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How to Use Real Estate Options for Maximum Gains

Aug 24, 2007
Using options is undoubtedly one of the most powerful ways available to investors today to gain control of real estate. Options give investors the legal right to purchase an asset at a predetermined price within a specified period of time. One of the primary reasons for using options stems from the high degree of leverage that can be obtained when purchasing stocks.

Option agreements are used by investors to gain control of an asset without having to take legal title to it, which in turn enables them to avoid expensive transaction costs. Furthermore, options can be exercised quickly, thereby allowing investors to be more efficient with their resources.

Options are a superb tool available to real estate investors that can be used to purchase property with very little cash of their own. In addition, the use of options as an investment tool enables investors to maximize the full power of leverage by gaining control of property with very little money.

Another benefit of using options is that they provide investors with the ability to limit their risk exposure in a particular property to only the premium paid for the option.

If the investor decides not to exercise the right to purchase, the option expires worthless and all that is lost is the premium paid for the option. Using options enables me to acquire the rights to land without having to take legal title to it until the construction of a new home begins.

So, for example, after purchase agreement or sales contract with a client to build a new home on one of the optioned lots, we then exercise our option at the predetermined strike price and purchase the lot.

The primary benefit of using options in a transaction such as this is that the required option premium as a percentage of the value of the deal is typically less than that required for a purchase using conventional financing.

In other words, an investor can often achieve a much higher degree of leverage by using options than by using more conventional financing mechanisms such as bank loans.

On one transaction in particular, I acquired the remaining 28 lots that were appropriate for construction in a residential community through the use of an option agreement. The lots were valued at a little over $1 million, and the option premium in this example was approximately 5 percent, or $50,000.

In most cases, I prefer to keep the option premium in the 1 to 2 percent range, but in this particular example, the seller demanded more. In fact, he started out asking for a much higher premium of a little more than $100,000, which I was not at all willing to pay.

After negotiating back and forth for several weeks, we finally agreed on 5 percent. Let's now examine the differences between using an option agreement and conventional financing such as that offered by a bank.

Option Agreement:
Purchase Price = $1,000,000
Option Fee = 5%
Total Cash Outlay = $1,000,000 x 5% = $50,000

Conventional Bank Loan:
Purchase Price = $1,000,000
Down Payment = 20%
Total Cash Outlay = $1,000,000 x 20% = $200,000

In this example, you can clearly see the power of added leverage achieved by using an option instead of a conventional bank loan. In this case, I could actually have purchased $4,000,000 worth of property using the $200,000 required for conventional financing as follows.

($200,000/$50,000) x $1,000,000 = $4,000,000
OR ($200,000/0.05) = $4,000,000

The advantages of using an option to gain control of the land in this example are twofold. The first advantage is that if our company has difficulty selling new homes to prospective buyers in this particular community, we are not stuck with the ongoing burden and cost of owning the lots. The only thing we have at risk is our option money. While $50,000 is a considerable sum to have exposed to risk, it is much better than having a $200,000 level of exposure.

The second advantage is that if we were actually to purchase the lots, the sale would trigger an increase in taxes due to a new and much higher assessed property value since the value of finished lots is much higher than it was when the developer first started improving the land.

In summary, the use of options can be an incredibly effective tool available to real estate investors who are interested in gaining control of investment property without having to take title to it. Options afford investors the ability to gain control of property with very little money down, thereby allowing them to maximize the fundamental tool of leverage.

This will help minimize the risk of loss of your capital, thereby enabling you to become more successful in your real estate endeavors.
About the Author
Adrien Brody ( http://propertysmarty.com ) is a full-time real estate investor. He has been researching investment strategies and make his own living. You can learn more about lease purchase strategies at http://leasepurchaseinvestment.com .
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