WHAT IS AN OPTION CONTRACT?
The option contract is unique form of contract that allows a buyer (called an “optionee”) to purchase something in the future from a seller (called an “optionor”).2 The optionee pays now (usually a small amount) to lock in a price that will be paid on a future date for the property, should the optionee decide to proceed with the actual purchase. The optionee can decide not to proceed with the purchase and let the option lapse or expire, and if that happens the optionee only loses what was paid for the option.
Option contracts are used in many areas of commerce. A commodities investor, for example, might buy an option to today to purchase a large quantity of oranges in six months. If the price of oranges goes up over the next six months, the investor will then “exercise the option” and actually buy the oranges. The investor will then turn around and sell the oranges at a profit. But if the price of oranges goes down over the next six months, the investor will decide not to exercise the option, and let it lapse. If the investor does not exercise the option, the investor loses what was paid for the option, but avoids a larger loss had the investor actually had to buy all the oranges.
The orange grower, in the example, might sell the option because he needs money now to pay the workers in the field to harvest the oranges. However, by entering into the option contract, if the price of the oranges does go up, the grower will not get to make the bigger money by selling the oranges at the higher price. And if the price goes down, the grower gets to keep what was paid for the option, but now must find a new buyer for the oranges.
Another example to help explain option contracts is when a movie producer options a book or screenplay to make into a movie. The price that must be paid to the author for the movie rights to the book might be very high, and there are many factors that could prevent the movie from ever being made. Tens of millions of dollars (if not hundreds of millions) will likely be needed to make the movie. The studios that will put up the money might only do so if some big-name stars agree to be in the movie. So the movie producer will sign an option contract to buy the movie rights to a book on a date in the future, and then try to sign up the stars so that the studios will put up the money before the option expires. If everything falls into place, the producer exercises the option and buys the movie rights and makes the picture. If things don’t work out, the option contract lapses, and the writer can sell the movie rights to someone else.
In real estate, fee simple holders can option their property for both purchase and lease. Also, a lessee can option their lease for assignment.
THE PARTS AND PIECES OF AN OPTION CONTRACT
Option contracts are subject to the same rules as other contracts but have some special terminology.
Option Fee or Option Price: All contracts require consideration (something given in exchange for something else).3 For an option contract this will be the “option fee” sometimes called the “option price.” It is different from what will be paid for the actual purchase of the property. For example, a property owner might be paid $10,000 as the option fee to sell his property for $200,000 in six months. The $10,000 pays for the option contract that locks in the price of the property and ties it up for six months. The $200,000 pays for the property.4
Option Period or Term: This is now long the optionee has before they have to pay for the property.5
Lapse of Option: This is when the option contract expires.
Exercise of the Option: “Exercising the option” is what it is called when the optionee decides to proceed with buying the property. By the end of the option period the optionee must give notice of the exercise of the option and pay the contract price.
A good option contract will have clear terms on when and how the option is to be exercised. Normally it should require a notice in writing that the option is being exercised, and a date by when the option must be exercised if it is going to be exercised.
Property Description and Purchase/Lease Terms: The option contract must also clearly state the terms of the ultimate deal. The price to be paid for the land must be stated and the land adequately described. If the ultimate transaction is a lease, all of the material terms of the lease should be set forth. Otherwise, the option contract might not be an enforceable contract, but instead an unenforceable agreement to agree.
Closing: If the optionee exercises the option then there is a “closing” where the parties sign the actual deed, lease, or assignment of lease, and the optionor is paid the contract price for the property. The deed or lease or assignment is recorded, and the transaction is complete.
Put and Call Options: These terms relate more to stocks and commodities rather that land, but you might hear them. A “Call Option” means an option to buy. A “Put Option” means an option to sell.
If the optionee decides not to exercise the option, the option “lapses” and there will be no closing. The optionor keeps the option fee and is free to sell or lease their property to someone else, or option it again.6
TYPES OF OPTION CONTRACTS
Option contracts are very common in real estate, often for the same reason as the investor in oranges in the example above: speculation. The buyer of the option may be speculating or gambling that they can find a buyer for the land at a higher price than what was agreed to in the option contract. If they do find a buyer at a higher price, they exercise the option and then almost immediately turn around and sell the land at a profit to the buyer they found (they “flip” the property).
Option contracts can also be sold unless the terms of the option contract prohibit their sale. The trading in option contracts is common with stocks. With real property in the CNMI it is not so common.
The property owner in the CNMI who decides to sell an option to a speculator is generally making a bad decision. This is because there is another way an owner can sell their property that will produce a higher return for them: listing the property with a real estate broker.
