Welcome to the Real Estate Options Handbook
Real estate options come in many types and uses. The purpose of this short post is to familiarize you with the most common real estate options and do it in such a way that you won’t fall asleep.
I will skirt most of the “legalese” and give you more “real world” info and examples. I’ll explain them and go over some that you wouldn’t normally think of as real estate options.
Option Terms To Know
There are a couple of terms that you need to know with real estate options.
- Option consideration.
This is the amount of money or something else of value traded for the option. I may be only a promise of something. Normally the option consideration is credited towards the sale if the buyer completes the transaction. There are a couple of instances where the consideration would be refunded.
- Strike Price.
When working in real estate options, one of the most important factors is the price you agree to pay for the property. The "Strike Price" is the property sales price that the buyer and seller have agreed upon.
The Purchase and Sale Contract.
This is by far the most common example of an option to purchase, but no one realizes it.
It has limited usefulness as an option, because the option becomes an agreement to purchase as soon as the inspection period is over. Some would argue that it’s not a true option, but for investor purposes…it’s good enough. Let me show you what I mean.
John the Real Estate Investor
Investor John was driving his farm area one day and noticed a new “for sale by owner” sign in a yard. Knowing that “fortune favors the bold” he stopped his car, got out and knocked on the door. A gentleman answered the door and said that they were selling the house and moving closer to the grandkids. John asked to look at the property and finally discussed price. There were a few misgivings about the house, but he didn’t want someone else to get to it.
He decided to put the house under contract, so he negotiated a little better price and had a contract signed. John couldn’t help but think “I wish I had more time to think about this deal. What can I do?” Suddenly a thought occurred to him, so he asked the seller “I’m leaving to go out of town for two weeks, are you good with a slightly extended inspection period?” The seller agreed and John filled out the inspection period for 20 days.
Was a Real Estate Option Created?
Did John just create a 20-day option to buy the property? I submit that he did, because John is using an As-Is contract that allows John to walk away for any reason during the inspection period.
There are a couple of other option possibilities for this contract.
The “Unintended Option”
Let’s suppose I gave you a written offer on your house. I filled out the contract but forgot to put a deadline for you to accept it. Unless I call you and withdraw the offer, I have effectively given you a “put option.” You now have the option to sell me the property at that price (which you will immediately shop all over town).
On the other hand, if you as the seller filled out the contract, and I put no inspection period or closing date (either one), I then have a purchase option.
I know, it’s a bit of a stretch, but it’s more to show you why you need to watch what you’re doing on your contracts.
Be Careful With Contracts
I once had a buyer send me a custom contract for a property I owned. He said, “Just sign it and fax it to my title company and they’ll get to work on it.” It was kind of vague on the closing date, and I found this clause buried in the middle of the page.
“Seller agrees that closing shall take place no sooner than 60 days after such time as Buyer signs the contract and returns a signed copy to the Seller. Seller also agrees that Sellers agreement to sell is immediately binding and cannot be withdrawn.”
My first thought was, “You little stinker” but then I noticed that he had sent it in a Word file. So, in the words of Tim the Tool Man, “I rewired it!” and sent it to his title company. He wasn’t happy with my additions, but we did eventually come to an agreement and did the deal.
Read the contract carefully, in these days of you can change anything with a computer. I’ve had people try to hide all kind of things in contracts. Commissions, credits, all kinds of stuff.
The Lease Option
This is probably the most widely known of the real estate options. It was used extensively during the 2001-2007 run-up of the market. There are several uses, lets go over a couple.
There are a lot of reasons that buyers can’t get financing right now but will be able to in 1 or 2 years. If they are new to the area, new to their job, or need to pay down some credit cards to get their score up, then a lease option might look good to them.
The buyers can choose a house in a neighborhood they like and start living in it now. They can lock in an agreeable price up front and may even pay extra rent to be applied as down payment. On occasion the mortgage company will view their good lease payment record as an affirmation of their ability to repay the loan.
Real Estate Investors
There are several ways that real estate investors utilize lease options to make money.
- To sell a property at a “futuristic” price
When a savvy investor lease options a property to a buyer, they will set the strike price at or above current retail. The contract may also include an annual increase of a certain percentage or amount, and a requirement that the optionee (buyer) pay additional yearly option fees.
