The Ins and Outs of Real Estate Option Contracts

What is an Option Contract in Real Estate?

A real estate option contract is a legally binding agreement between a buyer or investor (optionee) and a seller (optionor) that grants the optionee the exclusive right, but not the obligation, to purchase real estate from the optionor, at a specified price within a certain time frame. The contract allows the optionee an "option" to buy the property and avoids the immediate need to buy, while still providing the optionee with the possibility of purchasing the property in the future.
If the time period in which the optionee may exercise the option expires, the contract is terminated and the optionee may no longer purchase the property (unlike a right of first offer/right of first refusal contract, in which an expired time period typically has no effect on the right to purchase the property). An option contract requires that the optionee pay consideration to the optionor in exchange for the purchase option. In many cases, the option fee is 1% of the purchase price. If the optionee does not exercise its option, it will not receive the option fee back (unless the optionee includes a provision in the contract requiring payment of the amount to the optionee if the option is not exercised). If the optionee exercises its option, the purchase price of the property may be increased by the amount of the option fee paid to the optionor .
An option contract can be used to lock in a good deal, give the optionee time to line up financing (and possibly perform environmental due diligence if the contract is for an undeveloped parcel), or test out the market (by, for example, securing tenants for a property and then executing development agreements with the tenants before exercising the option). An option contract may include covenants restricting the optionor’s ability to sell or lease the property during the optionees’ option period, but such covenants are difficult to enforce as legal protections are limited for the option contract in many states until the optionee exercises its option.
Real estate option contracts are different from real estate sales contracts in that a real estate sales contract requires the optionee to buy the property and that the optionor to sell it within a fixed time frame. Further, while a sales contract requires that all material terms be agreed to prior to execution, an option contract may be signed without certain material terms being agreed to (e.g., price, closing date, financing, etc.). An option contract may be a simple written agreement between the parties or a real estate sales contract with an option to purchase or option to extend the term of the sales contract.

The Elements of an Option Contract

A comprehensive real estate option contract typically includes several critical components. First is the option fee, which is the price paid by the buyer for the exclusive right to purchase the property. The option fee is typically non-refundable; however, it is often credited toward the purchase price.
Next, the option period is the window of time that the buyer has the exclusive right to purchase the property. This provision usually specifies the start and end dates of the option period.
Finally, most option contracts contain a provision stating that the seller has the obligation to keep the property free from materials liens during the option period.

Benefits to Buyers and Sellers

An option contract can provide sellers with financial security. A seller may be seeking to move to a new area and, if necessary, will own two homes until a sale of the original property is completed. An option contract secures the sale and gives an immediate return. Or perhaps a seller requires funds for a different purpose. Alternatively, they may need to sell a property quickly to be able to purchase another property – especially in a hot real estate market. If the real estate contract does not pan out, the seller can continue to market the property under the same terms and conditions and thus, defer the closing and the need for outside financing. The seller will have gained time and perhaps still cover their carrying costs.
A seller is not restricted to option contracts with only one buyer; they may enter into a series of option contracts to sell their property. This organized approach provides the seller with greater flexibility. For example, if a second buyer is willing to pay more than the first, the seller can pursue that opportunity. Notably, there is no limit to the number of option contracts that a seller can enter into; however, all must be registered on title to show priority. This approach enables the seller to market the property to higher priced buyers but only commit to one purchaser. A seller can time the sale to meet their needs (for example, a timing conflict in coordinating the purchase of another property.)
Buyers can benefit from option contracts. An option provides buyers with an opportunity to enter into an agreement without committing themselves. Should the buyer decide not to proceed, they have minimal upfront costs and can walk away from the deal. Alternatively, should they choose to go forward, they have secured their position. Furthermore, by virtue of the option to purchase, they are guaranteed to purchase the property at a predetermined price in the future time. A buyer may be waiting for an improvement to a property to come to fruition. Should the potential home become unavailable they may have an opportunity to purchase a different property with an option contract. The buyer can reassign their rights to the property to another party who will be fair to assume the contract, and avoid an investment loss.
These advantages make option contracts a preferred approach to real estate transactions.

The Risks and Pitfalls

When used appropriately, real estate option contracts are a valuable tool for buyers and sellers. They are not without their risks and pitfalls, however. Both sellers and buyers should take care to be aware of these potential problems before entering into an option agreement. Common issues on the seller side include: Homeowners fabricating mortgage info or making incorrect representations to a lender. Homeowners often attempt to sell their homes (or at least a piece of it) as a way to get rid of the entire mortgage. For example, they may put out a sign: "Home for sale….Take Over Mortgage". Such an arrangement may sound great to a buyer, but it creates many risks to the lender. The lender may not have agreed to such a loan preparation before having examined the buyer’s credit. If a homeowner sells a property and tells the buyer that they don’t need to qualify for a loan, they are misleading a loan company. This violates the mortgage and can lead to a fraud charge against the seller.
Another problem with owner financing for sellers is that they may legally be viewed them as acting as the lender, in which case they will need to obtain a mortgage license and follow specific lending rules.
Buyers find themselves in many similar scenarios. Often, buyers of an option-in-progress just want to cut some corners. It usually ends up that one of them is not income-verified or credit-verified, which puts the lender at risk. Unfortunately, it is possible to sell a mortgage without the knowledge of the lender. If a lender finds out about this type of scenario, they can call in the loan balance and foreclose on the property- and of course, the buyer is out there searching for another property.

