The Ins & Outs Of Option Agreements
You may have heard of the term “option” in relation to the purchase or sale of commercial assets, but what does it really mean and how do options work?
What is Involved in an Option Agreement
When you are granted an option, you are being granted the right (without there being an obligation) to either buy or sell an asset at a set price (strike price) on or before a specific date (the option date), if it is beneficial for you to do so. An option to either buy or sell is normally purchased via a non-refundable deposit or option fee. When the option date is reached, the option holder can either exercise their option and buy the asset, or else they can let it expire if they no longer wish to proceed or if the deal becomes financially unviable.
Option agreements can be used for buying or selling any sort of commercial asset, including real estate and securities.
2 Types of options
There are two different types of option – Put and Call options.
A Call Option gives the option holder the right to buy the asset at a fixed price on or before the option date. You are not obligated to exercise the option and can simply allow the option to expire if the property or security you are buying has either depreciated in value or if the proposed purchase is no longer deemed profitable. If it is beneficial to exercise the option, then a legal and binding contract of sale is then normally drawn up and exchanged at the price which was originally agreed – Which could be substantially different to the true current market value. Put options are basically the reverse of a call option – It is an option to sell the asset, rather than buy it.
What Are Option Agreements Used For in Commercial Real Estate?
The most common type of option agreement in commercial real estate are call options. Someone seeking a call option on a property generally does so on the proviso that they are able to generate a profit on it prior to committing to the actual purchase. For example, a developer may be granted an option to buy a block of land from a private seller, and then seek a development approval from the local council (which in turn boosts the value of the property) and on-sell the property to another developer for a price higher than the strike price, thereby generating a profit. If they instead allow the option to expire, then they stand to lose whatever non-refundable option fee they have put up, which offers a potential financial incentive for the owner of the property.
Call option agreements are popular with large scale commercial investors and property developers in that it allows them to lock in a proposed purchase price for the property but defer the decision to proceed with the purchase until further investigations are conducted. If the option holder is unable to secure another buyer to transfer the rights to or if market conditions are not favourable, then the option holder reserves the right to allow the option to expire although they would forfeit the initial deposit or option fee.
Because these agreements allow for the option to be transferred from one entity to another without incurring stamp duty, they are also used in instances where the intended purchasing entity has not been established yet.
What Should you be on the Lookout for When Entering an option Agreement?
Trading in options can be a risky strategy, so you need to understand the in and outs thoroughly so you know what you’re getting yourself into. If you own a commercial property, and you are presented with a call option agreement from an interested buyer, then it is important that the buyer has some “skin in the game” – Meaning there needs to be some sort of financial incentive for you to enter the agreement. Make sure there is a sufficient non-refundable deposit payable to ensure the proposed purchaser has a genuine motivation to make the deal work and exercise the option, otherwise you are running the risk of having your property tied up for an extended period of time only to have the buyer pull out at the last minute without incurring any financial penalty.
As the potential buyer in this scenario, you would certainly want to try and limit your potential losses as much as possible. For example, if an option to purchase a property was being sought by a commercial developer, then it is likely that a significant amount of capital would subsequently need to be invested in obtaining town planning reports and development approvals, which adds extra layers of financial risk for the buyer. Additionally, these development approvals would certainly increase the value of the property, and if the buyer did not exercise the option to buy, then the seller stands to potentially benefit from them financially. All of these things would need to be considered prior to entering an option agreement.
In any case, you should always seek independent legal advice before signing any such agreement
‘Til next time, ciao 😊