Options on real estate are a very cool way to play the real estate game for the right person. But what are they? How do they work? Are they a good idea? Let’s break it down and learn together.
What Are Options On Real Estate?
If you own property you can sell an option to someone which gives them the right to buy it over some specific period of time at a fixed price. Usually during this time period, the person who buys the option occupies the property. Typically the seller of the option receives a lump sum payment for this right. In addition, the seller charges the buyer of the option a higher than market monthly rental rate. These two incremental payments are compensation for the option.
How Do These Options Work?
The best way to explain this is by way of example. Let’s say that Jane sells Marty an option on her house. Marty pays Jane a one-time payment of $3000 for this option. He also pays Jane $1500 a month in rent.
In return, Marty has the option of buying Jane’s home for 12 months. If he decides to do so, he’ll pay Jane $175,000. (This option period can be longer or shorter. It just depends on what the two parties agree on.)
If Marty decides he wants to buy the property at any time between the day they sign the contract and for 12 months thereafter, Jane must sell it to him for $175,000. If Marty doesn’t exercise his right to buy the house, or can’t qualify for a mortgage and can’t buy it, Jane pockets the $3.000 premium plus the monthly rent and goes on her merry way. Marty doesn’t have a right to get any of that money back.
Is Buying Or Selling Real Estate Options A Good Idea?
Right now, options on real estate is a risky business and probably not the best way to go for either party. Here’s why.
First let’s consider this from the view point of the seller. Right now, real estate prices are going up generally speaking. If that’s the case, why lock in today’s price when it might be substantially higher 12 months from now?
In most cases, it makes no sense. In fact, doing this only makes sense if the seller collects a high enough premium to make up for that risk. In this particular market, the only other time it’s smart for a property owner to sell options on real estate is if he or she really wants to sell to a particular person who may not be able to buy now but may be able to get a loan in the future. And if the seller wants to own rental property, they shouldn’t sell options because they could lose the property when the option gets exercised.
If real estate prices head south, selling options is great for a seller. But we can cover that story when and if real estate prices reverse course.
What about buyers?
If you buy an option on real estate, you should only do so if you are darn sure you can afford the house and that you’ll be able to complete the transaction down the road. If not, you’ll have paid the premium and you won’t get anything in return. Bummer.
Still, there are a few circumstances where this might be wise. For example, I can see someone buying an option if they can qualify for a mortgage but aren’t able to commit to staying in the area because of uncertainty at the workplace. But still, I would question this person about their situation.
If there is so much uncertainty now, what makes them so sure the job will be that much more stable in a year from now? Often, jobs that require a great deal of location flexibility always keep employees guessing. It rarely changes.
Options on real estate can work for the buyer and/or seller but rarely do. In a hot real estate market, sellers don’t have to settle for tying up their property so they probably shouldn’t. And buyers should only pursue this option if they are certain they can complete the transaction later on.
Have you ever been a party to an option on real estate? How did it work out for you?