A polished gentleman from a well-known stock brokerage visited my office the other day to coax a few investment dollars from my account. Curious, I entertained him for a moment. Rocking backwards in his chair, his tailored suit jacket gently fell open exposing royal blue suspenders. “Why do stock brokers wear suspenders?” I asked, “So you’re never caught with your pants down?” He laughed, “That’s right Mr. Parrish.” He proceeded to explain the issue of market risk versus reward as I quickly lost interest.
A two-headed beast, stock investors face the risk versus reward dilemma. Even “safe” investments are not really safe, considering the volatile nature of the stock market. In the most recent “correction” even investors in “low risk” stocks have lost their savings. Today, people are seeking new alternatives; and they’re trading their stock portfolio for real estate.
A major reason for the switch to real estate is that real property is, literally, real. Because buildings are tangible assets, their value is not as susceptible to market changes as the value of stocks. A property’s value is determined by its condition, its highest and best use, and the value of surrounding properties. On the other hand, the value of stock can be determined by real or perceived changes in legislation, elections, foreign policy, corporate decisions, competition, labor issues, and so on. The bottom line is that stocks are volatile, and real estate allows investors much more control over their investment.
Interestingly, some former stock investors are capitalizing on their knowledge of options to create profits in real estate. An option is a versatile investment tool which can also be used in real estate. The virtue of a real estate option is that it gives the holder of the option, the optionee, right to purchase a specific parcel of real estate at specified price and terms within a period of time, thereby giving the optionee control over the property. Such control is ideal for investors, given the high degree of leverage obtained in exchange for a relatively minuscule option payment.
Options Described in Terms of Purpose
An option can be used to control property for the short term. A short term option may be the ideal tool for an optionee who expects a property to increase in value, perhaps because of a new road or zoning change. A short term option is also ideal when a seller will not allow time in a contract for the buyer to obtain financing. Additionally, short term options are useful to investors who wish to resell a property without the formality, expense, or risk of purchasing the property.
An option can be used to control property for the long term. Shrewd investors may option to buy property during a depression when a low price can be easily negotiated. When market prices rise, the investor can sell the options for a profit.
Options can be used to assemble separate parcels of land into a single parcel. Commonly used by developers for that purpose, an option is the ideal tool given that it does not require a large capital outlay. Note: A savvy seller who suspects assemblage is the goal of the optionee can insist on a most favored purchaser clause. Knowing that the owners of the last parcels may hold out for top price, the most favored purchaser clause increases the purchase price to equal the highest price paid for any other parcel, or a percentage thereof.
Options Described in Terms of Purchase Price
Options can also be described in terms of price to be paid for the property. For an example, a fixed price option sets a constant purchase price during the option period. Under a step-up price option, the purchase price increases by specified amounts during the option period; the opposite is called a step-down price option.
Developers may use a step-up price option in combination with options on additional parcels of property to reflect the fact that as property is developed through the exercise of a series of options, the remaining real estate increases in value and optionors (owners) seek to share in the appreciation. Conversely, step-down price options may be used in combination with options of other parcels of property when the optionee is expected to acquire the most valuable parcels first, and optionors wish to induce the optionee to buy remaining parcels by agreeing to accept a lower price.
Options Described in Terms of Property Purchased
Options can also be described by the property which the option covers. A single property option gives the optionee the right to purchase a specified property, while a multiple-property option covers numerous parcels.
Often, a multiple-property option takes the form of a rolling option. For an example, a developer is interested in constructing a subdivision and does not wish to purchase or option the entire tract of land because he is not sure how the new homes will sell. Consequently, he enters into an agreement with the landowner to divide the property into parcels. The developer purchases an option to buy the first parcel of land at a set price. When the option is exercised, the developer has the right to “roll over” the option to the next parcel, for which the developer will pay an additional option payment, and, if the option is exercised, the developer agrees to pay a stepped-up price. As new homes sell, the option continues to roll-over to subsequent parcels.
The benefit to the developer is the ability to control the entire tract at a minimum cost. Although the developer will pay a higher total price using rollover options instead of purchasing the entire tract at once, the reduced risk justifies the extra cost. The landowner benefits by sharing in appreciation, although the disadvantage is that the parcels can not be sold to a third party until the option period expires without a rollover.
Options Described in Terms of Option Price
In order for investors to secure an option, it is customary to pay the optionor an option payment. The option price can be treated in several different ways.
Under a no credit option, the optionee receives no credit for the option payment against the purchase price if the option is exercised. Under a full credit option, the option price is fully credited against the purchase price to benefit the optionee. Under a declining credit option, the amount of the option payment credited against the purchase price declines with certain periods of time. Such is used by an optionor to motivate the optionee to exercise his option promptly.
Increasingly, as investors shift focus from the volatile stock market to real property, the use of options is generating real financial rewards. Although the real estate market is new for many, the essentials of game are the same. Those who educate themselves, those who know their options, will be prepared to profit.