A real estate option contract is a legal agreement between the buyer of a real estate property and its owner. The potential buyer must pay the property owner an option fee for the right granted in the option contract. Since it is derived from a real estate sale contract, an option contract is a financial derivative. If the option contract is transferable or assignable it has value by itself and may be transferred or assigned to another potential buyer for a profit.
Option versus Obligation
Like most option contracts, the real estate option contract normally gives the potential buyer a right to purchase but without imposing an obligation to do so. A property owner signing an option contract, though, has a legal obligation to sell the property under the terms specified in the real estate option contract. If a property owner fails to perform the sale under terms of the option contract the owner risks a lawsuit that could might force the sale of the property.
Obligation to Sell
While potential buyers don't incur an obligation to buy in a real estate option contract owners do have to sell at the specified price. If the real estate buyer or the purchaser of the option exercises the option to buy in the manner described in the contract, the property owner is obligated to sell. Property owners should only sign option contracts when willing and able to comply with the terms of the contract. Not fulfilling a real estate option contract's obligation to sell might lead to a specific performance lawsuit forcing the seller to comply.
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Advantages for Buyers
Option contracts allow potential buyers more time to secure financing, investigate property development possibilities and check problems or attract partners. Under option contracts, potential buyers are able to leverage a small amount of money in return for a large gain. Real estate options are commonly seen in rent-to-own or lease-option transactions where buyers lease property with purchase rights at agreed-to prices after a year. Buyers using real estate option contracts can also improve their credit and have part of their rent applied to a future purchase.
Disadvantages for Buyers
Potential buyers should be careful that the option fee they pay to get a real estate option contract is not too high. A potential buyer declining to exercise an option contract often forfeits the entire option fee. In the case of a lease-purchase or rent-to-own transactions, potential buyers may agree to a higher-than-market-value rent in order to apply part of the rent towards the purchase price. If such potential buyers later decide not to exercise their purchase option they normally forfeit the higher rent already paid.
Advantages for Owners
The primary benefit a real estate option contract for property owners lies in the option fee received. Most option contracts allow property owners to keep the option fee when buyers don't exercise their purchase options. If a purchase option is declined, the property owner is free to sell it to someone else. Option contracts can also allow property owners more time in a property before having to conclude a sales transaction, such as when an owner needs time to relocate.
Disadvantages for Owners
The primary disadvantage of option contracts for property owners is the loss of other transaction opportunities during the time the property is under option. If an option contract features a long purchase option period, for instance, and the property's value rises greatly the owner has potentially sacrificed a significant profit.