What is an options contract
Real Estate Options contract is a type of a legal agreement which states that a buyer can hold a right to buy the asset at a pre-decided price from the seller. Thus, in order for the contract to be executed, the buyer needs to pay a fee to the seller. This fee is called Premium Money.
Understanding options contract with an example
Consider a farmer who wants to sell a piece of his agricultural land to an investor. The current market price of the land is Rs. 50 lakhs. The investor is not sure of the demand for the land, yet he does not want to lose out on the opportunity to buy the property.
Thus, the farmer and the investor decide to enter into an options contract. It is decided that the investor will have the right to buy the land for Rs. 60 lakhs for the next 3 years. For this right, he pays the farmer Rs. 5 lakh as the premium money.
In this way the farmer gets to keep the premium money and use the land for the next 3 years. Also, the investor has the right to buy the land from him for a defined price, even if the demand exponentially rises. This contract makes it a win win situation for both the parties.
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How To Make Money In Real Estate Using Options Contract
Finding a right seller
It is important for an investor to find the right seller for executing the options contract. The ideal scenario should be such that the seller should be keen to sell the real estate asset after a certain duration. Thus, allowing the options contract to execute.
The investor needs to take full advantage of the contract period. When he has the right to buy the real estate asset for a determined price, he has reduced the risk of price inflation. During the contract period, the investor can conduct his market study, demand and the future prospects of the asset before executing his right.
Depending on the study, the investor can take a decision if the real estate needs to be purchased or not.
Deciding the premium and duration of options contract
This is the most critical step in setting the guidelines in the contract. The premium money is majorly dependent on 2 factors, the market value of the asset and the duration of the contract. The longer the duration, the higher will be the premium money.
Paying of premium money
Once the premium money, selling price and the duration is decided, the investor pays the premium money to the seller. This gives him the right to buy the property at the decided price. Having paid the premium money, it is decided that the land is owned by the investor. This provides an opportunity to further sell the asset for a price much higher then the price he will be currently willing to pay.
It is to be noted that the investor has not yet paid the full amount, yet he owns the right to re-sell the asset.
Finding the next buyer
Once the investor has the right to buy the land from its original sell. He can hunt for further sellers to re-buy from him. The investor needs to search for his next buyer within the contract duration to maintain the essence of the legal agreement.
Keeping the difference
When the investor finds the next buyer to sell the asset, he can re-sell the same for a much higher price. Thus, keeping the difference between the 2 buying prices.
For example, consider Ram has entered into an options contract with Shyam to buy the right to buy a real estate property for Rs. 1 Cr. for a contract duration of 5 years. For the execution of the contract Ram pays Rs. 5 lakhs as the premium money to Shyam.
Now for a price of just Rs. 5 lakhs, Ram has gained him the right to re-sell a property worth 1 Cr. Thus, before 5 years, Ram finds Lakshmi to buy the same property from him for Rs. 1.5 Cr. Thus, he can collect the money from Lakshmi, execute his options contract and buy the asset for Rs. 1 Cr. from Shyam.
This allows Ram to make a gain of Rs. 50 lakhs for an initial investment of Rs. 5 lakhs.
Advantages of options contract
Advantages from the buyers prospective
- It allows the buyer with some time to think about the prospects of purchasing the asset.
- The price of the real estate gets freezed with the contract. Thus, reducing the risk of market fluctuation.
- The buyer does not need to put forward the entire capital to buy and sell the real estate asset.
Advantages from the sellers perspective
- The seller of the real estate gets to keep the premium money before selling the asset.
- The seller has the right to lease the asset and make money even during the contract period.
- The real estate assets are freezed at a price slightly higher than the current market value. Thereby, promising a higher rate for the same asset.
Factors influencing the premium money
The price of the premium money is majorly influence by these 2 factors:
- Cost of the real estate asset
- Duration of the contract
Cost of the real estate
The premium money usually lies between 1-5% of the value of a real estate property. This premium also depends on the current market demand, its strategic importance and the future prospects of the asset.
Duration of the contract
Higher the duration, the higher will be the premium money. The premium is usually depends on the interest rate offered by the banks. More the rate of interest, more will be the premium money on duration.
It is to be noted that the premium money is not a fee based out a textbook formula. It is mutually agreed and decided buy both the parties. Thus, it can be negotiated.
Things to keep in mind
Duration of the contract
The buyer needs to understand that he has the right to buy the asset only during the valid contract period. Once the contract duration is expired, the buyer holds no right on the real estate asset and the price of the property gets revised.
It is the right but not the obligation
In this case, the buyer has the right but not the obligation. The contract does not force the buyer to purchase the property within the desired duration. The buyer may execute the rights or leave it. But the premium money will be non-refundable even if the buyer decided to not execute his rights.
Options contract is a great way for real estate investor to buy and sell assets.
If an investor has Rs. 1 Cr. as the capital, he can execute at least 50 such contracts and gain the powers to buy the assets at a predetermined price. Wherelse, in the absence of the contract, the investor may purchase just one real estate property with the same capital.
Also read: How To Calculate The Depreciation Of Real Estate Assets
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