Whether you’re in a red-hot real estate market or not, leveraging an option to purchase real estate is a powerful tool for investors looking to bide time before committing to buy a property.
In this article, we take a look at how options to purchase are used by both investors and lessees interested in tying up a piece of commercial real estate.
What is an Option to Purchase Real Estate?
An option to purchase real estate is a legally-binding contract that allows a prospective buyer to enter into an agreement with a seller, in which the buyer is given the exclusive option to purchase the property for a period of time and for a certain (sometimes variable) price.
During the option period, the seller cannot transact with any other parties interested in purchasing the property.
It’s worth noting that an option to purchase real estate is different than a right of first refusal, which also provides the signatory with exclusive negotiating power for a period of time.
A right of first refusal is sometimes included as a lease provision, in which a tenant is given first dibs to buy the property for a certain price in the event the owner decides to sell.
However, unlike an option to purchase, a right of first refusal can only be enacted when the owner actually decides to sell, which may or may not happen during the term of the tenant’s lease.
How is an Option to Purchase used in Commercial Real Estate?
An option to purchase real estate can take many forms.
In some cases, it is structured similar to a standard purchase and sale agreement, wherein the buyer is putting down a certain amount of money that is held in escrow.
Just like a P&S agreement, the option to purchase would outline certain milestones that need to be met during an investor’s due diligence process—contingencies, if you will.
If an investor does not meet these milestones, they’ll forfeit a portion or all of their deposit after a period of time.
An option to purchase can also take the form of a lease agreement, in which a tenant signs a lease that also grants them the opportunity to purchase (the option) the property.
The option clause in a commercial lease agreement might look something like this:
“Purchaser [Tenant] has the exclusive right and option to purchase the real property described on the attached Exhibit A during the term of this Agreement [Lease] for the price of $________.”
In most cases, regardless of whether the option to purchase takes the form of a P&S or lease agreement, the purchase price is usually fixed—a price that the potential buyer and property owner have agreed to in advance.
That said, there are some instances when the option to purchase real estate includes a variable price.
These situations could include:
- When a lease agreement extends out over a period of years, the purchase price may be adjusted for inflation and/or determined based on a new appraisal at that time;
- If the purchase price is going to be determined on something other fair market value, such as gross or net income, cap rates, etc.;
- If the purchase is dependent upon securing certain entitlements, in which case, the outcome of the entitlement process changes the value of the property (examples of this below).
Different Types of Options to Purchase Real Estate
The four most common forms of options are as follows:
1. The Straight Option, which gives a buyer an opportunity to purchase the property for a certain period of time for a certain price.
If you ultimately buy the property, this money can be deducted from the purchase price upon close.
If you do not buy the property, you forfeit the option deposit. This is the most common and simplest form of option.
2. The Letter of Credit Option, in which a letter of credit is issued from your bank to the seller in the amount of the option price.
There is a charge for the letter of credit, and the bank typically requests some sort of security. If the option is exercised, the letter of credit is voided.
If the option is not exercised, the seller collects the value of the letter of credit from your bank. This eliminates an investor having to put down any money up front, but it requires more paperwork.
These forms of options to purchase real estate are less common, and some sellers find this process to be too complicated to pursue in earnest.
3. The Interest Option, whereby the investor agrees to pay the seller the amount of interest that he or she would have earned on the purchase price (or appraised value of the property) during the period of due diligence.
If you ultimately decide not to close on the deal, then the seller at least benefits from this compensation while the property was otherwise tied up and unavailable for sale.
This is often referred to as compensating for the “loss of use” between the time of sale and time of closing.
4. The Rolling Option is used when the buyer and seller divide a larger parcel into smaller parcels, and is selling each parcel for an amount determined at the beginning of the option period.
With the rolling option, the buyer puts an option on the entire parcel, but has the ability to close on the subdivided parcels at different periods of time. The rolling option continues until all parcels are purchased.
If you decide not to purchase all parcels, the option amount is applied to the remaining parcels to be purchased and the buyer relinquishes future options and forfeits a portion of their original option fee.
