Earning money in real estate options

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.

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 real estate options trade

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

• Can the builder raise $1.5m through bank loans or other sources?
• Can the builder gain necessary permits for residential or commercial development or further subdivision of the property?
• 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 $2m over a period of six months. During this time, the builder can raise money, obtain permits, and either buy the property (spending a total of $2m 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 (six 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 ($2m)

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

Scenario 1: The builder is approved a $1.5m 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 $2m. The seller receives $2m plus keeps the additional $25,000 option premium.

Scenario 2: After two months, the builder discovers he will not be able to obtain a development permit. In the next four months, the builder manages to find another party willing to buy the property for $2m. 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 $2m. The seller receives $2m 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 $2m increases to $2.2 m in 5 months, the option buyer will benefit by exercising the option to purchase the property and then selling the property ($2.2m – $2m – $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.