An option to purchase property or land is a strategy used by many sophisticated investors and property developers.
It’s a way to get your foot in the door without coughing up a lot in upfront costs and reaping a significant return on investment.
Well, that’s how it’s meant to work, but what are the risks to be aware of?
What is an option to purchase?
An option to purchase is a legally binding agreement between a vendor (seller) that owns land or property and a buyer.
There are two parts to an option to purchase: the ‘call’ option and the ‘put’ option.
- Call option: This refers to your right, but not the obligation, to purchase the property within a predetermined time period (known as the currency of the option) at an agreed price (known as the exercise price).
- Put option: This is where the vendor (seller) exercises their right to offer the property to you at a specified price in the future.
The person granting the option is known as the ‘optioner’ or grantor and the person receiving the benefit is known as the ‘optionee’ or beneficiary.
Put and call options are often combined into one transaction known as a ‘put and call’ option agreement.
During the term of the option, the vendor cannot sell the property to a third party and must sell it at the pre-agreed price and terms set out in a contract of sale.
Only if you refuse to buy the land or property (exercise your right) does the vendor have the discretionary powers to sell the property to another party.
How long does an option last?
An option typically lasts 24 months but the timeframe to exercise is completely negotiable at the agreement stage.
Why would a vendor enter into an option to purchase?
There are several reasons why a vendor wouldn’t simply put their property on the market like normal.
If it’s an older property that needs some work, the vendor may not have the time, capital or even inclination to get it prepared for sale.
They’re betting on a developer or professional investor to make reparations to the property and increase the sale price.
This is common with heritage-listed properties that require a lot of love and care or a small building on a large block that can be developed into a block of units.
If it’s a large parcel of land, many developers and sophisticated investors would be interested in claiming an exclusive right to purchase and push the local council to rezone the property.
It may be a former industrially-zone property that has the potential for residential development.
Similarly, a residentially-zoned block of farmland may have the potential to be rezoned for commercial use, particularly near newly-built suburbs.
If the developer is successful in their Development Approval (DA) application, the sale price may increase immediately even before a single brick is laid.
It’s certainly a gamble.
The vendor is agreeing to a fixed price based on the intended improvements made by the investor, or zoning changes, to increase the sale price.
The risk is that the vendor could miss out on any extra profits that come from a much higher sale price than originally agreed to.
Another risk is that the put option may expire or the buyer may refuse to purchase the property when a call option is exercised.
It may be that the buyer can’t get DA approval or they run out of capital to continue renovation work or reparations to the land.
The saving grace is that if the sale doesn’t go ahead, the vendor can keep the option fee paid when the agreement was entered into.
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How much does an option to purchase cost?
The legal costs of entering into an option to purchase property can vary significantly.
Firstly, it’s best for both parties to seek assistance from a qualified solicitor.
This may cost anywhere between $1,500 to $2,000.
They can help you draft up the option agreement and the contract of sale that goes with it.
To save on legal costs, you can contact your state’s relevant land and property department for a template on what to include in the option agreement.
Check out the New South Wales information page for an example.
However, one cost you can’t avoid is the option fee.
This fee can vary anywhere between 3-10% of the property’s market value, although it is negotiable with the vendor.
Do I pay stamp duty on an option to purchase?
Stamp duty is not payable when an option to purchase is granted by the vendor.
It’s payable on the price of land when you exercise the ‘call option’ to purchase.
Be careful!
Stamp duty is applied when you buy an option already owned by someone else.
Luckily, the duty is calculated based on the price of the option not the land.
The transfer of property and land optiona is quite common in high-end investing and property development.
What are the benefits?
Manage your tax liabilities
Essentially, an option to purchase is a form of “land banking”.
The difference is that the upfront costs are much cheaper than buying vacant land or commercial land outright.
Once you’re granted an option to purchase, you don’t need to pay stamp duty, maintenance fees, land tax or council rates!
You get time to prepare your finances
By paying a nominal option fee to secure your right to purchase the property, you give yourself time to save up a deposit and apply for a loan.
You can also inspect the land, investigate local zoning laws and speak with council.
You don’t have to buy the property!
If, for example, the zoning on a parcel of land you purchased changes from commercial to residential, you can choose to trade your option, at a profit, to another investor or developer.
If you don’t exercise your right or you don’t sell the option, it simply expires and the vendor will have to find another buyer.
What are the risks?
- The main problem is that you risk losing your option fee if you decide not to proceed with the sale.
- An option to purchase is not a conveyance or deed of purchase so it may not have the same legal power as a contract of sale depending on the state in which your live in.
- Property option contracts are more complex than a standard real estate contract and require greater time to prepare. Additional time is also required to negotiate the terms of the agreement with the vendor.
- You’ll likely have to deal with an uncooperative council when it comes to getting a DA, delaying your development plans and constraining your final return on investment.
Option to purchase tips
It pays to have experience
Contrary to the ‘get rich quick’ spruik heard at many investment seminars, getting land rezoned is neither a simple nor cheap process.
The work of subdividing and improving property alone can cost significant upfront capital.
Those “green” to developing and high-end investing may struggle if they don’t have good contacts in place with the local council.
Do your due diligence
You’re really trying to benefit from a distressed seller: they don’t see the value in marketing the property for sale but you can see the potential by taking advantage of zoning changes.
Again, option to purchase agreements are only really for sophisticated investors and developers who have done their homework.
This means:
- Looking at the local economy and demographics.
- Being across planned infrastructure projects and zoning changes.
- Finding out what other developments are currently being undertaken that will support your planned development.
- Speaking to a solicitor about the legalities of an option to purchase property agreement in your state.
How do I enter into an option to purchase?
- Speak with the vendor and negotiate the fixed price and option to purchase timeframe.
- This agreed price will come at a premium to what the land is currently worth.
- With the help of a qualified solicitor, draft up a pre-agreed Contract of Sale that specifies these terms in writing.
- An option fee will be payable, although this is typically added to the purchase price for the land or property and not paid upfront.
- Typically, you’ll have 24 months to exercise your option.
Do you need help with getting a development loan or buying vacant commercial land?
Please call us on 1300 889 743 or fill in this free enquiry form to speak with one of our mortgage brokers about your development and construction plans.