Financing Focus

Consider the Options

Savvy investors can conserve capital and create leverage through options.

W hen fully understood, properly prepared, and used correctly, real estate options are an excellent way for knowledgeable investors to conserve capital, create leverage, and reduce risks. Investors and clients who may be short on capital may find options a good strategy for controlling properties with resale profit potential. Investors can shield their options profits from federal income tax by purchasing real estate options through self-directed individual retirement accounts. Investors are advised to use the services of qualified professionals when buying options through IRAs.

Profitable Opportunities

The key to being a successful options investor is knowing which properties to option to create equity without investing exorbitant amounts of time and money. Only about two out of every 10 properties are potential options properties. The most profitable properties for real estate options usually have one of these conditions:

• rezoning potential;
• condemned for code violations;
• underutilized;
• cosmetically rundown;
• obsolescent flaws, such as an outdated facade; and
• correctable problems, such as flawed titles or mold that make them non-marketable.

Vacant land located in the path of future growth can present opportunities to profit from options. Savvy investors can use public information on projected government infrastructure expansion projects, such as road construction, to plot the path of growth and buy options on vacant land located in the vicinity.

Options Strategies

The most profitable options deals usually are created by imaginative investors. Using local market knowledge, they identify unfulfilled market needs, find properties that best fill those needs, and put those properties under option.

One strategy is to sell the option to a buyer who has a use for the property. Selling an options agreement to a third party requires the assignment of the real estate option agreement and provides an assignment fee. This strategy eliminates property transaction costs and avoids any legal recourse that may result from not purchasing the property.

Buying options on properties located in emerging commercial areas that can be rezoned for more profitable uses is another strategy. An investor can buy an option on a vacant single-family house and then apply to the local zoning authority to have it rezoned for use as a professional office. Once the rezoning request is approved, an investor can either resell their option, or exercise it and buy the property. This strategy can be very profitable as converting property is much less expensive than acquiring land and putting up a new building.

An often-overlooked strategy is buying options on properties that have been destroyed by natural or manmade disasters. Astute investors can search out property owners who have been reimbursed by their insurers for their losses but have no desire to rebuild. The investor buys a one- to two-year option to purchase the property at a bargain price and clears away the rubble. The investor waits until the recovery is well underway and then resells or exercises the option. This strategy has a lot of profit potential because of the lack of competition from other investors.

Creating Agreements

Investors should protect their positions during the option periods by using well-written real estate option agreements that clearly define the terms, conditions, and provisions of the agreement, along with the rights and responsibilities of both parties. Have a board-certified real estate attorney draw up your option agreements. Option agreements must include the following provisions:

Option Fee. Include the full amount paid as the option fee and state that it is to be credited toward the purchase price when the option is exercised. The amount of the option fee is negotiable and depends upon the length of the option period and the value of the property. As a general rule, never pay more than 5 percent of a property's value as an option fee.

Option Period . State the exact length of the real estate option period by calendar dates. Try to negotiate six-month to 12-month option periods.

Purchase Price. Specify the fixed purchase price of the property under option, including how the purchase is to be financed. Financial tests are not usually necessary.

Exercise of Option. Outline exactly how the optionee is to exercise the option to purchase, including the method for notifying the optioner. Send the optioner an exercise of option notification letter by certified mail, with a return receipt requested.

Option Period Extension. State the optionee's right to extend the option period, including the length and cost of each extension period. Aim to negotiate three-month to six-month extensions at no more than $500 a month.

Option Agreement Assignment. Include a clause that gives the optionee the right to assign the option agreement to a third party. Failure to include an assignment clause could preclude an investor from reselling the option agreement.

Eminent Domain. Specify that the optionee will receive full refund of the option fee plus interest if the property is condemned by eminent domain during the option period.

Right of Entry. Include the optionee's right, upon notifying the optioner, to enter, clean, repair, market, and show the property.

Risk of Loss. Specify that the optionee is entitled to a full refund of the option fee plus accrued interest if the property is damaged or destroyed by fire, storms, and earthquakes during the option period.

Further Encumbrances. Include that the optioner is prohibited against placing any additional encumbrances, such as mortgages or deed of trust loans, against the property during the option period.

Title Transfer Documents. State that a warranty or grant deed and purchase agreement with the notarized signature of the optioner is held in escrow by a reputable attorney or title or escrow company, during the option period.

Recording Option. If permitted by a state's recording statute, specify that the optioner must execute and acknowledge a memorandum of real estate option agreement suitable for recording in the county's official public records, where the title to the property under option is recorded. Recording a memorandum of option gives the public constructive notice that the property has an option to purchase on it.

Potential Risks

Although real estate options are comparatively low risk, they are not totally risk-free. Potential risks that investors cannot control include foreclosure on the property, the property being placed under the control of a federal bankruptcy court trustee, and having a property taken as part of a government asset forfeiture lawsuit. As part of the due diligence, investigate property owners to see if they are involved in any pending or ongoing litigation that could adversely affect the property's title.

Thomas J. Lucier

Thomas J. Lucier is president and chief executive officer of Home Equities Corp. in Tampa, Fla., and the author of How to Make Money With Real Estate Options, to be published in February 2005. Contact him at (813) 237-6762 or tjlucier@homeequitiescorp.com.

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