Using An Option As An Investment Tool

By. Mark J. Puttick

An investment technique often overlooked by investors is the option. Its great virtue is that it can bestow on the holder control over large parcels of property for a very small cash outlay. Thus, it creates leverage and conserves cash, two objectives sought by every investor and speculator in property.

Purposes of an Option

An option gives its holder the privilege to buy (or to sell) specific real estate at a specified price within a designated period. An option to buy is known as a call; an option to sell is a put. Options usually serve one of two purposes. The first and, by far the most common, is to permit the option holder to tie up land while the holder decides to buy or not. For example, an investor receives information on a proposed new highway or a new shopping center development and obtains options on surrounding land for a period of time until a date when the information is expected to be confirmed. If the holder is wrong, he or she suffers only the loss of the option price; If the holder is right, the holder is in a position to make a bargain purchase.

An investor also may take a long-term option, running several years, in expectation of a change in economic conditions or the like.

Options are important in the assemblage process, too. A developer who is buying up contiguous parcels is interested in an all or nothing acquisition. To reduce the risk, in the event all the land cannot be acquired, he will proceed via options rather than straight purchases.

A second purpose of the option is to permit the holder to speculate in property on a very small cash outlay by buying and selling the option itself. For example, the speculator pays $1,000 for an option to buy real estate worth $50,000. Within the option period, the value of the real estate rises to $60,000. The optionee can sell the option to a third party for $10,000, realizing a gain of $9,000.

Checklist of Option Techniques

Fixed option: This is the simplest form of option, entitling the optionee to buy the property at a fixed price during the option period.

Step-up option: The purchase price of the real estate goes up in steps periodically throughout the option period. This is used in long-term options, or in rolling options (see below). If an option is renewable, frequently the step-up will occur at the time of renewal.

Rolling option: This is most commonly used by subdividers of raw land. The option covers a number of contiguous tracts. The developer buys and subdivides one tract and, if it proves profitable, he can acquire the next tract. Thus, the option rolls from one tract to another. Usually the price steps up as each tract is acquired, thus permitting the landowner to share in the increased value of the property as it is built up.

Full-credit option: The price paid for the option is credited fully against the purchase price of the real estate, if the option is exercised.

Declining-credit option: As an inducement to the optionee to act promptly, the percentage of the option price that may be credited against the purchase price of the property declines as time goes by.

Hidden Options

An option can exist even though called by another name. Suppose the developer buys a tract of land for a small cash payment, and a large-purchase money mortgage. The mortgage contains an exculpatory clause, limiting the seller remedy, in the event of a default by the buyer, to repossession of the land securing the mortgage. At the same time, the mortgage contains release clauses whereby the developer, as he sells individual lots, can release the lots from the lien of the mortgage upon payment of a portion of the mortgage debt. In effect, the developer holds an option, since at any time he can walk away without further liability except loss of the land not yet released.

Another example of the hidden option is a contract of sale with a small down payment and a clause limiting the seller remedy to the down payment in the event of the buyer default. Here again, the buyer may walk away without liability, if he decides not to complete the purchase, or he may sell his contract rights to a third party, and thus realize a large percentage return on his small investment.

Mark J. Puttick is a partner in the Real Estate Industry practice in BDO New York office. This article originally appeared in BDO USA, LLP Real Estate Monitor newsletter (Spring 2013). Copyright © 2013 BDO USA, LLP. All rights reserved. www.bdo.com