How much should you give a seller for "Option Consideration"?
Some legal sources state that it takes only $1.
Some guru's say you don't need any money and some say they give the seller $100.
What do you give the seller for an option consideration for your lease option and subject to deals?
Option consideration on a lease to own depends on the deal and depends on the state. In my opinion I think $100 option consideration for any lease with option should be sufficient.
Check with the contract attorney well-versed in real estate matters
The value of any option to buy real estate is the discounted present value of the anticipated increase in market value over the term of the option.
I'd like to see an attorney saying a dollar is sufficient! Obviously they never went to court and faced a better informed opponent.
Contracts must have consideration to be a valid contract, basic contract law, consideration can be almost anything, including a promise to perform (which you don't have in an option) but that consideration must be measurable financially, in dollars, which may also become the basis for any loss in the event a contract is not fulfilled.
So, we see; "One Dollar and other good and valuable consideration paid in hand...." which is simply stating the contractual requirement to form a contract.
The next and more important question is: Is the consideration equitable for the transaction contemplated. Consideration must also be reasonable, you can't say one dollar is reasonable for a transaction that puts at risk or sets aside or binds another in a million dollar transaction, that's silly, just as silly is a $10,000 transaction.
What an option does is it gives the optionee (buyer) the right to purchase an asset at an agreed price over a certain time frame, the reason options are made is not as to the guru crap we read about real estate, but you buy the right to purchase that asset for the sole purpose of obtaining the asset at a price set today rather than taking the market risks of prices increasing.
A simplified example, the strike price agreed is $1,000, the expectation of a price increase or market value is 10% annually or the price is expected to be $1,100.00. The price to be paid is negotiable a seller may want half the expected price to give the buyer the right to purchase at any time over the year, the option price might be $50.00 and that is reasonable, it might be reasonable to agree to an option price of $10.00 if the seller only needs to give notice of another offer, which might be done with a limited option.
In real estate, the future expected increases in value are determined, that amount is brought back to a present value using a cap rate applicable to the buyer as the basis for the offer to the seller.
On the seller's side, operators or investors more commonly state an option price, usually they seek all they can get, but that's not always a great idea, as reasonableness comes into play as to that formula mentioned. In residential real estate, 10% of the purchase price is the common price of a long term option, say 3 years.
10% is rather arbitrary but has been used for decades and is acceptable as it has more to do with contracts establishing an equity required to finance a property more than a discounted market approach.
So, if you're buying the option, your goal is to get it as cheaply as you can, if you're selling, you want the greatest price you can receive.
Other regulations apply as well, 10% pops up a lot, disguised sale transactions under the tax code, state laws as to requiring a foreclosure instead of a simple eviction might become relevant, equitable interests in the property may become an issue, does a optionee or buyer have an insurable interest in the property to insure it? So, bumping up to 10% can have other issues.
This 10% target has also been used more in financed options, where a buyer is making payments to the option price. This has been a customary arrangement so that a buyer reaches the 10% down payment requirement for financing purposes by the time of settlement, but these arrangements have been hammered by the Dodd-Frank Act as these are financing arrangements in the same light as making a loan, so a financed option price may be subject to loan qualifications under the Act.
The reason contracts are made in any matter, buying a car, airplane, boat is to set the intentions of the parties to writing in order to guide them to a settlement transaction, most contracts become invalid after settlement, some things just can't be done on a handshake and promise, real estate transactions are one of those areas (Statute of Frauds) requiring written contracts.
If you have a motivated seller and buyer, the contract may not be that important after it has been made. The parties may make changes and agree to do other things to get to settlement, there may not be any issues at all between the parties. But, what if there are issues?
There is no reason to make a contract that can not be enforced by law, or one that is unlikely to be enforced. If you want to protect your rights under a contract it must meet the legal AND equitable requirements for you to enforce your rights.
While contracts must have a legal purpose (I can't contract you to go commit a crime) contracts are also viewed in the degree of fairness, equity and reasonableness, there are limits. So, in setting an option price, you might ask what a reasonable person do, one having enough knowledge concerning the intended purpose.
Here is the rub, setting a price too low will not be seen as equitable or fair or reasonable for a seller to be required to perform, it's rare to force a seller to sell, but we say that you can make a seller wish they had sold. That forcing the seller to perform or paying damages has a lot to do with the consideration paid, if it was substantial amount, your much more likely in a position to require performance or seek damages than if you paid very little. The value of the transaction is reflected in the consideration given.
So, do you do one dollar as an option price? Legally you can but it won't get you far if there are issues, it will more than likely be seen as a frivolous amount and the contract not truly made in good faith. If you have no issues and both parties are motivated to close, you may not have any problems getting to settlement.
Considering the discounted method mentioned, $100 may be closer to equitable, depends on the price of the property. $500 will be much better to ensure a residential option is honored and $1,000 is going to be even better showing the value of the transaction contemplated.
I use 1% to 5% of the sale price as an option price, generally.
The first thing to gage is the motivation of the buyer or seller, besides the valuation process, buying or selling I judge the motivation of the other party and do so fairly quickly, if someone is wishy-washy I bind their butt to the door with consideration, if they are highly motivated, I'm not too concerned with us having any issues and just move on to settlement.
Sandwich Lease-Options carry a different degree of risk, you have a tenant in there things can go wrong, sellers get ticked off and you can have a fight on your hands. Another area is flipping options or selling from a contract, if your seller fails to perform, you're in default as a seller! So, in these arrangements you really need sufficient consideration to be paid, $100 would be on the low side, the circumstances certainly matter, but $500 or $1,000 might be worth more than the lost interest on that money.
The purpose of the option price needs to be examined carefully starting out and in all deals really. Is the price establishing equity to meet an end goal or is it simply needed to keep a buyer or seller honest? :)
Free eBook from BiggerPockets!
Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!
- Actionable advice for getting started,
- Discover the 10 Most Lucrative Real Estate Niches,
- Learn how to get started with or without money,
- Explore Real-Life Strategies for Building Wealth,
- And a LOT more.
Sign up below to download the eBook for FREE today!
We hate spam just as much as you
Create Lasting Wealth Through Real Estate
Join the millions of people achieving financial freedom through the power of real estate investing