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Why Lease Options?

Definition

Options: An option is a written contract giving the purchaser the "option" to purchase a particular property, usually for a specific price and within or by a specific time frame. Unlike a conventional S&P (Sale & Purchase) agreement, an option is effectively a one-sided agreement. The seller has to sell, if the purchaser "exercises" the option. However the purchaser is under no compulsion to buy. Of course there is a fee for this privilege. In effect, the option is being purchased. Generally this fee would be credited off the purchase price if the option is exercised.

So how does it work and why would you do it?

A vendor has a lifestyle lot for sale in Auckland. It happens that the land has just been rezoned and can be further subdivided, but the owner is a developer and wants to get on with another project. So the opportunity is to purchase the site, further subdivide and then on-sell, right?

Option 1: the traditional method

Enter into S&P and try to negotiate long term settlement with prior access to start subdivision. The vendor/developer will have to pay GST on the sale as soon as it is unconditional so seeks a short term settlement. In addition, dealing with the Council may take ages so how long is long enough to settle?

Assume a person manages to negotiate 6 months settlement on 5% deposit and that the subdivision will take 12 months to complete. But, it actually takes 18 months. Purchase price $500,000. So the numbers are:

• Deposit of $25,000 paid now out of revolving credit at 9.5% = $198 per month
• In 6 months the balance is settled at 8% = $3166 per month
• The subdivided sites are on-sold at $450, 000 with 10% deposit, balance subject to title.

Say the best happens and all are pre-sold by settlement date. This means there are $90,000 in deposits, but they are being held in a solicitor's trust account. 18 months out and title arrives and everybody settles.

• Total costs: Land $500,000
• Interest $60,000
• Development $90,000
• GST on sales $40,000
• Total $690,000
• Income = $900,000, less costs of $868,000
• Profit roughly $180,000.

That's great, but it required an unconditional purchase, organising of finance and settlement, plus being involved in the project for 18 months.

Option 2:

If an option had been taken on the property, things could have done differently. As an option doesn't trigger GST for a developer he may well agree to a 12 month option for a fee of - let's say - $5000. The option means the property can't be sold to anyone else but HAS to be sold to the option-holder when the option is exercised. The $5000 would be lost if the option is not exercised, but that $5000 comes off the $500,000 price if it is.

So what can be done differently in this scenario?

1. Advertise the property to another developer looking for sections to build on. The developer can either take over the option for an assignment fee or both can settle at the same time.

In other words, the property may be worth $600,000 as is, to a spec builder/developer who pays the option-holder a $100,000 fee and takes over the rights in the option. The initial option-holder gets paid with no mortgage and no holding costs other than the interest on $5000. And an entire year is available to find a buyer!

Profit $100,000, short time frame, no risk.

2. Advertise the 2 sections in the usual ways with 10% deposit and balance on title. A year is available to find buyers. After 12 months, the option goes to an unconditional S&P agreement and a negotiated 6 months settlement from that date. This is the same time that title will be out so all the sales can contemporaneously settle. No holding costs other than interest on $5000, no mortgages to find, etc.

Profit $240,000. Even more than normal, due to no holding costs.

3. Because of the 12 month option period, an investor is sought who is looking to capitalise on the 12 months capital growth potential, then simply assign the option immediately to another investor for a 10 or $20,000 fee. Less profit, but it may only a day's work in total. No risk, no mortgages.

Imagine these particular examples times 15 sites! The difference between a S&P and an option can range from $300,000 to $3.6M! And the risk is lower with the higher profit.

4. Here's another common situation where options are a great alternative to S&P's. A person buys a unit in a block of three and would love to get control of the whole block. The new neighbours are friendly enough but don't want to sell, now. They can be offered an option to sell their property upon their death or whenever they want to sell.

In this case the option may have a 50 year expiry and the purchase price may be fair market value but the buyer still gets to own the whole property, if desired. The opportunity to get control of millions of dollars worth of real estate for a grand or 3 is hard to oversell.

Information provided by Dean Leftus 1

----Perry 21:04, 29 December 2007 (NZDT)