Not all real estate purchase contracts involve an immediate sale or transfer of ownership. Something called an "option contract" can also be used to bring about the sale of real estate, though on a much more elongated schedule than usual.
The idea is that the home- or landowner extends and keeps open an offer to sell, in return for an up-front payment by the buyer (the "optionee"). The offer remains open for a certain amount of time (potentially years), at a certain price, and to a specific potential buyer.
The potential buyer is in many cases a tenant who is renting the property, in which case it's called a "lease-option contract". Or the potential buyer might be a developer, interested in a plot of land but needing to do more research and perhaps obtain permits before committing to the purchase.
If the option is exercised according to its terms and conditions, a binding purchase contract is created. The seller must sell, and the buyer must buy, for the price or consideration and on the terms stated in the contract.
We'll provide more detail here on:
- what's in it for each party to an option contract
- basic legal requirements for option contracts
- a sample scenario for using an option contract, and
- what recourse the tenant or optionee has if the seller reneges on the deal and won't sell to them.
Who Gets What Under a Real Estate Option Contract
Option contracts can be beneficial to both the property buyer and seller. (By the way, option contracts are most commonly used for real estate, but can be used for other things, as well.)
Let's start with what the seller gains through this arrangement: an immediate payment of money (commonly between 3% and 10% of the property's market value) and the prospect of a future sale.
Why wouldn't the seller just put the property on the open market, though? Not every piece of real estate is an easy sale, and readying the place for sale, then marketing it, takes work no matter what. Keeping one potential buyer interested can overcome a variety of preparation and marketability issues. If the sale goes nowhere, the seller at least gets to keep the option money (in most cases).
The benefits that the buyer of the option gains are many, starting with time in which to secure financing or save up a down payment, investigate zoning laws, and inspect the land, and all without the threat that the seller might sell to someone else first. The option can also be used as an investment: Someone buys the option, waits for the land’s value to increase, then exercises the option, buys the property, and makes a profit on its sale.
In an option contract, only the seller is bound to the actual sale. That is, the buyer is not required to eventually buy the place. And the seller is required to sell under only the specific terms of the option contract. In other words, a buyer and a seller of property could enter into an option contract but, for whatever reason, the deal could eventually fizzle.
Legal Requirements and Essential Aspects of Real Estate Option Contracts
Like any contract that pertains to land, an option agreement must comply with the “statute of frauds,” so it must:
- be in writing, along with any cancellation or change (“modification”) of the option, and
- be signed, at a minimum by the seller, but ideally by both parties.
In addition, like with any other contract, the option must be supported by what's called "consideration" in order to be enforceable in court. This is a legal term meaning that there has been value given—most likely, money—in exchange for the seller's promises within the contract. The option should state the exact consideration the buyer pays.
Without consideration, the seller could withdraw the offer without becoming legally liable for a breach of contract. If the consideration stated has value, like $10, it will be sufficient. This is true even if the value is minimal or clearly inadequate relative to the subject of the contract.
The option should also state how long the offer will remain open. If it's for a fixed period, like six months, the exercise of the option must take place within that time. If a time is not specified in the option contract, a court will require the seller to hold the offer open for a “reasonable time.” An option can’t be extended for an indefinite time or “forever.”
In addition, the option must state clearly the sales price for when the option is exercised. That could be either a dollar amount or the means of determining the price, such as by bringing in a qualified appraiser.
If a court can’t determine the price from the contract, either directly or by other means, or if the price is left to future agreement by the parties (“We’ll decide the price if and when you decide to exercise the option!”), the contract will be missing an essential element and won't be enforceable.
Any conditions to the exercise of the option should be clearly stated within the contract. Conditions often take the form of limitations, for example, providing that the option can be exercised only by written notice, or in a specified form, or only by certain persons.
Example of How an Option Contract Might Be Used to Buy a Home
Imagine that Bob is interested in purchasing Mary’s home in Brooklyn for $980,000 cash. However, he is awaiting a job offer that might force him to move to Washington, D.C. Bob obviously wouldn’t want to buy the house now, if within a month, he might learn that he needs to sell it and move. Mary realizes that she has a potentially good buyer, but that Bob will have to refuse the purchase until he knows for sure about his job.
Mary and Bob decide to enter into an option contract. Mary agrees that, for 30 days, Bob has the exclusive right to buy the home for $980,000 cash. Bob pays Mary $250 for this exclusive right. The two set the terms of this agreement in writing, and sign it. They have created an option contract, in which both have benefited: Mary has a potentially good buyer “on the hook,” and Bob has bought himself some time to figure out his career situation. The option contract is supported by $250 worth of consideration.
Option contracts can be beneficial to both the buyer and the seller of property.
Remedies If Property Seller Breaches an Option Contract
Although an option contract is in some ways open-ended, and the buyer can walk away at any time, a seller might “breach” or violate the contract in a number of ways. Clearly, there’s a breach if the seller refuses to sell after the optionee properly exercises the option, or if the home seller cancels the option early without the optionee’s consent.
Using the example above, imagine if another buyer came along and offered Mary $1 million a few days after she made the option agreement with Bob. If Mary were to take the extra money, this would be a breach of her contract with Bob.
What if the seller sells the land to someone else during the option period? So long as the seller sells the land subject to the continued existence of the option (meaning that the new owner would have to abide by its terms), there’s no breach. So long as the buyer had notice of the option at the time of the sale, the optionee can enforce the option against the new buyer.
However, if the buyer doesn’t have notice of an option at the time of the sale, the optionee’s rights are terminated, and the seller is in breach of the option contract. If a seller violates or “breaches” the option, the buyer’s remedies can include:
- Specific performance, in which the buyer sues, and if successful, receives a court order forcing the seller to sell the land to an optionee who has exercised the option.
- Money damages, including any money that the optionee spent in connection with deal, such as having a survey made, or the difference between the price the optionee paid for other land and the price of the land stated in the option.
This is a complex area of real estate law, requiring careful thought and contract language to avoid misunderstandings down the line. Your best bet is to hire an attorney to help structure such an agreement.