What is a Real Estate Option?

By Wendy Polisi

In the real estate market, an option is essentially an agreement between a seller and a potential buyer to purchase a specific property at some point in the future. Such options are rarely sold during boom periods in a real estate market, because they limit the seller's choices. Nevertheless, they are common in periods of declining property values or in specific real estate markets that the seller has invested in and now seeks to get out of.

Most aspects of option agreements are negotiable, although some states and localities impose restrictions or mandate certain terms. The general idea is that the potential buyer pays the seller an option fee, which gives the potential buyer the option of purchasing the property at the end of the agreement. An option also prevents the seller from selling it to someone else during the period that the agreement is in force. The length of an option is negotiable, although most are for a period of between one and three years. The longer the option, the more likely it is that the actual value of the property will diverge from the fixed amount agreed to in the option agreement.

Although there is nothing inherent about an option agreement that dictates that the final purchase price be fixed, this is usually part of an option as without it the option makes little sense for the buyer. Fixing the price means that the buyer gets the option to purchase the property at an agreed price, regardless of what the actual value of the property is at the time that the option expires. Further, the option holder also usually has the right to sell the option to a third party as long as the agreement is in force, making it a tradable commodity in its own right.

The seller automatically receives the option fee, which is rarely refundable. The amount of the option fee is subject to negotiation and there is no fixed limit. Some sellers, desperate to unload a property will offer an option fee as low a one dollar, though a more typical amount is between one and five percent of the agreed upon sale price. This is the primary benefit to the seller, and if a property is currently losing the owner money, selling an option can help offset this significantly. Selling an option also radically increases the chance of attracting a buyer for the property, though the buyer is not obligated to exercise the option and purchase the property at the end of the agreement.

In this respect, options are popular among real estate speculators, especially when the option fee is extremely low. As there is no obligation on the part of the buyer to exercise the option and purchase the property and the option can be sold by the buyer to another party, low cost options are useful in real estate speculation. If the property value increases over the period of the option, then the owner of the option stands to make a solid profit through buying the property at the lower amount agreed to in the option. Conversely, if the property value declines in value, the option holder can decide not to purchase the property and forfeit his option fee.

For the average person, an option may be useful if there is a determination to buy a home in a particular area for reasons other than investment. An option also allows the buyer to "hold" the property for the duration of the agreement, allowing them to raise the required funds for the down payment and make other arrangements for the purchase of the property. The availability of options is usually indicative of a buyer's market and tend to benefit the buyer more than the seller; but they can also provide some relief to sellers as well. People looking to buy a home in the future, but not in a position to do so presently, may find options extremely useful.