How To Use A Real Estate Option

Using a real estate option to control land can turn a small cash investment into big profits. And the downside? You can lose all your investment, and many options DO expire worthless.

An option is a simple concept. You pay for the right to buy something within a certain amount of time at a certain price with certain terms. But you have no obligation to follow through and buy it.

Example of a Simple Real Estate Option

Suppose you want to build a home on a piece of land that is for sale for $52,000, but you are not sure you'll be able to. Since you don't want to lose the opportunity to build on this particular piece of land, you decide to try to "tie it up" with an option. You tell the seller you might want to buy it for full price, but you are not sure about your financing yet.

You explain that if he will give you an option to buy it at $52,000 within the next six months, you're willing to pay an option fee of $1,000. You don't have to buy it, but if you don't buy it within that six months, he gets to keep the $1,000 - and presumably sell it to somebody else. If you do buy it he gets his full price plus that $1,000 (although sometimes the contract is written so that the option fee applies towards the purchase price).

Now lets go one step further with this example. You add "or my assigns," "or assigns" or something similar (ask an attorney) after your name on the contract. This means that if you can't buy the property, you can assign the option to somebody else, and they can buy the property according to the terms of the contract. In other words, they can take your place in the deal. You can let your friend buy it, or you can assign it for a fee to someone, and maybe get your $1,000 back.

Example of Big Money Option Deals

The big money is made when options are used in inefficient markets. These are markets where it is tough to put a price on things, and in real estate it includes markets where value can change dramatically according to use. For example, a corner on the edge of a town can be worth $65,000 while used car dealers are the likely market, an then a year later worth $200,000 when several fast-food companies realize how much traffic goes by there.

Where do options come into this? You use them to connect a property with buyers who will put it to it's highest use, meaning they will also place a higher value on it. Basically, you "tie up" a property with an option - preferably for a year or more - and then go looking for the right buyer. Find that right buyer and you can sell your option for a large profit.

Many times an option will expire and nothing will have happened - you didn't find a buyer for it. That means you lose the option fee. That is the primary complaint that would-be options investors have against this strategy. On the other hand, those who know how to work this game just play the odds and don't worry too much about losing several small option fees to win an occasional huge profit.

Lets put the theory into a simplified example. Farmer John has 80 acres just out of town, and you think it would make a fine new subdivision. Developers are making subdivisions in the area with great success. John hasn't given too much thought to selling, but when you approach him with the idea, he says that he figures the land is worth $280,000.

You tell him that you are not sure if you can buy it or not. You need time to talk to possible partners, and to look into financing. You tell him that if he will sign an option giving you (or anyone you assign the option to) the right to buy it in the next 16 months, you'll give him $5,000.

16 months is a long time to tie up the property, he says. You remind him that he wasn't planning on selling yet anyhow, and he gets to keep the $5,000 if you don't buy. Not only that, but you will set the price at $300,000, so if you do buy, he'll get even more than he hoped. He agrees.

Of course, you have done some homework before this, and you know who the biggest developers are and what prices they have paid for land. You have sixteen months now to get one interested enough to buy your option. Otherwise you lose $5,000.

You get to work developing a marketing plan. You get a plat map of the land and make photocopies. You lay out on paper how the land can be split into the highest number of lots. You find sales of nearby homes, and work up some numbers for how much in total sales is possible.

You present the property and plans to several developers, letting them know that you want to do business with whoever will give you a decent price. One developer offers you $10,000 for the option, and will pay cash now, and take the risk that he can't make the deal work. That isn't enough, so you talk to others.

After a few months, you find a buyer for the land at $420,000. You sign a contract and plan simultaneous closings. In other words, you'll buy the land at $300,000 and at the same time sell it for $420,000. After your costs, you net around $105,000. You can see why options investors are willing to lose on a few real estate options on the way to the good deals.