How Do Option Contracts Work?
In a previous post, we talked about option contracts as they relate to longer escrow periods. In essence, the seller is giving the buyer the option to purchase the subject property, based on some terms and conditions that were agreed upon in this option contract. Based on that description, you could probably even conclude that a short escrow period is also an option, but the term seems to more often refer to the longer escrow periods.
The option contract is essentially the purchase agreement for the property and much of time is called just that. The contract will establish the purchase price, due diligence period, deposits, escrow period, time extensions, remedies for default, and a lot more legal language. What tends to be more unique about an option contract is that the extended escrow period allows time for the buyer to complete some specified activity, such as the entitlements, final engineering, grading, or site improvements.
One of the key components for a longer escrow period tends to be the amount and timing of non-refundable deposits. The property is being taken off the market and the seller will want some form of compensation should the buyer never close on the transaction. As an example, if the purchase price is $10 million, it would be customary that the buyer put up 3 – 5% as the deposit at the beginning of when escrow opens. This deposit would be refundable to the buyer until the end of the due diligence period, which would be a negotiated time frame. At the end of the due diligence period, and if the buyer wishes to proceed with the transaction, the deposit becomes non-refundable and the compensation to the seller if the buyer does not perform down the road.
Based on the activity or conditions to be completed, the buyer and seller will have agreed on when escrow shall close. The closing may be tied to a specified event, such as city council approval of a project, and will usually have an outside date, such as 18 months from the end of the feasibility period. If the buyer does not perform and close on the property during this time frame, the seller will keep the deposit as compensation for entering into the option contract and allowing the long escrow. As well, the option contract may provide for the buyer to extend the escrow period beyond the 18 months, by putting up additional non-refundable deposits. All of this deposit and escrow language is agreed upon between seller and buyer in the option contract.
Additional terms related to the escrow period will also include how the deposit is handled, as it could be retained in the escrow account during the escrow period or it could be released to the seller immediately after the due diligence period ends. While the initial deposits are usually applied to the purchase price, the extension deposits may be negotiated to be non-applicable, which essentially means they increase the purchase price. Much more thought and negotiation will occur when the escrow period is longer.
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