These are often used by developers who do not have the capacity to purchase and/or redevelop larger sites all at once (and cannot afford the carrying costs of the other parts of the site in the interim).
Why do investors like using Options to Purchase Real Estate?
There are many reasons why commercial investors like to use options to purchase real estate.
Sometimes, options are used in sale-leaseback or build-to-suit arrangements when the seller is unable to obtain the financing necessary to improve the property.
For example, a business that owner-occupies a property may need to make significant investments in the business. Say the company has a major capital need, such as the need to purchase new, expensive equipment.
Using an option is a way to enter into a valuable sale-leaseback situation in which the business ultimately sells the property but then signs a lease to continue operating out of the space under new ownership.
Options are also used by investors in situations where the development potential of the site is unknown.
For instance, a prospective buyer may be interested in a 2-acre property that is currently zoned for industrial businesses uses.
The investor is interested in redeveloping the site into a mixed-use project, with residential units above ground-floor retail.
In this situation, the investor puts an option on the property that is contingent upon entitling the site for the mixed-use project.
With entitlement scenarios, the purchase price is typically based upon what is ultimately approved to go on the site.
For example, a developer might put an option on a property that stipulates a $15 million purchase price, but that option is contingent upon the current owner seeking a zoning amendment with the municipality that would allow for a portion of the site to be converted from residential use to office/lab use.
If the current owner is unable to obtain that zoning amendment, and the interested developer is required to include a residential component under the zoning code, the developer may still purchase the property but at a lower price.
Instead of buying the site for $15 million with the anticipation of being able to build 1 million square feet of office/lab, the developer decides to pay only $10 million as the developer views the residential requirement to be of less value in this market.
Options to purchase real estate are also commonly used by smaller-scale multifamily developers. In these cases, the option to purchase may include a variable scale related to the entitlement process.
For instance, the option may include a base price for the property based on the existing zoning – say the developer can build 8 units of housing on that site by-right, per the zoning.
There may be an incentive clause in the option agreement whereby the purchase prices increases, incrementally, per additional unit of housing that is ultimately permitted for the site.
Along these same lines, investors will often use options to purchase real to bide time to do site due diligence.
For instance, the buyer may want to do some preliminary site investigations, such as soil testing or geotechnical analysis, to determine what can physically be built on the site, regardless of what ultimately gets permitted on the site.
This often includes a look at existing utility hookups, which are often a key factor in a developer’s ability to build certain product types (like wet lab – which is water and power intensive).
Another reason investors like using options is because it buys them time to line up the capital they need for a project. For instance, a builder has $400,000 on hand and wants to purchase a property listed for $3 million.
The builder puts an option on the property, and in the meantime, assesses whether they can raise the other $2.6 million needed (though bank loans, equity partners or otherwise).
At the end of the day, the primary reason investors like using options to purchase real estate is because it lowers their ultimate downside risk.
An overly-eager or novice investor might wrongly assume they can redevelop a property for one use, only to fail to get the permits needed after closing on the property.
In that case, the buyer may end up overpaying for a property based on their incorrect assumption that they’d be able to build something that they, in fact, cannot ultimately build—or finance.
An investor who uses an option is limiting their downside risk by only putting their option payment at risk, instead of a significantly larger share of their equity.
Flipping Options to Purchase Real Estate
Investors can also use options to purchase for profit. Most options contain a clause that the prospective buyer can fulfill the terms of the deal or, upon consent of the owner, find another buyer to fulfill the terms of the deal.
So how does the investor make money?
Here’s an example: an investor puts a one-year option to purchase on a property.
The buyer and seller agree to a sales price in advance. But behind the scenes, the investor feels like the market is on an upward trajectory and believes that within that one-year period, the value of the property will increase.
Meanwhile, the investor starts shopping around to find another buyer interested in purchasing the property.
The investor might have an option to buy a property for $1 million, but then finds someone else who is willing to buy the property for $1.2 million. The investor essentially flips the option to another buyer, in the process earning $200,000 without having to do anything other than sign some paperwork.
As you can see, there are many reasons why investors like to leverage options to purchase real estate. They provide buyers with more flexibility and low-risk, low-cost investing opportunities.