This is the seventh in our series of articles of ways to invest in real estate.
Real estate options come in two flavors: Over-the-counter (OTC) options to buy property and exchange-traded options on REITs and REIT exchange-traded funds.
OTC Options
OTC options are private contracts between a buyer and seller. They are quite different from exchange-traded futures. They are not regulated by an exchange, have no standard pricing mechanism, do not require marking-to-market or maintenance margin, and settlement is not guaranteed by a clearinghouse or other third party. If a dispute develops between the buyer and seller, the case could result in a lawsuit.
OTC Real Estate Options
A real estate option gives the buyer the right, but not the obligation, to purchase specified land or other property. They are used when a potential buyer, such as an investor, developer or builder, wants to lock up the rights to purchase a piece of property without committing to the purchase. The option contract is a cautious business decision when contingencies cloud the property’s outright purchase. Example contingencies include zoning restrictions that would have to change or waiting for a decision about whether a new road will be constructed near the optioned property.
Because it is a private written treaty between the option buyer and seller, the terms of the option are completely negotiable. However, the following terms are typical:
- Location: The location of the property must be fully identified. This might include an address and/or a parcel identification number. For raw land, the contract should include the legal description of the property, including its PIN and boundaries.
- Timeframe: The contract specifies the time period by which the buyer must exercise the option. This is completely up to the two parties — it could be 24 hours or 5 years. The buyer can exercise the option at any time within the agreed timeframe, but because each contract is unique, there may be certain other factors tied to specific periods within the timeframe.
- Consideration: This is the amount of money or other asset the buyer pays the seller to purchase the option. The option consideration is typically a small percentage of the property’s value. The option price is one of the points negotiated between the buyer and seller.
- Purchase Price: This is the price that the buyer will pay to exercise the option to purchase the property. It is usually net of the original consideration paid by the buyer to obtain the option.
Characteristics of OTC Real Estate Options
The following table summarizes the primary characteristics of OTC real estate options.
CHARACTERISTICS | COMMENT |
---|---|
Minimum investment | Small relative to the price of the underlying property. |
Liquidity | Illiquid. These are private contracts that do not trade on any market. |
Control | Complete. The parties agree on all the terms of the contract. |
Diversification | None. The option applies to only the underlying property. |
Leverage | Little to none. The buyer might borrow the money to purchase the option. |
The closest REIT analog to an OTC real estate option is a private REIT because it is also illiquid. But otherwise, the two are vastly different and serve different purposes.
Options on REITs and REIT Exchange-Traded Funds (ETFs)
These are exchange-traded options on underlying shares of a REIT or REIT ETF. Each option contract gives the buyer the right, but not the obligation, to buy (via a call) or sell (via a put) 100 of the underlying shares at a specified price (the strike price) by a specified date (expiration date). The consideration for purchasing an option is the premium, which is a function of several factors:
- The relationship between the asset price and strike price.
- The amount of time left before the contract expires.
- Volatility of the underlying asset.
- Interest rates.
Option buyers can lose only the premium amount they pay for the option. Option sellers can lose more than the premium they collect, since they must either buy (for a put) or sell (for a call) the underlying asset if the option is exercised.
Example of Call Option
The buyer of a call option on XYZ shares (XYZ is either a public REIT or REIT ETF) with a strike price of $45 pays $300 per contract when the share price is $44 and the contract has three months until expiration. The call is “out of the money” because the share price is below the strike price. In other words, the call premium stems solely from its time value, which decreases as expiration approaches. The call has no intrinsic value until the shares rise above $45. The call buyer could exercise the option and purchase the 100 shares for $4,500, in which case the call seller would deliver the shares and collect the $4,500. This might occur if the share price rises above the strike price, as each $1 rise above the strike adds $100 of intrinsic value to the contract. Alternatively, the buyer could simply sell the call and collect its current premium. If the shares fail to rise above the strike price, the call will expire worthlessly.
Example of Put Option
The put option works like the call, except that it is meant to profit from the fall in the underlying asset’s price. An out of the money put might have a strike price of $44, $1/share below the current price of the underlying shares. If share prices fall and the buyer exercises the put, the seller must deliver 100 of the underlying shares at the strike price. Sellers collect an initial premium and hope that the option’s price rises, so that the buyer won’t exercise it and the seller keeps the full premium.
Characteristics of Options on REITs/REIT ETFs
The following table summarizes the primary characteristics of options on REITs/REIT funds.
CHARACTERISTICS | COMMENT |
---|---|
Minimum investment | Small relative to the price of the underlying property. |
Liquidity | Illiquid. These are private contracts that do not trade on any market. |
Control | Complete. The parties agree on all the terms of the contract. |
Diversification | None. The option applies to only the underlying property. |
Leverage | Little to none. The buyer might borrow the money to purchase the option. |
Summary
We see that options give contingent control over an underlying asset for a given time period. OTC options are illiquid and customized to a particular deal. Exchange-traded options can be used to speculate in REITs or hedge against losses in REITs.
This article is intended as educational content and is not a substitute for advice from a licensed investment advisor.