This guarantees at least some additional appreciation for the seller.
- To lock in the price of a property at todays price and have a renter pay the bills.
An investor with a bullish attitude about future appreciation will attempt to lease option as many properties as possible at the best strike price possible. Properly orchestrated, this plan could create a very large payday in a rapidly appreciating market, such as 2012 – 2019. A quick look at US median home prices shows that if the investor lease optioned a home for $220,000 on Jan 1, 2012, it would be sold $338,000 in December 2017. That’s over $100,000 profit.
- To lock in the price of a property and then “sandwich” the lease option to a tenant.
The “sandwich” lease option is named as such because the investor “sandwiches” themselves in between two lease options. It’s a scenario like this.
Investor Steve lease options House A from the seller with a master lease with an attached option to purchase any time in the next five years under the following terms
Strike Price $150,000
Monthly Rent $1,200
Security deposit $1,000
Option Consideration $0
(Homeowners don’t understand option consideration, so he didn’t bring it up).
Then Investor Steve lease options House A to a buyer under the following terms.
Strike Price $175,000 plus a 3% increase per year
Monthly Rent $1500
Security Deposit $2000 + last month’s rent in advance
Option Consideration $8,000 + an additional $500 per year renewal fee
The Investors Position
The investor is in a very good position at the moment.
He is making a $300 per month profit on the monthly rent, and he has already pocketed $8000 in option consideration. (it is my understanding that option consideration profits are not taxable until the option is either exercised or extinguished. Check with your tax advisor on this.)
He is in a good position. If the market drops, he can walk away…or so he thinks. He cannot “walk away”, he has a contractual obligation to sell House A to his buyer for $175,000. This can go wrong in several different ways, the most likely on being that the seller refuses to close for some reason, like maybe death. If anything happens the investor has a real mess to clean up. While doing sandwich lease options can be very profitable, I don’t recommend them.
If you want to really deep-dive into lease options, pick up The Secrets To Lease Option Profits by Mark Warda and Jack Shea.
The Purchase Option
Builders use real estate options for large transactions. It works like this.
Fred the Builder is having a great year. The market is booming, and his latest subdivision Fleabag Acres is nearly sold out. He just broke ground two months ago on his next 100 home project, Mosquito Haven, and already has a lot of presales.
Fred is concerned though. The available land inventory is drying up, and prices are starting to escalate. The cost of raw land has gone up 20% in the past year. If it keeps going up, he’s afraid that he will get pushed out of the market. He talked with his lenders, and he can’t purchase another tract of land until Fleabag Acres is finished and Mosquito Haven is 60% complete.
The Cost of Waiting
He knows that if he waits it will cost him hundreds of thousands of dollars. Fred decides to see if he can make something happen now. There is a large ranch about 2 miles outside of the prime building area that is for sale by owner. He contacts the owner and buys a 5-year option to purchase the land. His strike price is $3,000,000 and he agrees to pay the rancher $75,000 per year for the real estate option. He also agrees that the rancher can continue using the land at no charge, as this will keep the taxes on the land to a minimum.
Great deal for both.
He locks in his price for the future, and the rancher gets some extra income.
Purchase Back Option
This option would allow the seller to sell that property today and reserve the right to purchase all or part of the property back at an agreed upon price on a later date.
This works well when investors want to partner on a deal but keep it simple.
Johnny Nobucks finds a great deal that he wants to rehab and retail. He goes to hard money lender Friendly Frank (we actually had one that used that name) and asks to borrow the purchase and fixup money. Friendly Frank thought the deal was good but knew that Johnny had no bucks. Frank agreed to purchase the property in his company name and fund the entire deal. Johnny would provide all the repair labor, and then they would sell the house. They created a “contract for option” that allowed Johnny to purchase a 50% interest the property for $1 at the time of closing on the sale and paying off the mortgage that Frank had placed on the property.
It was a good deal for both.
As you can see there are many things that you can do with real estate options. They can be bought, sold, and traded. There are many more exotic types that I don’t see the need to go into here.
Disclaimer: I am not a licensed attorney, nor a licensed CPA. All statements made above are to be considered opinion only.