Option Contracts: Your Get Out of Jail Free Card Or A Golden Ticket?

Feb 15, 2018

A commercial real estate contract also termed a purchase and sell agreement, has several purposes. In addition to detailing the property being sold, it also lists the obligations each side has agreed to, as well as the specific steps that need to be taken in order to fulfill those responsibilities.

Purchase Contracts Do Much More Than Conclude The Sale

Although novice investors think of the purchase and sale agreement as the symbol for the conclusion of a successful purchase, in reality, the contract acts as a guide to both the buyer and seller for the period before the sale is concluded, known as the pre-closing period.

Due to its importance, buyers and sellers will often find themselves going to head on the minutest of details, and occasionally, even a good deal can fall apart if the mutual agreement can’t be reached on the terms of the contract.

At the same time, the period before the contract is signed is the time for buyers to do their due diligence about the property, so that any conditions relating to the physical condition, economic performance, or any other factors that have the potential to impact on the NOI of the property be spelled out before the sale takes place.

Buyers may decide to add clauses to the contract requiring the seller to perform a specific repair, or they may add terms that apply to the present tenant of the property. For example, a buyer who discovers an environmental spill on industrial land may require the seller pay for a cleanup before they are willing to purchase the property.

The seller may or may not have been aware of the environmental issues associated with the property, in which case they will either agree to the condition, offer to lower the cost of the property in lieu of paying for the cleanup or reject the condition completely.

Sorry, There’s No Such Thing As A Standard Contract

Sorry, There’s No Such Thing As A Standard Contract

There are of course certain sections that must be included in a purchase and sale agreement, such as the title conditions, examination of title, confirmation of inspection and evaluation of the property, a listing of closing documents, warranties, and much more.

However, due to the fluidity of conditions required by each part, there actually is no “standard” commercial purchase agreement since each side is likely to add many more provisions to the original document. Instead, the agreement is drawn up by the seller, with additions, clauses, and other edits made by the buyer’s lawyer.

Don’t Forget To Include These Essential Contingencies In Your Contract

Financial Contingency – Financial contingencies are an important part of every contract. They specify the terms of financing and the amount of time you have to apply (and receive) the loan. If for some reason the loan falls through and you are unable to find another lender, this contingency allows you to withdraw your offer without penalties and while recovering your earnest deposit.

Appraisal Contingency – Another important component of a commercial real estate contract is the appraisal contingency. Sellers offer a property at a particular price due to numerous factors, but if the lender appraises the property for less than the seller’s price, then the buyer won’t be able to receive a loan for the full amount of the loan.

While it’s possible the buyer could decide the appraisal is incorrect, or that the profit potential of the property makes the extra amount worth it, they would still need to come up with a significant amount of money from a different lender, which isn’t easy and may take more time than either party has.

Due Diligence Contingency – The due diligence contingency gives the buyer a set period of time to inspect the property. This period is essential for the buyer, as it allows them to investigate every aspect of the property in order to ensure there aren’t any hidden pitfalls that may affect the profitability of the property

Insurance Contingency – All commercial properties must have insurance. Usually obtaining insurance isn’t a problem, however in some instances, particularly where there is suspected or confirmed environmental contamination, some insurers may refuse to insure a property. Certain areas of the country, as well as particular property types, are also more difficult to insure.

An insurance contingency gives buyers the chance to waive the deal in the event that an insurer refuses to cover the property.

Right To Assign Contingency – The right to assign contingency is especially important for wholesalers, who need written approval to assign the contract to another investor. Most lawyers recommend you also include an Assignment of Contract as well, which clearly states that you will be assigning the rights of the property to another buyer, and grants you permission to do so.

This protects the wholesaler in the event that the buyer backs out of the deal, ensuring he does not become obligated to purchase the property.

Are Option Agreements Purchase And Sale Contracts?

If you’ve heard of option agreements, you may be wondering how they differ from a straight purchase and sale contract.

Option agreements, particularly those called “straight options” are a form of creative real estate financing that gives you the option of purchasing the property before it is offered to another property. In the residential real estate, it’s called a “rent to own” contract, where the owner of the property acts as a bank to the tenants, who pay the owner a monthly payment instead of a bank.

This type of contract is fraught with problems for residential real estate investors, but for commercial investors, option agreements are fairly straight agreements.

In the commercial real estate, an option agreement simply states that before a seller can sell the property, the owner of the option agreement must be given the chance to purchase the property before it’s offered to anyone else. The option agreement does not obligate the buyer to purchase the property, however.

Option agreements are for a limited period of time; investors pay a non-refundable sum in order to lock in the purchase price and the right to buy the property at a later time.

When Is An Option Contract Used?

When Option Agreements Are Used

Option agreements are limited to a specific time period, which allows the buyer to do further due diligence on the property.

This is essential for investors who want to ensure any necessary zoning law changes or other approvals will be cleared before building or renovations begin on the property. Option agreements also make sense for developers or investors commissioning expensive tests or inspections; no one wants to pay for expensive tests only to find out the property was sold to another investor.

Advantages Of An Option Contract For Investors

Advantages Of An Option Contract For Investors

Smart investors use options to acquire properties with profit potential at a low risk.

For example, if an investor locates a particular property in a neighborhood set for growth, they may choose to approach the buyer and lock down the price. They can then approach developers or other investors with a concrete plan that shows the potential of the property. They can then sell the exclusive rights to the property at a much higher price, without having to invest any of their own money in the deal.

Other investors, rather than selling the property, hold on to an option with the expectation of future appreciation – essentially ensuring equity before the property is even purchased.

Investors might also choose to approach sellers having trouble selling a commercial property; the investor is confident they can market the property at a good to a private list of buyers. The investor is essentially selling the option for a set fee.

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