A real estate broker earns their money by selling the property of others at the highest possible price. Brokers are generally paid a commission, based on a percentage of the sales price of the property. Therefore, the more the broker sells the property for, the more the owner makes, and the more the broker makes.
A typical broker in the CNMI charges between 6% and 10% with 10% having become very common in the CNMI.7 If an owner will accept $500,000 for their property but the broker finds a buyer for $1,000,000 the owner makes $900,000 and the broker makes $100,000. If the owner options his property for $10,000 now for what he is willing to accept ($500,000) and the optionee finds a buyer at $1,000,000, then the owner will realize $510,000 from the transaction and the will optionee will realize $490,000.
Money is always short, and it is hard to turn down someone offering to pay money for an option now and promising a big return later. But if the owner can afford to wait and go with a real estate broker to sell their property, they will likely be better rewarded in the end.
Similar to the speculation option is the use of option contracts to acquire a number of lots in different locations to try to be in the right place when some future event happens like a new development going up. For example, Phase Two of the Imperial Pacific Casino is to be in Marpi, but for a time where in Marpi was unknown. If you only had a limited amount of money and you wanted to be close to Phase Two, you could have optioned several different lots in Marpie. Then once the actual location of Phase Two was announced, exercise the option just for the lot closest to where the casino ended up.
The option contract gives the holder control over property for a very small cash outlay. It in effect achieves a high degree of leverage, conserving the investor’s cash.
Options to Consolidate Lots
A legitimate and common use of options in real estate is to consolidate multiple lots. Imagine that there is a developer who needs 10,000 square meters for his project. He finds the perfect land, but it is divided into several lots, each owned by different people, and each alone too small for the project. The developer cannot use the land unless he can lease all the lots and combine them together. So what the developer does is start buying options.
Each option is conditioned on all the other owners agreeing to lease their land. If all the owners eventually agree, the developer exercises the options and has leases to the 10,000 square meters needed. If not all the owners agree, the developer does not exercise the option and is only out the option fees paid to the owners who agreed to lease.
Options to Allow Time to Meet Conditions
Another use of options in real estate is to allow the buyer time to obtain financing to pay for the property or to satisfy conditions such as changes to zoning or obtaining government approvals. Technically, an option contract is not necessary to obtain time to meet conditions and in fact options are not often used for this purpose. A purchase agreement or agreement to lease will accomplish the same purpose as an option contract if what is needed is time to obtain financing or satisfy conditions.
Full Credit and No Credit Option Contracts
Some option contracts provide that the consideration for the option applies to the purchase or lease price of the property if the option is exercised. This is a “Full Credit Option.” The opposite is where what is paid for the option is not credited to the property purchase or lease price. That is the “No Credit Option.” Both are legal. Whether the parties agree to full credit or no credit depends on their bargaining strength, and the knowledge they each have about real property transactions.
Option contracts are a common and useful tool used in real estate. If you are a developer, option contracts can help you consolidate lots, or protect your cash when you are not sure which property you will ultimately want to develop. If you are a property owner, avoid selling an option to a pure speculator.8 A brokerage agreement with a reputable real estate broker will likely be better for you in the end. Always go see an attorney to make sure you understand the contract you are being asked to sign.
2 The Restatement (Second) of Contracts at §25 defines an option contract as “a promise which meets the requirements for the formation of a contract and limits the promisor’s power to revoke an offer”.
3 Consideration is required for all contracts. See, Restatement (Second) of Contracts, §87(1) regarding option contracts.
4 The option contract might apply the option fee to the purchase price if the option is exercised. This is common on Saipan and is referred to as a “Full Credit Option Contract.”
5 The Rule Against Perpetuities can apply to option contracts but in the CNMI where we deal mostly with 55-year leases, it is usually not an issue. To put the Rule very simply, the property interest must become effective (“vest”) within 21 years of a life in being (a designated living person). The Rule Against Perpetuities is beyond the scope of this article and is something to talk to your attorney about.
6 Under the Restatement, and option contract is binding if it is in writing and signed by the offeror, recites a purported consideration for the making of the offer, and proposes an exchange on fair terms within a reasonable time; or is made irrevocable by a statute. Restatement (Second) Contracts at §87.
7 Sometimes much higher than 10% is charged. Also, historically, Japanese rarely paid even 6% to brokers. The commission is a product of negotiation.
8 This is business advice as opposed to legal advice, and if you believe the market is in decline, with property values heading down, making a little money selling an option to a speculator might be the smart thing to do.