Formulating a Winning Option Contract

A very important consideration in drafting an option purchase contract is whether it should be recorded as an ancillary document to the deed. It is the general rule that an option contract must be recorded to be enforceable against a third party purchaser of the fee simple when the option is exercised. The better practice is to include the option to purchase as a covenant in the deed as opposed to recording the option elsewhere. The deed itself should contain an affidavit from the seller is which the seller will agree to unconditionally and absolutely convey the subject property plus the reserved right to purchase in fee simple within a specified period of time. There are instances when an option contract will not be enforceable without a specific reference to the option to purchase in the deed itself, but those instances are few and far between as long as the contract is recorded.
If the option purchase contract must be recorded, consideration should be given to the inclusion of a broad array of contingencies which are required to be satisfied before the option contract becomes absolutely binding on the owner of an option who initially has a right to say "no" to the exercise of the option: (1) the option purchaser must have the right to terminate the agreement within a fixed period of time if the option purchaser is not satisfied with certain conditions, including but not limited to zoning, subdivision approval and the like; (2) any third party benefits that the option purchaser might receive, including, but not limited to, real estate tax reduction and agricultural easement support programs, may be assigned to a land trust prior to exercising the option and in order to preserve the economic interest of the option purchaser; (3) there must be coordination with lenders , municipalities and the like to ensure that they are aware that an option exists; (4) the timing of the exercise of an option is of critical importance in terms of establishing consistency with other investment opportunities; (5) the ownership of the options must be free and clear of all liens and encumbrances; (6) the option to purchase must be clear and free of any contingencies on the part of the option seller so that the option purchaser may proceed with the option without concern as to consent by the owner of the property; (7) there should be a clause which protects the option purchaser in the event that there are any encumbrances filed against the owner of the option without the knowledge and consent of the option purchaser; (8) a review of easements, deed restrictions and the like should be undertaken prior to the preparation of the option document; and (9) a provision should be included in the option document that no additional agreement, parol or otherwise, will be entered into which will modify the provisions of this agreement. It is advisable to have legal counsel evaluate the contract prior to the effective date of the document to ensure that all aspects of the document will be enforceable and that all appropriate closing documents necessary to consummate the transaction are agreed upon between the parties. The option contract must also include a statement regarding the ability of specific lenders and the relationship with them, along with consideration of appraisal rights, exclusion of sales tax from the purchase price, the approach to business costs at settlement and representation on the part of the option purchaser regarding its competence and capacity to close the transaction in accordance with the subject option purchase contract.
There can be many reasons why an option purchase contract is pursued. It literally allows an owner of property to hedge on its future right to purchase land since it is typically more cost-effective to do this based on the present value of the money as opposed to borrowing money against the property in the future to pay for the cost of the land as it appreciates in value over time.

Option Contract Examples

Consider a residential developer who writes a signed option contract that allows the optionee, usually a potential tenant or occupant, to elect to purchase the property within an agreed timeframe at a specified purchase price under specified conditions. The applicant is not obligated to purchase or even to accept the option offer, but should he do so and the terms are satisfied, the developer must convey the property to the applicant. Such contracts are also commonly used in the commercial sector and among business partners.
A recent Alberta circumstance involved two acquaintances who entered into a real estate option contract with respect to a one-acre parcel of land. The option agreement provided the option to purchase four one-foot by five-foot lots at a total cost of $60,000 in five years. After the five years had passed, the optionee refused to pay the stated price of the property because he believed that the price was not fair, since the land was worth at least double that amount.
In a similar case, consideration was given to a dispute relating to a commercial land transaction. In contrast to the previous example, the option agreement in this dispute was seen as obligatory on both sides once it was executed. The parties had entered into an agreement in which they agreed upon the purchase price of a piece of commercial property belonging to the optionor in exchange for a $10,000 deposit. Another provision of the option contract stipulated an obligation for the optionee to enter into a lease and development agreement with the optionor upon exercising his option to purchase. The question was whether the contract vested unconditionally on the date the parties executed the option contract. The court determined that, while the option amendments were dependent on further consent, this did not mean that the option had not been exercised or that a binding land or commercial lease had not followed the exercise of an option.
Another intriguing example involves an option contract that provides the developer the first opportunity to purchase a piece of land before the owner sells to any other party. For instance, the owner of a small piece of land may want to sell to a business in the vicinity, whereas the business would rather have the option to purchase the land once it had had a closer look at the site. During the option period, the owner forgoes seeking other offers. This idea of trade-off is the basis for many successful option contract scenarios.

Regulatory Issues and Compliance

Regulatory considerations and compliance
The legal and regulatory frameworks governing real estate option contracts and payments vary by jurisdiction. In a survey by the NASAA , thirty-two US jurisdictions indicated that there are no exemptions for option contracts or option payments from state securities laws with respect to such contracts being treated as a security. Ten jurisdictions allow the use of option contracts so long as certain requirements are met.
Compliance Requirements
Those jurisdictions that require option contracts to be registered generally allow for the offer and sale of an option contract only with the prior consent of the state regulator. The NASAA survey indicated that the jurisdictions requiring registration allow for an offer and sale of an option contract only if the offering documents comply with certain filing and disclosure requirements.
Common Legal Challenges
Common challenges or problems associated with option contracts are summarised by the NASAA as follows: