When a seller lists their home for sale in the traditional real estate market, they have the option of considering a variety of purchasers and selling to anyone they choose. However, when an option contract is added to the equation, everything changes: the buyer now has the sole right to purchase the property but is not compelled to do so. Here’s how option contracts for real estate operate.
What is an Option Contract?
A real estate option contract is an arrangement, where the seller gives the buyer the option to purchase property at a given price for a set period. This one-of-a-kind contract is solely between one seller and one buyer.
The option itself usually comes with a specific purchase price and is valid for a set time, usually 30 to 90 days. It’s worth noting, with an option contract, the buyer is not required to purchase the property, while the seller is required to sell to the buyer within the contract’s terms.
Options must be purchased at a predetermined price, which becomes the fixed price. If the buyer does not complete the transaction within the specified time frame, the property owner retains the funds used to purchase the option.
Real estate option contracts have four components:
- The contract must be in writing.
- The contract must specify the location, such as the lot and block, subdivision, city, and state.
- The agreed-upon time frame of the contract must grant the buyer’s right to purchase.
- The buyer and the seller must agree upon the purchase price.
What is the Purpose of an Option Contract?
The purpose of an option real estate contract is to provide the buyer with options. Early exercise, option expiration, and second-buyer sales are all possible outcomes depending on the type of buyer. Essentially, real estate professionals use option contracts to enable flexibility in specific types of real estate deals.
Generally speaking, option contracts in real estate provide flexibility; however, there are some additional reasons option contracts can exist.
- Purchase agreements, land contracts, deeds of trust, and mortgage notes all have clauses making them naturally option contracts.
- Option contracts can attract high-net-worth individuals to high-end real estate deals.
- Option contracts can depreciate real estate without actual ownership.
- Option contracts can reduce initial investment costs for all types of investors.
- Option contracts can reduce the possibility of future EPA liability for the seller.
Option Contract Examples
Let’s take a look at how this type of contract can apply to different real estate transactions. As discussed earlier, option contracts can be used in many different ways, but here is a perfect textbook example.
Real estate developers use option contracts frequently. Let’s imagine a developer wants to buy a $6 million building but won’t be able to acquire financing for at least a year. Real estate option contracts can provide the developer exclusive rights to the property while the buyer gets financed; in return, they are usually willing to put a portion of the cost down.
You’re probably wondering if a seller would go for something like this, but it’s more common than you think. More often than not, a seller may be eager to offload their property for personal, financial reasons, or a little bit of both. Option contracts exist to benefit both the buyer and the seller.
An option contract in real estate provides reasonable assurance that the property buyer is earnest about their intention to satisfy the selling terms and transfer the property, rather than waiting for a solvent buyer to come along, which is some cases could be rare.
Who Uses Real Estate Option Contracts?
Buyers, investors, and developers all use real estate option contracts for transactions. They are usually a fantastic deal for buyers because of the flexibility and advantages they provide. Options contracts in real estate are typically received by buyers, assignors, and assignees, who sign them with the seller.
There are a variety of ways real estate is purchased. For many people in the United States, the most basic real estate investment is a family home or a rental property. Buying a single real estate property can be a significant, profitable investment with a variety of uses. Single-property investments are frequently considered safe, stable, and rewarding due to their versatility, duration, and appreciation.
Real Estate Investing
There are numerous hurdles to overcome and risks associated with flipping properties. While you can make a lot of money flipping properties, you can also lose a lot of money and miss out on deals due to various issues that can arise, including financing, appraisals, and disreputable title agents, to name a few.
An option contract removes the risk from the equation. It is a terrific strategy for all investors to consider, particularly newcomers, because it is a low-risk, high-profit method for purchasing real estate.
As a wholesaler/investor, the option contract allows you, as a wholesaler/investor, to address the motivated seller’s dilemma by assisting them in selling the property they desperately want to sell. You have the contractual and legal right to buy a residence with an option but not the responsibility to do so. So you’ll have the opportunity to buy, but you won’t be legally forced to do so unless you exercise it.
