Not all real estate purchase contracts involve an immediate sale. Something called an "option contract"—essentially, a contract not to revoke an offer once it’s made—can also be used to bring about the sale of real estate, though on a much different schedule than usual.
The idea is that the home- or landowner extends and keeps open an offer to sell, in return for a payment by the buyer (the "optionee"). The offer remains “open” for a certain amount of time, at a certain price, and to a specific potential buyer. The buyer is in many cases a tenant, who is currently renting the property (in which case it's called a "lease-option contract") or might be a developer, interested in a plot of land but needing to do more research and perhaps obtain permits before committing to the purchase.
(Option contracts are most commonly used for real estate, but can be used for other things, as well.)
If the option is exercised according to its terms and conditions, a binding contract is created. The seller must sell, and the buyer must buy, for the price or consideration and on the terms stated in the contract.
Who Gets What Under an Option Contract
Option contracts can be beneficial to both the buyer and the seller of property, but are often particularly helpful for the buyer.
Let's start with what the seller gains through this arrangement: namely an immediate payment of money (commonly between 3% and 10% of the property's market value) and the prospect of a future sale. Why wouldn't the seller just put the property on the open market? Not every piece of real estate is an easy sale, and marketing a property takes work no matter what. Keeping one potential buyer interested can overcome a variety of marketability issues. If the sale goes nowhere, the seller at least gets to keep the option money (in most cases).
The benefits that the buyer of the option gains are many: time in which to secure financing or save up a down payment, investigate zoning laws, and inspect the land, and all without the threat that the seller might sell to someone else first. The option can also be used as an investment: Someone buys the option, waits for the land’s value to increase, then exercises the option, buys the property, and makes a profit on its sale.
In an option contract, only the seller is bound. That is, the buyer is not required to buy. And the seller is required to sell under only the specific terms of the option contract. In other words, a buyer and a seller of property could enter into an option contract but, for whatever reason, the buyer could ultimately decide not to exercise the option to buy.
No Conditions Permitted in an Option Contract
A contract that is contingent or conditional on the occurrence of a certain event is not an option contract. So, for example, if a contract states that the seller will sell and the buyer will buy if and when the buyer secures financing, both parties are bound upon the occurrence of the stated occurrence.
Indeed, it is common in many real estate and other types of contracts to include one or more conditions or contingencies that must take place before the deal closes. However, this language would not be found in an option contract. In an option contract, the buyer is not bound to buy until he or she decides to exercise the option.
Legal Requirements and Essential Aspects of Option Contracts
Like any contract that pertains to land, an option agreement must comply with the “statute of frauds,” and so it must:
- be in writing, as should any cancellation or change (“modification”) of the option, and
- be signed, at a minimum by the seller, but ideally by both parties.
In addition, like with any other contract, the option must be supported by what's called "consideration" in order to be enforceable in court. This is a legal term meaning that there has been value given—most likely, money—in exchange for the seller's promises within the contract. The option should state the exact consideration the buyer pays.
Without consideration, the seller could withdraw the offer without becoming legally liable for a breach of contract. If the consideration stated has value, like $10, it will be sufficient. This is true even if the value is minimal or clearly inadequate relative to the subject of the contract.
The option should also state how long the offer will remain open. If the option is for a fixed period, like six months, the exercise of the option must take place within that time. If a time is not specified in the option contract, a court will require the seller to hold the offer open for a “reasonable time.” An option can’t be extended for an indefinite time or “forever.”
In addition, the option must state clearly the sales price—that being the price for the land once the option is exercised, or the means of determining the price, such as by stating a maximum price to paid.
If a court can’t determine the price from the contract, either directly or by other means, or if the price is left to future agreement by the parties (“We’ll decide the price if and when you decide to exercise the option!”), the contract will be missing an essential element and won't be enforceable.
Any conditions to the exercise of the option should be clearly stated within the contract. Conditions often take the form of limitations, for example, providing that the option can be exercised only by written notice, or in a specified form, or only by certain persons.
Example of How an Option Contract Might Be Used
Imagine that Bob is interested in purchasing Mary’s home in Brooklyn for $600,000 cash. However, he is awaiting a job offer that might force him to move to Washington, DC. Bob obviously wouldn’t want to buy the house now, if within a month, he might learn that he needs to sell it and move. Mary realizes that she has a potentially good buyer, but that Bob will have to refuse the purchase until he knows for sure about his job.
Mary and Bob decide to enter into an option contract. Mary agrees that, for 30 days, Bob has the exclusive right to buy the home for $600,000 cash. Bob pays Mary $250 for this exclusive right. The two set the terms of this agreement in writing, and sign it. They have created an option contract, in which both have benefited: Mary has a potentially good buyer “on the hook,” and Bob has bought himself some time to figure out his career situation. The option contract is supported by $250 of consideration.
Remedies for Breach of Option Contract
Although an option contract is in some ways open-ended, a seller might “breach” or violate it in a number of ways. Clearly, there’s a breach if the seller refuses to sell after the optionee properly exercises the option, or if the seller cancels the option early without the optionee’s consent.
Using the example above, imagine if another buyer came along and offered Mary $650,000 a few days after she made the option agreement with Bob. If Mary were to take the extra money, this would be a breach of her contract with Bob.
What if the seller sells the land to someone else during the option period? So long as the seller sells the land subject to the continued existence of the option, there’s no breach. If the actual buyer had notice of the option at the time of the sale, the optionee can enforce the option against the new buyer. So, for example, if the sales contract with the buyer stated that there was an option, the buyer is bound by it.
However, if the buyer doesn’t have notice of an option at the time of the sale, the optionee’s rights are terminated, and the seller is in breach of the option contract. If a seller violates or “breaches” the option, the buyer’s remedies can include:
- Specific performance, in which a court order forces the seller to sell the land to an optionee who has exercised the option.
- Money damages, including any money that the optionee spent in connection with deal, such as having a survey made, or the difference between the price the optionee paid for other land and the price of the land stated in the option.