This article talks about options in relation to land and buildings (in legal terminology, 'real property'). The underlying concept can be applied to other assets including company shares.
An option is a device that allows a buyer to buy an 'opportunity' to buy the land itself later. A buyer usually seeks to buy an option when they want to commit the seller to sell, but before some other event.
An option gives its holder the right but not an obligation to buy or sell an asset at a price that is calculated according to a pre-arranged formula or at a fixed price in advance.
They are closely related to futures contracts, but they give a holder the upside without the downside risk. Because this means that the person selling the option takes the risk but foregoes the opportunity to profit, they are usually compensated for taking the risk. In other words, the right to buy or sell is itself usually bought.
Options to buy can be granted over any type of asset – the most common types are for financial securities such as shares or bonds, or a commodity, or quite frequently, land.
An option buys time. That time can be used in any way. The option holder may need time to raise purchase money. They may need to ask consent of others to join in the transaction. They may want to make enquiries before committing themselves.
The commonest reason to take an option on land is to try to secure planning permission before buying. A field may be worth several tens of thousands of pounds as agricultural land, but worth several million with consent for residential development. Someone skilled in obtaining planning consent may think he is "in with a chance" even though he may have to spend money on architects and other fees to achieve anything.
Whether or not an option is in respect of registered land, the buyer should register it at the Land Registry. He or she does need a solicitor to do this, but he or she will require a site plan unless the area covered by the option is the same as the seller’s registered title. That way, no other person will be able to register an interest in priority over the buyer’s interest.
Terminology
An option that gives the buyer of the option the right to buy an asset is a call option.
An option that gives the buyer of the option the right to sell an asset is a put option.
The asset the option is called the underlying asset.
The price at which the underlying security is to be bought or sold is called the strike price or exercise price.
Pricing
When considering the mathematics of an option, there are several variables:
- the price of the option
- the time until the last date by which the option must be exercised, or lapse
- the exercise price (the cost of the land or item if the option is exercised)
- expenses (like professional fees) required to achieve the target reason for seeking the option
- the statistical chance of achieving the target reason (such as obtaining planning permission)
Because some of these are subjective, the calculation of a 'deal' to offer to the other party is difficult and there is no standard.
The first step is a high-level cost/benefit assessment. There should be enough total profit (after tax) to pay for your work and provide an incentive to the land owner to sell you an option to buy.
Remember that the land may be worth more than current actual use value simply by re-building or renovating what is there already.
Legal aspects of options
An option to buy anything except land or financial instruments is a transaction you can negotiate without interference from the law. You can buy an option to buy a domain name, a patent, or a car under any terms you like.
To protect yourself however, you must have a water-tight written agreement. This is particularly important for an option contract because so often, the option holder takes some action to either commit to the purchase or enhance the value of the subject matter. Either way, the seller would be tempted to change the terms if you had not tied him down!
A contract to enter into a contract is void. A contract to buy and sell land needs only:
- to be in writing
- describe the land
- specify the price
- be signed by the parties and dated
After exchange of contracts, the parties must sign a document that actually transfers the property. The time between exchange and completion is usually taken by various enquiries and checks by the buyer's solicitor, but those can actually be made earlier. When push comes to shove any land transaction can be compressed into 24 hours. So you do not need a solicitor to actually enter into a contract - if you know what you are doing. In practice, there are many matters which you need to get right. The contract is by far the most complicated document in the conveyancing process.
Most of the terms to be included in a contract for the sale of land have been fine tuned by solicitors over the years and are standardised in the small print of a contract document form. Often, the other matters take few words. But in some commercial contracts, the 'extra' paragraphs may run to many pages.
An option agreement is binding only on the seller - because the option holder may choose not to exercise it. If the holder does not exercise it by the last date for exercise, it lapses and is dead. So it follows that it is very important to use a contract that is as thorough as possible. When you agree with someone to buy their land, they expect the lawyers to produce reams of papers. But when you call one evening with a agreement under your arm, they may well be put off if it is six pages long and needs a lawyer to explain it. So, if you are dealing with a sophisticated owner, by all means take no risks and get it right with a full document. But if your other party is likely to be worried, you might be better off with a simpler document, even if that throws up possible delays or other problems later.
Use of put options within property deals
Most commonly, options agreements used in the property development industry are call options. The owner of the property sells the right to buy the building or the piece of land to the prospective buyer. It is then the buyers choice as to whether to exercise the option and buy the property. The land or asset owner is obliged to sell if the buyer of the option exercises their right.
Being a property owner and buying a put option for would enable you to profit in a falling market.
The versatility of options also means that certain strategies enable you to profit in a static market. Selling a put option, for example, when you feel that the underlying land price will remain stable or at least not fall dramatically, allows you take in premium income. As the option nears expiry, the time value of your short put will be eroded and if, as you forecasted, the underlying price has not moved sharply, you will be able to close out your short put position at a cheaper premium than that at which you sold to open the position, thus benefiting from a profit.
Further reading and documents
The next article in this series covers methodology and finer points when using options and a third ocompares options with pre-emption agreements and conditional contracts.
If you would like to download a document template, see our option and conditional contract agreement templates.