Option contracts can also be beneficial to rental property leasing agreements. A lease option, commonly known as a rent-to-own deal, is available to tenants who want to acquire a rental property. Because a lease option can be complicated and technical, it’s in your best interest to have it reviewed by a lawyer.
A lease agreement option allows a renter to acquire a property after a defined renting period. The agreement usually specifies a purchase price and a percentage of rental payments that goes towards the future purchase price.
Included in lease options is an exclusive right to buy. If the renter doesn’t buy the property, they will lose the money they put towards the purchase price. Usually, in these instances, the owner will keep the extra rent premium and rent option fees. As a result, renting to own can be risky, and renters should carefully analyze their choices before making such decision.
Are Real Estate Option Contracts Required to Be in Writing?
Yes, these contracts are required to be in writing. They must comply with the Statute of Frauds, which is the rationale for this obligation. To be legally binding and enforceable, option contracts must follow regular valid contract requirements.
What is an Option Fee?
Option fees or option costs are normally non-refundable costs that occur during the duration of the option period. In plain terms, it’s the fees accrued to keep the exclusive right to buy the property. In most cases, buyers forfeit the option money if they do not exercise their option to purchase the property within the agreed-upon time limit. The term of the option period and the option cost must be explicitly defined in an option-to-purchase contract.
Like all valid real estate contracts, the buyer and seller must exchange something of value for the contract to be legitimate and enforceable. The option cost cannot be insignificant, but there is no guideline on what is reasonable. In a lease option, the option fee is usually a portion of the rent, while in an investment deal, it usually is a percentage down or a monthly fee.
Before closing on a house, earnest money or a good faith deposit is put down to indicate the buyer is serious about buying.
When a buyer and seller sign a purchase agreement, the seller removes the property off the market while the transaction completes. If the offer falls through, the seller will have to relist the home and begin the process all over again, perhaps resulting in a significant financial loss.
If the buyer backs out, the seller is protected by the earnest money. It’s usually between 1% and 3% of the sale price, and it’s held in an escrow account until the transaction is completed. Your market’s customs determine the actual quantity. The earnest money is applied to the buyer’s down payment or closing costs if everything goes smoothly.
What is the Difference Between an Option Fee and Earnest Money?
An option fee is usually always deposited in the seller’s account. On the other hand, an earnest money deposit is placed in an escrow account managed by a bank or a real estate agency. While it’s nearly impossible to get a refund for an option fee once it’s in the seller’s account, in some circumstances buyers might be able to get a return of their earnest money.
The size difference or cost is also an important difference between the two options. As discussed earlier, earnest deposits are usually a percentage of the sales cost, while an option fee may be a monthly fee. Depending on the circumstance one may be cheaper than the other. It’s tempting to save money whenever feasible, given all of the additional costs of buying a property, from paying for an inspection to covering closing costs. However, potential home buyers and sellers should be aware of several significant variations between option fees and earnest money.
Option costs only provide you unlimited cancellation rights for the duration of the agreement, which is usually ten days. Earnest money payments, on the other hand, may grant cancellation rights beyond the agreed-upon period, such as in the following situations:
- After a third-party inspection, legal disclosure, or lead-based paint is discovered in a property built before 1978.
- The release of HOA (homeowners association) records that expose unexpected buyer limitations or liabilities.
- The inability of a buyer to obtain finance for purchase within the 30-day pre-closing time frame.
So to recap, option costs or fees, are non-refundable, and you can only cancel them for a certain amount of time. Earnest money payments are usually more costly, they can be applied to closing fees, and they offer buyers greater negotiating power during a real estate deal. So both terms, aren’t exactly the same things but are close to it.
What to Know for the Exam
When it comes time for your real estate exam, remember a real estate option contract is an arrangement, where the seller gives the buyer the option to purchase property at a given price for a set period. This one-of-a-kind contract is solely between one seller and one buyer. These contracts can be utilized in many different ways which we discussed extensively here. And of course remember the difference between option fees and earnest money. If you can remember all of this, you’ll be set come exam day.