Traditionally, when sellers put their home on the market, they can consider many buyers and sell to whomever they want. But when an option contract is introduced to the mix, that all changes -- the buyer gets the exclusive right to buy the property but is not obligated to do so. Here's how real estate option contracts work.
The basics of option contracts
A real estate purchase option is a contract on a specific piece of real estate that allows the buyer the exclusive right to purchase the property.
Once a buyer has an option to buy a property, the seller cannot sell the property to anyone else. The buyer pays for the option to make this real estate purchase. The option usually includes a predetermined purchase price and is valid for a specified term, such as six months to a year. However, the buyer does not have to buy the property, whereas the seller is obligated to sell to the buyer within the terms of the contract.
Options have to be bought at an agreed-upon price. If the buyer doesn't buy within the time frame, the seller keeps the money used to buy the option.
Advantages for buyer
A real estate purchase option can be great for buyers. For example, if you want to buy a lot of land to build a new home, a purchase option can be used to keep the lot available for a certain amount of time, until you have funding.
The landowner cannot sell the plot to anybody else during the term of the option. At the end of the term, the landowner must sell the land at the price agreed upon, even if property values have risen in the interim. However, some option contracts may include terms that put a cap on the property's price, or include other factors to determine the final price.
Advantages for investor
Investors can use real estate options to secure high-profit investments at relatively low risk. Here's an example: An investor notes that a specific plot of land is in a prime location for further development, such as subdivisions or a shopping plaza. Instead of purchasing the land outright and then selling it to developers, he purchases exclusive rights to the land through an option.
With the option in place, he approaches investors and developers, offering them the land at a much higher price than his locked-in option purchase price. Once his higher offer is accepted, he either sells the option itself for the purchase price or purchases the land and then flips it to the developer, pocketing the difference.
Lease options and their risks
Tenants interested in buying a rental property can use a lease option, also known as a rent-to-own arrangement. A lease option can be tricky and technical, so it's in your best interest to get a lawyer to go over it.
A lease option allows the renter to purchase the property after a predetermined rental period, which the buyer pays to obtain. The lease option could determine a purchase price or state the property will sell at market value. A portion of the rental payments -- which will likely increase due to the addition of a new premium -- can be applied to the future purchase. All of these terms will be in the lease option contract.
You will lose money on a lease option if you don't buy the property. The owner can pocket the additional rent premium and rent option costs if you don't buy. For this reason, you should carefully review and weigh your options. In addition to a lawyer, meet with a financial planner to make sure you will be able to buy the property before the term ends.
Updated from an earlier version by Dini Harris