For many Americans, real estate, in the form of a family home or rental property, is their single largest class of investment. These investors often perceive real estate as one of the safest and most reliably profitable investments over a period of time. However, real estate investment involves a high cost of entry (usually funded by a loan with interest), a long investment period, and great uncertainty. Instead of buying actual property, investors can consider burying real estate options as a way to invest in real estate at a lower cost and with fewer expenses.

A Realistic Look at Calculating Profit in Real Estate

A novice real estate investor may look at a two-bedroom apartment and see that in 5 years it increased in value from $100,000 to $300,000 and conclude a tripling of investment value. However, this simple analysis misses routine related expenses which can include financing charges for property purchase, monthly interest payments, registration and stamp duty charges, property taxes, commissions to agents during purchase or sale, monthly association fees, maintenance and repairs, insurance, and other applicable local taxes (for example, capital gains tax at sale or a property valuation above a certain level that qualifies the owner for a wealth tax).

Considering all these factors, the realistic valuation of returns for property is reduced substantially, and may not be fully understood by the common investor (related: How To Calculate Your Investment Returns). Developments during the investment period may lead to difficulty in selling the property later. For example, a noisy new highway or a spike in crime may devalue the property. (Related: The Most Important Factors For Investing In Real Estate)

A lower cost way to invest and profit in real estate is through real estate options.

What Is a Real Estate Option?

A real estate option is a specially designed contract between two parties (a buyer and a seller). The seller offers the buyer the option to buy a property, for a specified period of time at a fixed price. The buyer purchases the option to buy or not buy the property during the specified time period.

For the right of this option, the buyer pays the seller an option premium. If the buyer decides to buy the property (in other words, exercise the real estate option), the seller must sell the property to the buyer according to the terms of the preexisting contract.

You may have encountered the concept of options when purchasing stocks. Options provide many choices to the buyer. They can be exercised early (American type), held until option expiry, or sold to a second buyer before expiration.

Real estate options are commonly used by property developers and investors in commercial or high-end residential property. Real estate options provide more flexibility and low cost trading and investing opportunity to buyers, with limited benefits to sellers.

Example of a Real Estate Options Trade

Here is a comprehensive analysis of risk and reward of a real estate options scenario. Assume that a builder has $500,000 and wants to purchase a land for which the seller wants $2 million. The builder is unsure of few things:

1) Can the builder raise $1.5 million through bank loans or other sources?

2) Can the builder gain necessary permits for residential or commercial development or further subdivision of the property?

3) Can the builder raise money and obtain permits before another builder buys the land?

In this situation, a real estate option is appropriate. For a defined nonrefundable cost (called the real estate option premium or the consideration) of say $25,000, the builder can enter a real estate option contract with the seller. The real estate option allows the builder to lock down the property sale price at $2 million over a period of 6 months. During this time, the builder can raise money, obtain permits, and either buy the property (spending a total of $2 million plus the $25,000 option premium), walk away from the property (and lose the $25,000), or sell the option to another buyer for a negotiable price. Either way, the seller will make an additional $25,000 from the property.

The real estate option contract will include the following conditions:

• property details (location, size, and other specifics)
• duration of the contract (6 months from trade date)
• option premium or consideration amount ($25,000 nonrefundable paid by the buyer to the seller on the trade date)
• agreed purchase price if the option is exercised during the contract ($2 million)

For the 6-month duration of the contract, there are four possible scenarios.

Scenario 1: The builder is approved for a $1.5 million bank loan. He also confirms he can obtain necessary permits for development. He exercises his real estate option to purchase the property at predetermined price of $2 million. The seller receives $2 million plus keeps the additional $25,000 option premium.

Scenario 2: After 2 months, the builder discovers he will not be able to obtain a development permit. In the next 4 months, the builder manages to find another party willing to buy the property for $2 million. The builder sells the real estate option to the new party for a new price of $30,000. The new party replaces the builder in the original option contract. The new party exercises the option and purchases the property for $2 million. The seller receives $2 million from the new party plus keeps the $25,000 option premium from the builder. The builder sold the option for $30,000 and thus makes $5,000 and is not saddled with a property he cannot use.

Scenario 3: The builder is simply an option buyer looking to benefit from price appreciation of the property. If the demanded price of $2 million increases to $2.2 million in 5 months, the option buyer will benefit by exercising the option to purchase the property and then selling the property ($2.2 million $2 million $25,000 = $175,000).

However, instead of entering property ownership and all the associated fees, taxes, and costs that will lower the $175,000 profit, the option buyer can instead sell the option to a new party willing to buy the property. As the underlying property price increases, the real estate option price will also increase in what is called a delta). The buyer can sell the option at a new premium which includes the change in value of the property.

The original option buyer can sell the option for $200,000 to the new buyer. The new buyer will be willing to pay $200,000 because it means the total purchase price of the property will be $2.2 million ($2 million paid to original property owner/option seller plus $200,000 to the existing option holder).

At the end of the transaction, the property owner gets $2 million plus the $25,000 option premium, the original option buyer profits with $175,000, and new option buyer purchases the desired property at current market rates.

Scenario 4. The builder is not able to secure a loan or permits. He also cannot find a new buyer for his option. The builder lets the option expire and loses the option premium. However the buyer was able to avoid a bad $2 million investment by paying the $25,000 premium (just 1.25 percent of the actual deal value). The seller benefits by $25,000 over the option period of 6 months and continues to search for a buyer.

In all cases, once the seller enters a real estate options contract, the seller no longer has choices on whether to sell the property and at what price. The seller must wait for the buyers decision to exercise the option. This is why the seller receives and keeps the option premium upfront.

The Bottom Line

Real estate options offer a lower-cost method to trade, invest, and profit from real estate investments. However, they are effectively OTC contracts between two individual parties with no outside regulatory oversight. The involved parties must ensure that the options contract is fair. Default by the option seller is one of the major challenges in real estate options agreements. In such cases, the buyers only recourse is a lawsuit. Lack of publicly available information and past records on real estate options participants is another challenge. Real estate options investors should also consider additional expenses like fees for legal services such as drafting and registering the contract.

Recommended article: Chomsky: We Are All Fill in the Blank.

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