Options: Minimizing Cash Outlays

By Brian Bader

A real estate purchase option gives its holder the right to buy a parcel of real estate at a specified price and on specified terms within a fixed period. Purchase options can be a valuable technique for investors and developers because they are the ultimate form of leverage, permitting the option holder to control property for a relatively small cash outlay. In most cases, the optionee makes a cash payment to the optionor when the option is negotiated. However, an optionee may be able to negotiate a "pay as you go" plan that spreads the cost over the life of the option. The optionee thus is in a position to apply an initial cash outlay to several options over different properties, so increasing the likelihood that one of the options may prove profitable. Several of these approaches are described below.

When negotiating an interest option, the parties first must agree on the present value of the optioned property. The optionee then agrees to pay to the optionor at designated times during the life of the option (say, every six months) "interest" at an agreed-rate or based on a designated standard such as the 10-year Treasury. If the option is not exercised, the optionor keeps the payments; if the option is exercised, normally the payments are applied to the agreed-upon purchase price.

A letter of credit is an agreement by a bank or other lender (the issuer), at the request of a customer (the account party), that the lender will honor a draft for payment by a third party (the beneficiary) in accordance with conditions set forth in the letter. Thus, the credit of the lender is substituted for that of the customer, eliminating the risk that payment will not be made when due (e.g., when the option is exercised or the option period ends.). If no exercise occurs, the optionor receives the agreed-upon option fee. If the option is exercised, the optionor received the agreed price. Until then, the only cost to the optionee is the interest charged by the bank for issuing the letter.

Developers frequently use options to tie up land that may not be ready for development for several years. An "effort option" from the landowner requires the developer to obtain preliminary development plans and all necessary approvals within the option period at the developer's expense. If the developer decides not to exercise the option at any time during the option period, all the plans and studies as well as any lease commitments from third parties become the property of the landowner. On the other hand, if the option is exercised, the developer will pay the agreed-upon price.

An alternative for a developer holding long-term land is to pay for an option on land ready for development with a portion of the longer term property, perhaps transferring a parcel each year that the option continues.

Yet another approach tying up vacant land at minimum cost is for the optionee to agree to pay all of the costs of the vacant land until a specified date (unless terminated earlier by the optionee). If the option is exercised, the optionee will pay the agreed-upon price. The landowner then knows all expenses will be covered during the option term, including property taxes that may rise over time, as well as special assessments for roads or utilities.

An option with another name is a contract with a liquidated damages clause. A developer signs a contract with the seller, making small down payment. The contract contains a liquidated damage clause limiting the seller's remedy to the down payment in the event the developer fails to close. Since the developer can walk away without liability during the contract period, he in effect holds an option.

Another approach is for the developer to buy property for a small cash payment with the balance of the price in the form of a purchase money mortgage. The mortgage has an exculpatory clause that limiting the seller's remedy to repossession of the land in the event of default. Here again, the buyer in effect holds an option. If the mortgage permits release of individual lots as they are sold off by the developer, the transaction is the equivalent of a rolling option.

Contracts with limited liability, as describe above, have an advantage over options resulting from the fact that the holder of an option has no legal or equitable interest in the property as does a contract vendee. For example, an optionee has no standing to seek a zoning change, but must act through the optionor, whereas a contract vendee can act directly.

Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman's New York office. He can be reached at (212) 885-8203.

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