BROKER RISK MANAGEMENT
WEEKLY PRACTICE TIP
Option Agreements
Q: I am a buyer’s agent. My buyer won’t have the money to purchase the home she wants until the sale of her business closes in six months. Seller is willing to go along with the buyer because she is offering a good price but does not want to wait that long unless he gets some money up front. Both are willing to do a lease option and allow her to move in. How do I write that up?
A: First, you have to understand that options are different from usual transactions.
DEFINITION: An option agreement is an agreement today to sell a property in the future at a fixed price and on certain terms.
In an option agreement, there is no “non-refundable deposit” since the option consideration (the amount paid up front for the seller or “Optionor” to give buyer or “Optionee” the option to purchase the property) is not a “deposit” but instead is a payment directly to seller for the option contract. This option consideration can be paid directly to seller/Optionor, or be paid through escrow to seller. But in either event, once the option consideration is paid, that money is sellers to keep unless seller commits fraud or the property is substantially destroyed.
The seller has to weigh the risk of entering into the option agreement because during the option period the seller can sell to no one else. Also, if the property value goes up during the option period, the buyer gets to buy at the lower option price. If the property value instead goes down, the buyer will not exercise the option. So, the seller needs to decide how much that risk is worth when deciding on the amount of the option consideration.
Buyer has a risk also. If, at the end of the option period the buyer cannot exercise the option, perhaps because of lack of funds, the option consideration is gone.
Here are the steps in creating an option agreement:
1. OPTION AGREEMENT: Fill out the option agreement (CAR form OA) indicating:
A. The amount of the option consideration to be paid and when the option consideration will be paid. (Paragraph 1) Usually the option consideration is paid several days after the Option Agreement is ratified by the parties to give the buyer enough time to do property investigation and due diligence, including checking the Preliminary Title Report and title issues as well as other matters affecting the value or desirability of the property. So, in paragraph 1.A check the box to indicate that “Option Consideration will be paid “Per paragraph 13.”
Then insert into Paragraph 13 “Other Terms and Conditions”: “Option Consideration will be paid __ days after the Option Agreement is ratified as follows: During that time, Optionee may conduct inspections and investigations of the Property and title matters. If, by the end of that time, Optionee is satisfied with the Property, Optionee shall pay to Optionor the Option Consideration, otherwise Optionee may cancel this Option Agreement by written notice to Optionor.”
B. The length of time of the option agreement; that is, the time during which the option may be “exercised.” (Paragraph 3)
C. The manner of the exercise of the option. (Paragraph 4). The “exercise” of an option is the step necessary for a buyer to let the seller know that he/she is actually going to buy the property. It is usually accomplished with a letter from buyer to seller that says something like: “I hereby exercise my option to purchase __________________ property pursuant to that option agreement dated _________, 20___.
D. How much of the option consideration will be applied to the purchase price. (Paragraph 8.C)
2. PURCHASE AGREEMENT: Note that the Option Agreement form requires that a filled-out purchase agreement be attached setting forth the terms under which the property will be purchased.
A. Have the parties sign the purchase agreement.
B. Do NOT use calendar dates for contingency removals, close of escrow, etc., in the purchase agreement. Instead, use “days after” since the option agreement specifies that the dates in the purchase agreement only start upon the “exercise of the option.”
C. Although there is no requirement that escrow be opened yet (because the purchase agreement is not an operating purchase agreement until the “exercise of the option”), it is generally a good idea to open the escrow to obtain a Preliminary Title Report for the buyer to review prior to parting with the option consideration.
D. The Purchase Agreement attached to an Option Agreement is different from the usual contract in that:
(1) The timeframes in the Purchase Agreement do not start when it is signed but instead start when the Option is exercised. See Paragraph 8.A of the Option Agreement.
(2) It usually has few if any contingencies because the buyer has already done due diligence up front and would not exercise the Option unless he/she had the financing already lined up and ready to close;
(3) It frequently has a very short time for COE because in the usual option agreement once the buyer exercises the option, he/she is ready to close soon. This is the reason for the “days after” language for COE rather than a fixed calendar date; although a fixed date may work in some circumstances. This should be discussed with your clients.
(4) It usually will not have an initial deposit specified because of the Option Consideration paid up front and the quick close.
3. LEASE: If the Buyer/Optionee is going to also take possession of the property upon the signing of the option agreement (e.g., rent the premises), then also fill out and attach a fully-completed lease agreement by checking the appropriate box in Paragraph 2.
4. DISCLOSURES: Note Paragraph 7 of the Option Agreement specifying the up-front disclosures which are required to be made.
PRACTICE TIPS:
1. Options are useful for only a limited number of circumstances. Be sure you and your clients understand the uses of an option agreement, and where it would be useful.
2. Option agreements are complex. Recommend in writing that your sellers and buyers have the documents reviewed by legal counsel.
3. Review all of the documents with your manager before proceeding, so as to get another set of eyes to check that all documents are accurate and are internally consistent.
4. Advise your buyers that it is wise to record a “memorandum of option” to put the world on notice of their option rights. This must be prepared by counsel – not you.
5. Do not refer to the Option Consideration as a “deposit” or “non-refundable deposit” since that money is not a deposit, but rather is a separate consideration for the seller granting the option to purchase to the buyer.
DO NOT FORWARD TO CLIENTS OR THIRD PARTIES. This Weekly Practice Tip is attorney client privileged and for the exclusive use of clients of Broker Risk Management and their agents. It may not be reproduced or distributed without the express written consent of Broker Risk Management. The advice and recommendations contained herein are not necessarily indicative of standards of care in the industry, but rather are intended to suggest good risk management practices.