Options: Minimizing Cash Outlays
A real
estate purchase option gives its holder the right to buy a parcel of real
estate at a specified price and on specified terms within a fixed period.
Purchase options can be a valuable technique for investors and developers
because they are the ultimate form of leverage, permitting the option holder
to control property for a relatively small cash outlay. In most cases, the
optionee makes a cash payment to the optionor when the option is negotiated.
However, an optionee may be able to negotiate a "pay as you go" plan that
spreads the cost over the life of the option. The optionee thus is in a
position to apply an initial cash outlay to several options over different
properties, so increasing the likelihood that one of the options may prove
profitable. Several of these approaches are described below.
Interest Option
When negotiating an interest option, the parties first must agree on the
present value of the optioned property. The optionee then agrees to pay to
the optionor at designated times during the life of the option (say, every
six months) "interest" at an agreed-rate or based on a designated standard
such as the 10-year Treasury. If the option is not exercised, the optionor
keeps the payments. If the option is exercised, normally the payments are
applied to the agreed-upon purchase price.
Letter of Credit Option
A letter of credit is an agreement by a bank or other lender (the issuer),
at the request of a customer (the account party), that the lender will honor
a draft for payment by a third party (the beneficiary) in accordance with
conditions set forth in the letter. Thus, the credit of the lender is
substituted for that of the customer, eliminating the risk that payment will
not be made when due (e.g., when the option is exercised or the option
period ends). If no exercise occurs, the optionor receives the agreed-upon
option fee. If the option is exercised, the optionor receives the agreed-upon
price. Until then, the only cost to the optionee is the interest charged by
the bank for issuing the letter.
Effort Option
Developers frequently use options to tie up land that may not be ready for
development for several years. An "effort option" from the landowner
requires the developer to obtain preliminary development plans and all
necessary approvals within the option period at the developer's expense. If
the developer decides not to exercise the option at any time during the
option period, all the plans and studies as well as any lease commitments
from third parties become the property of the landowner. On the other hand,
if the option is exercised, the developer will pay the agreed-upon price.
Real Estate as Consideration
An alternative for a developer holding long-term land is to pay for an
option on land ready for development with a portion of the longer term
property, perhaps transferring a parcel each year the option continues.
Land Cost Option
Yet another approach tying up vacant land at minimum cost is for the
optionee to agree to pay all of the costs of the vacant land until a
specified date (unless terminated earlier by the optionee). If the option is
exercised, the optionee will pay the agreed-upon price. The landowner then
knows all expenses will be covered during the option term, including
property taxes that may rise over time, as well as special assessments for
roads or utilities.
Contract With Liquidated Damages
An option with another name is a contract with a liquidated damages clause.
A developer signs a contract with the seller, making a small down payment. The
contract contains a liquidated damage clause limiting the seller's remedy to
the down payment in the event the developer fails to close. Since the
developer can walk away without liability during the contract period, he in
effect holds an option.
Another approach is for the developer to buy property for a small cash
payment with the balance of the price in the form of a purchase money
mortgage. The mortgage has an exculpatory clause that limits the seller's
remedy to repossession of the land in the event of default. Here again, the
buyer in effect holds an option. If the mortgage permits release of
individual lots as they are sold off by the developer, the transaction is
the equivalent of a rolling option.
Contracts with limited liability, as describe above, have an advantage over
options resulting from the fact that the holder of an option has no legal or
equitable interest in the property as does a contract vendee. For example,
an optionee has no standing to seek a zoning change, but must act through
the optionor, whereas a contract vendee can act directly.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional, or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman's New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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