What is an "option to purchase"?

December 1, 2016

An option to purchase contract is when somebody tries to lock you down on a sale price but isn't committing to purchase the property (unless they find a buyer at a higher price).

 

We have never used an option to purchase contract. It's not that we're against it but we feel that if you want to pull cash out of your property by selling it quick, you don't want to have to wait and hope the option doesn't expire. 

 

It just doesn't feel right, so we have never done it. 

 

If you received an offer for an option to purchase from a company (or person), you may be wondering what it means exactly. This post will hopefully help you understand what it is, why it's used, and what the benefits are.

 

An option to purchase gives the buyer an exclusive right to buy the property at a predetermined value. The buyer also have to close in a certain time frame. During this time frame you cannot sell the property to anybody else and your buyer with the option may purchase the property at any time for the agreed upon price.

 

That explains what it is, the next question is why it's used. There are a variety of reasons why someone may choose to use an option contract rather than a standard sales contract. Some of the most common reasons are listed and explained below.

 

1) The property obviously has some value, but lack of recent sales make it difficult to formulate an idea of what the value might be.

 

Dealing in vacant land, it is often difficult to figure out the value of a property. Vacant and raw land is difficult to establish value because the majority of people purchase houses. A very small percentage of the population purchase lots to build on.

 

If there have been no sales in a particular area, it’s hard to tell what people would pay for land in a particular area or IF it would even sell at all.

 

As investors, the worst thing we could do is end up with a property that we can’t sell or that takes 10 years to sell (unless our plan was to hold it for 10 years). By utilizing an option, an investor can reach out to their buyers and see if any of them are interested without risking their investment.

 

2) The owner (you) want more than an investor is willing to pay.

Sometimes an offer isn’t quite enough for an owner to sell. The owner numbers and the investor numbers don't match up. But maybe the numbers are close. If the numbers don’t work but there is still potential margin in the deal, it can be mutually beneficial for a buyer and seller to use an option contract.

 

It allows the buyer to offer more money since they aren’t risking anything financially. In an option, they don’t put up their money at the beginning, they only spend the money if they choose to exercise the option. They would only be exercising the option under certain circumstances, again limiting their risk of financial loss. Those circumstances would be:

  1. They find a buyer for the property. In that case they will either exercise the option to purchase the property at the agreed upon price or they would sell their interest in the property and assign the contract to somebody else. They would then purchase the property at the agreed upon price. Either way, you would have your property sold at a price you are comfortable with.

  2. After doing more research the investor decides the property would work as a long term investment. In this case, they would exercise the option and purchase the property at the agreed upon price.

Note: As of this writing, we have never assigned a contract to somebody else nor have we ever closed a deal with an option contract. This is for informational purposes only.

 

3) There’s market activity in the area, but no “normal” range.

 

In this scenario, there may be properties selling on one street in a neighborhood for $1,200, $3,500, and $15,000.

 

Size and general locations of the properties are the same but the prices of the properties are all over the place. So how would an investor decide on an acceptable price?

 

This happens a lot with land.

 

I'm not sure why, but in some areas similar lots go for tremendously different prices while others sit on the market and never sell. There seems to be less of it in the housing market, but my guess is it's because there are so many potential buyers of houses. After all, everyone needs a home.

 

So let's say you think your property could sell for $15,000, but there is no way to be sure. Maybe it would only sell for $4,000 or worst yet, for $1,200 (or even worse, not at all). If market research indicates it could sell for any of these numbers, there is no real way to tell.

 

In this case, an investor may insist on an option contract. It would give them more time to feel out the market and see if there are any potential buyers in their Rolodex. 

 

(*For you youngin's reading this... do a google search for Rolodex to understand what it is).

 

Investors are not in the guessing or gambling game.

 

Warren Buffet once said, investing rule number one is “never lose money”. As unpleasant as it is, investors must abide by that rule if they plan to help provide for their family. 

 

I'm sure there are other reasons for using an option to purchase contract, but since we don't use them I can't think of any more. 

 

Hopefully this answered some of the questions you may have had about options. For the most part, investors use them to limit their financial risk and to get more time for research and/or funding. 

 

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