An option to purchase is a widespread and very versatile killer property strategy every serious property investor should be familiar with.
What follows is of course a short explanation of the strategy, an introduction. It does not make you an expert; it identifies some of the main features and benefits.
Dig deeper and link up with property people fully familiar with the intricacies of options to gain greatest investment benefit.
1. Characteristics of an option
It is easy to get confused when you hear people talking about “options” in relation to property. The term can be used in a wide variety of ways and in different situations. There are different types of options.
Here we are looking at a legal option to purchase – an agreement where a seller (or donor) is willing to give a buyer (or donee) the right to buy a property in specified circumstances.
In a basic option, the donor gives the donee the right (but not the obligation) to buy a property for a known price within a fixed timescale upon payment of a consideration or option fee, which can be as little as £1.
MUST KNOW PROPERTY STRATEGIES
Rent to buy (property is rented before it is bought)
Delayed completion (completion is delayed to make a profit)
Seller finance (the seller helps a purchaser to buy)
The key elements of an option are:
- The length or duration of the option, during which time the right to buy can be exercised
- The known price to be paid for the property
- The consideration or option fee which makes the agreement legally binding.
The option agreement may be more elaborate, dealing with the terms and conditions on the subsequent sale-purchase of the property.
If the option fee is substantial, it is a bonus for the buyer if the option agreement allows the option fee/consideration to be treated as part payment of the price on a subsequent purchase.
The donor will ideally want the option fee to be non-refundable if the donee does not go on to buy the property.
2. Uses of an option
An option is a device that can limit or control the actions of a property owner in the future.
A property owner can use an option to delay a sale or can agree to sell in the future in return for a substantial option fee payable now.
A buyer can secure the right to buy a property pending steps to make it worthwhile to buy – such as by obtaining planning permission which adds value to the property.
An option can be used to obtain practical, financial or tax benefits for the donor and/or donee.
An option can be combined with a lease to create a lease option strategy.
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3. Practical example
Here is one of several examples of how an option could be used in practice:
Archibald has a property worth £1m at the moment. He knows the property will be worth £2m if planning permission can be obtained to develop it into flats.
Archibald agrees to an option in favour of Fiona for a fee of just £1 with the purchase price fixed at £1.5m. Fiona insists on a tiny option fee since she will be incurring significant costs in trying to secure planning.
Archibald knows he is giving away a large amount of potential profit, but he is at that time of life where he wants an easy life and would prefer someone else to do the heavy lifting.
Further, Fiona has the experience, capital and expertise to apply for planning permission, which he lacks.
She will bear all the costs and risks of applying for planning permission so he is willing to agree a price £500,000 below the anticipated market value upon the grant of planning.
Planning is obtained and Fiona exercises her option, paying £1.5m.
Once the development is completed, Fiona laughs all the way to the bank. After her finance, legal and other development costs are deducted she makes a very healthy profit of several hundred thousand pounds.
Archibald is not crying because he has gained around £0.5m for doing very little.
4. Benefits for the donor
The donor of the option, the owner, may enjoy the following benefits or advantages:
- The financial benefit of the option fee, especially if substantial and non-refundable
- The high probability that the donee will proceed to buy within the option period
- The opportunity to plan their affairs to their advantage on practical, financial or tax grounds.
5. Benefits for the donee
The person with the benefit of the option, enjoys a number of pluses:
- The right but not the obligation to buy the property
- The right to control the property for the duration of the option period
- The price stays the same even if the value goes up
- If there is a right to assign the option, it can be sold on for a profit.
6. Downside and risk factors – donor
Options are not without their drawbacks for both sides. A problem for the donor is that they are restricting the use of their property for the duration of the option.
If the option period is long, that may increase the possibility of the occurrence of some adverse event – such as dispute, relationship breakdown or insolvency – which results in issues, challenges or serious problems which put the option at risk.
In agreeing the price or a mechanism for fixing the price, the donor will have made certain assumptions about future increases in property prices or the value which the donee may be able to add.
If the donor ends up being wrong, they will lose out financially.
7. Downside and risk factors – donee
A primary concern for a donee will be the element of gambling. That may work in favour of the donee, but it can also work against.
For instance, the donor may insist that the option fee is not refundable if the donee fails to exercise the option.
If it is not in the donee’s financial interest to exercise the option, the option fee will be lost.
Similarly, the donee may agree a price based on adding say £2 million to the value of the property by planning gains. If only half that amount can be added, the donee is unlikely to be willing to buy and would lose any non-refundable option fee.
Either party could suffer detriment if property prices rise or fall unexpectedly during the option period.
As a rule, greatest risk probably lies with the donee where their option fee is non-refundable.
The skill is for donees to negotiate the lowest possible option fee and to seek at least a part refund in the event of not being able to exercise their option on reasonable grounds.
Option agreements can be as elaborate as the parties wish. It is up to each side to retain the highest quality lawyers to ensure that their best interests are identified and protected.
Have you used an option? What were your experiences? Please leave your comments below.
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Rebel Property Coach
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Categories: 06 Strategies