in a rural part of the state.
These sales aren’t as easy as an ordinary family home, which are likely to have more potential buyers (especially if it’s in a good area).
Readying an office building or piece of land for sale can take time and money.
Then you have to market it and find an interested seller.
Keeping just one potential buyer interested requires a lot of effort, and if the sale goes nowhere then you’re back at square one.
When you engage an option contract, then you give your buyer time to decide whether to move forward while giving yourself some insurance money in the form of a fee.
Final thoughts
Real estate option contracts offer alternative ways to make money and help to avoid large risks.
Developers can benefit from holding multiple real estate option contracts while selecting only a few based on the evolution of the market during the holding period.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.