Elements of the Option Contract
Options typically contain the following elements:
● Period. The purchase option gives the buyer a limited time period to exercise the option’s purchase rights. The period is negotiable and can last from a few hours to a several years.
● Option fee. To obtain the option, the buyer usually pays a fee. If the buyer does not exercise the purchase option, the seller will keep that fee. The option fee is often applied toward the purchase price if the buyer does decide to exercise the purchase option.
● Pre-determined price. It is to the buyer’s and sometimes the seller’s advantage to set the price. With longer term options (3+ years), the option may include an index that allows the seller to adjust the price higher according to inflation or market changes.
● Exit clause; and first right of refusal. Some options may give the seller an exit clause, should the seller find a different, more attractive buyer. Such a termination clause may require the seller to return the option fee with interest and penalties. Whenever the option does contain an exit clause, the buyer should try to negotiate a first right of refusal, whereby the buyer can immediately exercise his purchase option to negate the exit clause.
● Legal instrument. The option is a legally binding instrument. The buyer should make sure that it is notarized and recorded with county. Recording the option will establish an encumbrance on the property, warning all other buyers that the current owner is prohibited or restricted from selling the property without first notifying the option buyer.
Perhaps the best advantage that options offer is that many lenders allow the investor to exercise the purchase option and acquire the property with a refinance loan, instead of a purchase loan. The refinance loan approach allows the investor to use the property’s value rather than the purchase price. The main requirement is that the purchase option be at least 12 months old; and many lenders require that the option be legally recorded for at least 12 months.
Example: Option purchase
Donna sees an undervalued property that the seller is considering selling, but has had no serious takers. Donna offers the seller $5,000 for a purchase option with a term of three years and a fixed price of $100,000. If Donna were to buy the property now, the best loan she could qualify for would be an 80% LTV loan—$80,000. After one year, Donna can still only get an $80,000 loan. But now she is able to appraise the property for its full market value of
$140,000; and 80% of that appraised value is $112,000-more than enough to pay off the seller completely.
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