If a potential buyer is seriously weighing whether or not to move forward with a transaction, and the seller thinks they'll be able to raise capital and close, the option to buy may come into play. It’s a way for a seller to allow a buyer the necessary time to do their due diligence and secure financing without having to worry that another interested party will come in and muddy the waters.
An option to buy is like an engagement to be married. Enter one only after thinking it through very carefully. You can’t legally get married to more than one person at a time, just like you can’t sell a piece of property to two different entities simultaneously. The option to buy is where you "put a ring on it"; maybe you’re not finalizing a contract, but you’re heading down that road. Nobody gets to that point without thinking it through carefully. Or at least they shouldn’t.
What is an option to buy?
Before we begin, note that the terms "option to buy" and "option to purchase" or "purchase option" are interchangeable terms.
Also note that when we discuss "option to buy” here, it’s for the option contracts in commercial real estate as opposed to residential real estate leases with option-to-buy provisions. A lease option grants the buyer the right to purchase a piece of residential property while they are paying to lease it.
An option to buy in commercial real estate is a contract provision that grants an investor the exclusive right to purchase a piece of real property for a certain price (usually a fixed price, but sometimes variable) within a certain time frame (the "holding period") in exchange for a sum of money called an "option consideration." The holding period for this type of option to buy is much shorter than in a residential lease with an option to buy. It's valid for weeks or a few months. The purpose is to give the potential buyer a way to legally tie up the property and stop other potential buyers from making offers while the option-holder looks to secure capital.
Why is it a good move in some situations?
A real estate transaction is among the larger types of purchases that any person or entity can make -- and very few people can afford to pay for a piece of real estate immediately and with their own funds. The larger the transaction, the slower and more complicated the process, and serious buyers want to be able to go through the necessary steps without worrying that another party may swoop in and make their own offer or otherwise complicate the process. From a seller’s perspective, if they have an offer from a buyer that they like, and they want that buyer to have a few weeks to pull together capital, they can offer an option to buy not only as a show of good faith, but also to put a countdown clock on the deal.
Why might you, a potential buyer, not receive an option to buy if you want one?
If you aren’t willing to put down the necessary money for option consideration, you won’t get an option to buy.
However, even if you do have the money, a buyer may not grant an option to buy if your offer is lower than they think they can get for the property. They won’t want to tie up a piece of property in the hopes of a disappointing offer coming together if they think they can find a better offer.
In some cases, a seller may decide -- rightly or not -- that the potential buyer really is uncertain and just looking to buy time before committing to the deal. They may decide not to give up their right to shop the property in exchange for someone saying essentially, "I need more time to figure this out."
Keep in mind, the holder of an option can force a sale if the terms of the option are met. For some sellers, this may be too absolute.
Key elements in any option-to-buy contract provision
There are only six key elements, but regardless of the seeming simplicity of the provision, it’s advisable that a real estate attorney draft each one to ensure that crucial details like the agreed price of the property and the option period are defined and agreed upon by both parties.
- Optioner (seller).
- Optionee (potential buyer).
- Option consideration: An option to buy can’t be formally contracted without a monetary exchange, as determined in this line.
- Option period, aka holding period.
- Real estate option: What is the specific piece of property this contract covers?
- Exercise of option: What is the process for the optionee to signify in writing that they’re moving forward to exercise the option and complete the transaction?
Different types of options to buy
There are several types of options to buy. The most common:
- Straight option: The monetary consideration here acts as a deposit to be rolled into the down payment if the option is exercised.
- Interest option: Buyer agrees to pay whatever interest the seller would have earned on a full purchase price if the sale would have closed at the start of the option period.
- Letter of credit option: Instead of putting money down, the buyer gets their lender to issue a letter of credit.
- Rolling option. If the seller breaks a piece of real estate into several smaller parcels, the option is good for all the parcels, but the holding period allows time for the buyer to close on each parcel separately. This might necessitate a longer holding period, since the buyer and seller are essentially working toward closing multiple transactions one after the other.
Pros of option to buy
The pros or upsides of an option to buy from the buyer’s perspective are risks from the seller’s perspective. The buyer gets time to do their due diligence, to look into things like gross income, potential entitlements, clouds on a title, etc. They also get time to look around and make sure there are no better pieces of property nearby. Meanwhile, the seller has to wait. To again use the engagement/marriage analogy, they’re being promised their day in church -- but people get left at the altar often.
Cons of option to buy
For buyers, the main downside to an option to buy comes if you want to back out after paying option consideration. You won’t get the money returned. And keep in mind, it’s not a lease that grants the right to stay in the property while pulling together the funds to buy the property, like the residential kind of lease option agreement is. You pay the option fee just to lock up the property so no one else can make an offer.
Every other potential downside and risk really comes at the expense of the seller. Especially if the contract has a variable price, all sorts of things are uncertain during the holding period, from whether the financing will come through to whether the buyer may make a lower offer based on things they’ve learned.
And finally, unlike with first right of refusal, where a buyer can be first in line to buy only when the seller is ready, in an option-to-buy scenario, the buyer can go forward with the transaction regardless of whether the seller gets cold feet.
The power of an option to buy
Obviously, an option to buy is something to be granted sparingly and strategically. It can cause great frustration if a seller enters one with a lookie-loo who has no real intentions to purchase a property or, worse still, has some sort of ill intent. But on the other hand, a legitimate investor may have plenty of reasons to ask for an option. A buyer can’t really have a blanket policy of "no options," so it’s best to make sure a knowledgeable attorney is advising and writing up the contracts.