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What is an Option Contract in Real Estate?

Is an option contract right for you?
Is an option contract right for you?

Just like the name suggests, an option contract is an agreement between the buyer and seller in a real estate transaction that gives the buyer exclusive rights to purchase the property within a specified timeframe. 

Option contracts can be beneficial for both the buyer and seller, but they aren’t always the best choice for a variety of reasons. 

Continue reading to learn more about an option contract in real estate, its pros and cons, and the costs involved with option contracts. 

What is an Option Contract in Real Estate?

Let's talk about an option contract in real estate and why you may want to use this agreement.

The option contract is used by a buyer and seller to provide the buyer with the “option” to purchase the property. 

Option contracts are used for a variety of reasons, but most importantly they provide the buyer with flexibility in timing their home purchase. Buyers can use this agreement to secure the purchasing rights for a property at a predetermined price without having to commit to the purchase right away. 

Here are the key components of an option contract in real estate:

  • Option Fee: Entering into an option contract isn’t free of charge. The buyer must pay the seller an upfront amount known as the option fee. This fee serves as consideration for the right to purchase the property at the agreed-upon price negotiated with the seller.
  • Option Period: Option contracts don’t last forever, which is where the option period comes into play. This is the window in which the buyer has the right to purchase the property from the seller. The option period lasts anywhere from a few months to a year or longer for most option contract agreements. 
  • Exercise Price: Also known as the strike-price or purchase price, this is the agreed-upon price that the buyer will pay for the home if they choose to purchase it. It’s worth noting that the exercise price remains the same regardless of changes in the market value of the property during the option period. 
  • Legal Considerations: There are several legal considerations that buyers and sellers must take into account before entering into an option contract. Because of this, it’s advisable to work with a qualified real estate attorney to draft the option contract. 

Advantages of Option Contracts

Here are the benefits of option contracts in real estate.
Here are the benefits of option contracts in real estate.

Option contracts can be extremely useful for buyers and sellers in certain situations, and there are plenty of advantages that come with them. Here are the pros of option contracts in real estate:

Flexibility for Purchase

Buyers may prefer an option contract for flexibility in their home purchase decisions. Certain cases where an option contract may be useful include buying a property in a competitive market, attempting to negotiate a lower purchasing price with sellers, or when thorough due diligence is needed.

On the other hand, option contracts also offer sellers flexibility. They can offer option contracts to qualified buyers who aren’t ready to purchase while still maintaining the flexibility to sell to other buyers if needed.

Exclusive Rights

An option contract is especially beneficial for buyers, as it grants them exclusive rights to purchase the property. This means that the seller can’t sell the home to other buyers even if they receive better offers. 

Reducing Risk

Both buyers and sellers benefit from option contracts by minimizing the risk associated with the real estate sale. Buyers can lock in a purchase price for the property and protect themselves against price increases or market fluctuations

With an option contract, sellers receive certainty regarding the sale of their property within the timeframe and reduce the risk of their property sitting on the market for an extended period of time. 

Income for Sellers

The option fee, which we’ll discuss more later, is a fee paid to the seller for the buyer to secure the property for purchase within a specified window. This fee is non-refundable and provides immediate income to the seller for taking the property off the market.

Drawbacks of Option Contracts

An option contract may not be the best option for many buyers and sellers.
An option contract may not be the best option for many buyers and sellers.

While option contracts have their merits, there are also some downsides to consider before entering into an agreement:

  • Non-Refundable Buyers Fee: Like we mentioned, the option fee is a non-refundable fee that buyers must pay in order to secure the property. If the buyer chooses not to exercise the option, they forfeit the upfront fee and incur a loss that could’ve been used to finance a more suitable property.
  • Limited Seller Upside: An option contract tends to be more beneficial for buyers looking to secure a property on an irregular timeline or under special circumstances. Sellers miss out on potential appreciation if the buying window is longer than normal or if the buyer chooses not to purchase the property. 
  • Disputes: Option contracts sometimes result in disputes between buyers and sellers. The option contract is complex and misunderstandings can lead to legal battles and more headaches for both parties. 

Who Uses Option Contracts?

Who uses option contracts in real estate?

Option contracts aren’t unique to just average home buyers and sellers. Let’s talk about all the people who use option contracts and why they’re so beneficial for these groups:

Real Estate Investors

Using option contracts is often used as part of the investment strategy for real estate investors. With an option contract, they can control properties without having to commit to purchasing them immediately. 

This allows investors to tie up properties at favorable prices while they assess their investment potential or secure long-term financing. It also gives them the ability to secure properties at reasonable prices in case of changes in the real estate market

Individual Buyers

Many individual home buyers use option contracts for the flexibility they provide during the home buying process. It also gives them ample time to secure financing with a mortgage, as the lending process can take several weeks or longer. 

Due diligence is another key factor when it comes to buying a home as an individual investor, and option contracts help give buyers time for inspections and appraisals before committing to buying the home. 

Real Estate Developers

Real estate developers use option contracts for a variety of reasons. First, an option contract can help developers secure land for future development projects at predetermined pricing while they obtain permits, approvals, and financing for the project.

An option contract also helps reduce risk for developers. They can control properties without having to commit a significant amount of capital upfront and can minimize financial exposure for development projects. 

Real Estate Agents and Brokers

Both real estate agents and brokers use option contracts when working with buyers to help them navigate the process. They help negotiate important terms like the option fee and option period to meet the needs of their clients.

Option Fees

Understand option fees and how they work within option contracts.
Understand option fees and how they work within option contracts.

Let’s talk about option fees more in-depth and why they’re important to understand before entering into an option contract. 

The purpose of the option fee is to compensate the seller for taking their property off the market and giving exclusive rights to the buyer. The fee is designed to provide the seller with some compensation for the time and opportunity cost for not considering other buyers during the option period. 

The option fee amount is negotiable and typically varies depending on the value of the property, the length of the option period, and current market conditions. However, most option fees fall between $100 and $500. 

Final Thoughts

The option contract in real estate is a useful tool for buyers and sellers in certain cases. This agreement allows the buyer to temporarily secure a property without the possibility of the purchase price increasing. If they choose not to exercise their option, they forfeit a minimal amount of money and can continue shopping for more suitable homes.

For sellers, option contracts can be particularly useful in slow markets or for homes that have been on the market for an extended period of time. Aside from this, option contracts typically provide limited upside for sellers who could be entertaining better offers from other buyers. 

Related: Real Estate Wholesaling Contracts

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