Housing: Using Rolling Option
By David Tevlin
Housing markets have been very weak in recent months, and new home construction remains at low levels. However, some hope is being expressed about the housing market beginning to improve, particularly if the economy shows signs of strengthening. Looking to the future, some developers may be thinking of tying up desirable land for residential subdivisions in attractive locations in order assure themselves that land will be available when needed. One way to do so is by utilizing rolling options, viewed as a more conservative method of controlling land inventory than outright purchase.
The option holder retains maximum flexibility so that if the economy remains weak, outstanding options can be left unexercised or can be renegotiated. (On the other hand, the option seller will tend to price land higher than in the case of a straight purchase as compensation for the uncertainty of a final sale, particularly if the option term is long.) And as with any option, failure to exercise means the loss of the option fee paid by the holder.
Consider the position of a developer who has completed the legal steps of subdividing land into lots and recording a plat. At that point, preparatory to installing roads and utility services, the developer wants an agreement with a builder for construction of homes. The builder sees the possibility of new homes on the entire tract but lacks the financing to purchase the land outright. Instead, the parties enter into a rolling option whereby the developer gives the builder a series of options to buy lots over a specified time period. The initial option may cover only a small number of lots on which the builder can construct model homes. If the market response is positive, the builder will then exercise the second option for additional lots for speculative homes or homes already contracted for. Each time an option is exercised, it rolls over to the next designated tract of land or series of lots, often at a stepped up price to reflect the additional land value created by the subdivision. Failure to exercise an option, on the other hand, will eliminate any further rollover.
Benefits to the Parties
The benefit to the builder is his ability to control the entire tract at a minimum cost. It is true that if the entire tract ultimately is purchased through the exercise of the options, the total price would be higher than in the case of an outright purchase. However, the reduced exposure to risk justifies the extra cost. For the developer or landowner, the disadvantage of a rolling option is that lots or land cannot be sold to third parties until an option period expires without a rollover. However, he is receiving increasingly higher prices as options are exercised and would not be likely find to another buyer in the event the original builder fails to exercise some option.
Drafting the Option Agreement
The key provisions in a rolling option agreement relate to the price of each option, its time period and the portion of the tract covered by the option. As already noted, the price of each successive option typically increases, which, in effect, permits the landowner to share in the rising land value.
Due to the existing construction, a price increase may be a specified percentage, may relate to the sale prices of the finished homes or may be affected by the characteristics of the portion of the land covered by the option. The time period within which each option can be exercised also is a matter of negotiation. The builder will want a longer time in the event sales proceed slowly; the landowner will prefer a shorter time so that sales proceeds are received more quickly. The builder may be agreeable to paying a higher option fee in order to extend the time of exercise. Alternatively, the builder may be given a right to extend a particular option upon payment of a specified fee. Finally, the option agreement must specify which portions of land are covered by each option. The owner will want each successive option to cover land immediately adjacent to that already developed to avoid ending up with isolated portions that cannot easily be sold if all options are not exercised. On the other hand, the builder will want the right to reject any land or particular lots that cannot be built upon because of grade or subsoil conditions or similar reasons.
Developer as Optioner
When the rolling option agreement is between a builder and a developer who undertakes to render the lots suitable for construction of single family homes, a number of additional issues must be addressed. For example, the developer must agree to complete all work on a specific schedule to render purchased lots suitable for the construction of homes and for the issuance of a building permit. The developer normally also will be required to perform any offsite work and to obtain easements for utilities and drainage. Any required permits and payment or performance bonds also should be specified in the agreement. To the extent that the local government requires the dedication of space for schools, streets or parks, the developer should be responsible for doing so. Finally, the developer should make the representation and warranties normally found in a sales contract, including those relating to zoning, good title, the amount of land conveyed and environmental issues.
Please contact us to discuss any questions you have regarding this topic.
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Somerset CPAs, P.C.
3925 River Crossing Pkwy.
Indianapolis, IN 46240