How Real Estate Options Work
Real estate options are contracts that allow one side to purchase the right to buy the underlying real estate at maturity for a certain price on a future date, both determined in advance. Some of the benefits of entering into a real estate option contract are as follows:
Considering the very large amount of money required to flip property, real estate options are useful tools to profit from real estate trading, which requires only a small amount of capital for the option fee.
Individuals who do not have sufficient cash but wish to buy a house may purchase the real estate option, which allows them to lock in a price and gives them time to secure financing.
Further, as options give buyers the right, but not the obligation, to buy the underlying, individuals (for instance, investors who want to purchase real estate for a shopping mall business) can take their time to evaluate zoning laws, conduct marketing research and inspect the land, with the assurance that they have fixed the price, in case they want to purchase the real estate in the future. (For related reading, refer to How To Make Money With Real Estate Options).
Real estate option transactions do not differ much from plain vanilla options that are traded in exchanges. An optionee (the buyer of the option) transfers an option fee (like the premium) to the account of the optionor (seller of the option) and, in return, purchases the exclusive, unrestricted, and irrevocable right and the option to purchase the property at a fixed purchase price during the option period. On the exercise date, the optionee can choose to either let the option expire worthless or exercise the option.
Once the option is exercised by the optionee, the optionor becomes legally obliged to honor the terms and conditions of the contract and the purchase consideration must be paid to the optionor in full. If expired worthless, the optionor keeps the option fee and the optionee cannot claim this amount back. (For related reading, refer to What's the difference between a regular option and an exotic option?).
How Real Estate and Plain Vanilla Options Differ
Unlike many plain vanilla stock options, real estate options are not traded in exchanges but rather over-the-counter (OTC) because exchange-traded optionsare standardized contracts, including the standardization of the underlying (e.g. size, quality, etc.). However, it is not possible to standardize real estate options due to the nature of the underlying.
Another difference between real estate options and financial options is that in real estate options, the option fee paid to the optionor is usually applied against the purchase price, if the option is exercised. This means that the option fee becomes a down payment once exercised. However, in financial derivatives, the premium paid to the option seller is a separate compensation for the option writer to assume risks.
Indirect Ways of Using Options on Real Estate
There are plain vanilla options traded in exchanges that give investors a chance to have exposure to real estate. The underlying of such options is not directly real estate, but rather financial instruments tied to this property. Such options may provide some of the features of real estate options but are offered in an easier way. For example, options on home price indices traded on the Chicago Mercantile Exchange (CME) allow investors to profit from an increase (or a decrease) in housing prices, and this may require even smaller capital than the option fee mentioned above. More specifically, cash-settled American-type S&P Case Shiller Home Price Index options are traded on the CME.
What makes such contracts look more complex to average individuals is that the underlying of these options is housing futures contracts; thus, these are options of futures. However, once exercised, the options are settled in cash, and holders do not take a position in the futures contracts. Moreover, these options can be used to hedgeagainst future price increases or decreases. For instance, if you are planning to purchase a house in Los Angeles in a year's time and you want to hedge against the increase in home prices, you can do it by purchasing a call option on the S&P/Case-Shiller Los Angeles Home Price Index. (For related reading, refer to An Introduction To Real Estate Futures).
Another indirect way to gain exposure to real estate prices through options is to purchase options on the stock of the companies whose shares are highly correlated with real estate prices, such as investment trust companies. For example, Pennsylvania Real Estate Investment Trust (PEI) is an investment company that focuses its investments on retail shopping malls located in eastern US. Naturally, its shares will exhibit a high positive correlation with the performance of the real estate types in which it invests. Investors who seek exposure in that kind of real estate can do so by investing in options on PREIT shares. (For related reading, refer to How To Analyze Real Estate Investment Trusts).
The Bottom Line
Real estate options are contracts that give the buyer (optionee) an irrevocable right to purchase the underlying real estate for a predetermined price on a certain date for a small option fee that acts as a down payment. It is kept with the optionor, should the option expire worthless. These options are bilateral contracts. However, investors can also use plain vanilla financial options to gain indirect exposure to real estate that offer some of the advantages that real estate options offer.
By: Elvin Mirzayev
