Real Estate Acquisition Tips

The Rolling Option

by Marvin Levin

My colleague, Bob Kagan, has been teaching real estate finance at Golden Gate University for the past 28 years, and is a treasure house of innovative real estate ideas. I asked Bob for his explanation of the “rolling option,” and he submitted the following case.

Regarding land acquisition transactions, buyers are often trying to obtain the maximum leverage and, therefore, ask sellers to provide significant amounts of seller carry-back financing. Usually this financing will provide for accelerated release provisions.

In response to this request, it is not uncommon for sellers to express resistance, mainly on the grounds that they are not in the lending business. They are often not equipped to evaluate credit risk, and are often unwilling to collateralize their future benefits with a note and deed of trust on the property that could be subject to various debtor rights such as bankruptcy should a buyer default on his obligation. The seller’s anxiety in realizing the implications of all of this, along with the buyer’s quest for a highly leveraged transaction, may result in an impasse.

A neat solution to the problem is a rolling option. In simple terms, this means that the buyer takes an option on the entire property, pays for the property over an agreed-upon time period, and takes title to the property incrementally in proportion to the payments made. In other words, in this scenario, the seller agrees to transfer title to the property incrementally. As the buyer advances money (analogous to a partial release), the seller conveys a portion of the property in fee and without liens. For example, let’s say the buyer advances 25% of the total acquisition cost. The seller may then choose to convey 20% of the property. The net effect of this is that the buyer obtains his requested leverage and the seller is not involved with seller carry-back financing because the seller stills owns the portion of the property not paid for, but the buyer controls the portion not paid for by way of an option. Provided that the buyer makes his payments as per the option schedule and acquires portions of the land as agreed, the option will stay in place. The seller will be obligated to convey title to the buyer and will be precluded from selling the property to anyone else.

However, in the event that the buyer fails to make a payment timely, the option is subject to cancellation. Because title never passes for any portion of the property until the money is received, the seller is free to resell the property to someone else without having awkward encumbrances or clouds to the title.

This is in contrast to seller carry-back financing where a default would result in an expensive and long drawn-out foreclosure proceeding. Worse yet, the seller carry-back financing could be compromised in the event of bankruptcy of the buyer.

The rolling option set forth above seems to be a win-win solution. The buyer obtains his leverage and the seller is not subject to credit risk.

In addition, the buyer might reduce substantially his “holding” cost if the option cost is less than the interest would have been on a purchase. And, if the economics change, the buyer can drop the option without necessarily sacrificing a substantial equity that would have been the case in a conventional purchase.

If you run into a land parcel with entitlement issues, please contact me.