What Is an Option Contract in Real Estate and How Do You Explain One to Your Clients?
Table of contents
- What is an option contract in real estate?
- Who uses real estate option contracts?
- Do real estate option contracts need to be in writing?
- What is the purpose of an option contract?
- What are the advantages of a real estate option contract for the buyer?
- What are the advantages of a real estate option contract for the investor?
- An example of how option contracts in real estate work
- Option contracts in real estate can be an effective strategy for some buyers and sellers
Written by Timothy Ware
Like all industries, real estate has a lot of jargon that is easily understood by those in the business but not by anyone else. An option contract in real estate is one such example. While some might have a general idea of options in finance (the right to buy or sell a stock in the future), they might not know that there are (somewhat) similar contracts in real estate.
Those who are interested in drawing up a real estate option contract still might not understand them fully. As a realtor, it is your job to explain exactly what an option contract is in real estate.
Let’s go through option contracts in real estate together, along with all the advantages, purposes, and terms included so that you are ready to help your client sign a real estate option contract.
Whatever contract you are drawing up with your clients, SignTime has you covered with this recent article detailing everything you need to know to draft your own real estate contracts as well as links to helpful templates for use in every state.
What is an option contract in real estate?
A real estate option contract is a two-party contract between a buyer and a seller. The seller offers the option to buy a property for an agreed upon amount for the duration of the contract. Conversely, the buyer pays for the right to be able to buy the property for the agreed upon amount at any point during the duration of the contract.
Note that, just like option contracts for stocks or commodities, the buyer is under zero obligation to ultimately make the purchase. They are merely paying some amount, up front, for the right to purchase the property for a set period of time.
Who uses real estate option contracts?
Investors and developers are the primary users of option contracts. For example, developers may sign an option contract for farmland at the edge of a city that they intend to turn into a subdivision.
Once they have the option contract in hand, they will bring their development to the county for approval. If it is approved, then they will exercise the option to buy the land. If it isn’t approved, then they will choose not to exercise the option.
In this case, if the developers had simply purchased the land, then they would be left holding a property that they need to either sell or wait until a government amenable to their proposal is elected.
Do real estate option contracts need to be in writing?
Yes, all option contracts in real estate must be in writing. They must also contain all of the following key terms.
- Option fee: The person buying the option to purchase the property must provide a reasonable, non-nominal fee to the seller. Note that this fee is non-refundable, so if the purchase option is not exercised, then the would-be seller gets to keep the option fee.
- Duration: An option contract in real estate must be for a set duration. Typical durations are between one and five years. The buyer has the right to make the purchase at any point during this period. Once the period has expired, the option contract is automatically terminated.
- Real estate purchase price: Option contracts in real estate must include a specified purchase price. This price can be a simple one, for example the current price according to a third-party appraiser. However, it can also be a dynamic one, such as the current market price at the time the option is exercised. This is often the case when the duration is several years or longer.
- Choice of law clause: The choice of law clause stipulates the rules that the agreement will follow. This is usually based on the local laws where the property is located.
What is the purpose of an option contract?
The main purpose of option contracts in real estate is to provide flexibility to the buyer. Especially when a property is expensive and the intended use is as an investment, the buyer is willing to pay a little extra for more flexibility.
As a seller, offering an option contract is a good way to attract wealthier investors to look at an expensive property. That’s because it lowers the initial cost of investment.
As a buyer, option contracts are a good way of mitigating risks, for example those imposed by EPA rulings.
What are the advantages of a real estate option contract for the buyer?
If your client is looking to buy land and build their own home, then an option contract might be a great way to lock down some property. They can secure the land and then shop around for financing to build the home, as well as the architects, contractors, and everything else.
What are the advantages of a real estate option contract for the investor?
Major real estate investments are a risky business. Option contracts are a great way to provide the opportunity for a real estate play while drastically reducing the associated risks and dropping the initial investment required.
An example of how option contracts in real estate work
A group of real estate investors wants to develop 100 acres of land into a subdivision. They pay $20,000 for the right to buy the land for $2,000,000 with a duration of three years.
They then draw up all the plans, find all the required contractors and subcontractors, and forecast the potential profit. If the plans look solid, they go to the county to seek approval.
Once everything is approved and they have much higher confidence that the project will work out, they exercise the purchase and pay the seller $2,000,000. Finally, they start work on the new subdivision.
Option contracts in real estate can be an effective strategy for some buyers and sellers
Option contracts are usually used by investors and wealthy clients to reduce the risk of major purchases. However, they can also be used by clients looking to have a custom home built.
Whether you represent the seller or the buyer in an option contract, there are a lot of advantages to these flexible arrangements.
When it comes time to sign an options contract, or any other contract, SignTime is there to help. With convenient e-signature capabilities, you’ll get signed contracts back from your clients in record time.
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