Process
With a purchase option, the buyer pays the seller for an option to buy the property at a certain price within a certain amount of time. This option contract can be arranged to provide a variety of conditions, contingencies and exit strategies.
The option contract approach offers key advantages to the buying investor:
- Exercise purchase with refinance loan after 12 months
- Minimize risk exposure and expenses
- Lock in price and property
- Contract is transferable
The basic terms of the contract is that the seller takes the option fee as income. The option buyer does not own the property, but has the option to buy it outright. If the buyer exercises that option, the buyer merely has to pay the balance of the agreed price. If the buyer does not exercise the option, the seller keeps the option fee and is free to sell the property to anyone else.
If the seller finds a different buyer at a higher price during the period of the option contract, the contract sometimes may allow that seller to buy out the option contract—usually with a premium to the original buyer. However, in most cases, the seller will be unable to sell the property to anyone else (except for the option holder) until the option period has expired.
It is important to note that with the option contract, the seller keeps both the title and possession of the property. The buyer does not get to hold, possess or use the subject property. That buyer only receives a limited interest in the property. However, this right to purchase typically implies the right to market. So the option holder can sell the property, even if he or she does not have full ownership.
Returning to the analogy of options on stocks and commodities, most people are familiar with the investment maxim of "buy low, sell high." However, most people fail to realize that you don't have to buy low before you can sell high. You can first sell high (something you don't really have) and buy low later to satisfy any sales agreement you may sold. The real estate option contract allows you to sell (preferably high) a property that you don't yet have.
Example: Buy and Sell Using Option Contract
Connie finds a house on sale for $70,000. After some research, she discovers that the median price in the area for recently sold similar properties was about $92,000. With some cosmetic repairs and improvements, Connie believes that she can resell the house for about $100,000.
Unfortunately, Connie has no current employment and income, and her credit is awful, so she will not be able to qualify for mortgage financing. She does have some money set aside, so she obtains a three-month purchase option to buy the house for the asking price of $70,000. She also arranges with the seller to allow Connie to make cosmetic repairs and improvements to the home—at Connie's expense. This primarily involves repainting some rooms, repairing the front porch and some landscaping.
Connie completes the improvements within a week and then immediately finds a buyer to purchase the property from her for $100,000. She then arranges a simultaneous purchase-and-resale closing in which she buys the property from the seller and sells it to the buyer at the same time. Connie's buyer brings $100,000 in down payment and loan funds to the closing and gives it to Connie; Connie uses part of that to pay off the seller; the seller gives the title to the property to Connie, who then transfers it to the buyer. Connie receives a gross profit of about $30,000.
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