What is an Option to Purchase in Real Estate Investing?

This is a fundamental and powerful concept in real estate investing.

What is an Option to Purchase?

An Option to Purchase (or a “Purchase Option”) in real estate is a contractual agreement that gives an investor (the “Option Holder”) the right, but not the obligation, to buy a specific property at a predetermined price within a set period of time.

Think of it like paying for a reservation. You pay the property owner (the “Optionor”) a non-refundable fee, called the option fee or option consideration. In return, you get the exclusive right to decide whether or not to buy the property. If you decide to buy, the owner must sell. If you decide not to buy, you simply walk away, having lost only the option fee.

Key Characteristics of an Option:

• Right, Not Obligation: This is the most important feature. The investor controls the fate of the deal.

• Option Fee: This is the price for this control. It is typically non-refundable but is often negotiated to be applied toward the purchase price if the option is exercised.

• Strike Price: The pre-agreed-upon purchase price, fixed in the contract.

• Option Period: The length of time the option is valid (e.g., 6 months, 1 year, 2 years).

• Exclusivity: The property owner cannot sell the property to anyone else during the option period.

Several Examples in Real Estate Investing

Here are several common ways options are used by investors, from simple to more complex.

Example 1: The Simple Land Speculation

An investor identifies a vacant piece of land on the outskirts of a growing city. They believe the area will be developed in the next 2-3 years, dramatically increasing the land’s value.

• The Deal: The investor approaches the landowner and negotiates an option. They pay $5,000 for a 3-year option to purchase the land for $200,000.

• The Outcome:

  • Scenario A (Investor Wins): After 2 years, a major developer announces a new project nearby. The land’s value soars to $350,000. The investor “exercises” their option, buys the land for $200,000, and immediately sells it for a massive profit.

  • Scenario B (Investor Loses): After 3 years, no development occurs, and the land is still worth only $210,000. The investor decides the small potential profit isn’t worth the effort and lets the option expire, losing only the initial $5,000 fee.

Example 2: The “Rent-to-Own” or Lease-Option

This is a very popular strategy for helping tenants become homeowners or for investors to control a property with little money down.

• The Deal: An investor finds a motivated seller but a tenant who doesn’t yet qualify for a mortgage. The investor signs two agreements:

  1. A Lease Agreement: The tenant pays $1,500/month in rent.

  2. An Option Agreement: The tenant pays an upfront $5,000 option fee for the right to purchase the home in 2 years for $300,000. A portion of the monthly rent (e.g., $300) may be credited toward the down payment.

• The Outcome:

  • The investor gets a tenant who has a strong incentive to maintain the property (as they plan to own it) and pockets the non-refundable $5,000 option fee.

  • If the tenant buys the house, the investor sells it at the pre-set price.

  • If the tenant cannot buy the house, the investor keeps the option fee and any rent credits, and can then either move in, re-lease, or sell the property (which has likely appreciated).

Example 3: The “Subject-To” with an Option (Controlling a Distressed Property)

An investor finds a homeowner who is behind on mortgage payments (“distressed”) but has significant equity. The homeowner wants to avoid foreclosure but isn’t ready to sell outright.

• The Deal: The investor makes an offer with two parts:

  1. They will take over the mortgage payments “subject to” the existing loan (the loan stays in the seller’s name, but the investor pays it).

  2. In exchange for saving their credit, the seller grants the investor a 2-year option to purchase the house for its current market value of $400,000.

• The Outcome:

  • The investor controls a valuable property without getting a new bank loan. They can lease it out for positive cash flow.

  • During the option period, the investor can either:

    • Exercise the Option: Secure a loan, buy the house for $400,000, and own it free and clear.

    • Wholesale the Contract: Sell their valuable right to purchase to another end-buyer for an assignment fee (e.g., $10,000), without ever having to close on the property themselves.

Example 4: The Zoning Change Play

An investor finds an old, single-family home in an area that is likely to be re-zoned for multi-family use (e.g., duplexes or townhomes).

• The Deal: The investor gets an option on the property for 18 months with a strike price based on its current value as a single-family home.

• The Outcome: The investor then spends the option period working to get the property re-zoned. If successful, the property’s value (as a developable lot) skyrockets. The investor exercises the option, buys the property at the low single-family price, and either develops it themselves or sells it to a developer for a large profit. If the re-zoning fails, they let the option expire.

Summary of Key Takeaways:

• For the Investor (Option Holder): It’s a tool for controlling a property with very little capital, locking in a price, and limiting downside risk to just the option fee. It provides time to secure financing, find a buyer, or wait for market appreciation.

• For the Seller (Optionor): It provides immediate cash flow from the option fee and a potential buyer at a guaranteed price. The main downside is taking the property off the market for the option period, potentially missing other offers.