What is a Land Option?
Improve Cashflow and Reduce Risk within Real Estate Development Projects
As a kid, my parents only bought used cars from individuals. Not new and not from a dealership. For sale by owner. My dad would conduct a thorough interview with the seller. In addition, my dad would “test drive” the car. Once behind the wheel, he would drive straight to a mechanic. The mechanic would perform a full inspection, including spot-checks for common ailments of the given make, model, and year.
While returning to meet the owner, he would pull into a large stadium or church parking lot. There, dad would hammer the gas pedal, slam on the brakes, weaving from side to side, and test every feature the car offered.
By the time my dad was ready to hand over the payment, he had an up-to-date picture of his risk and opportunity. His success rate of buying used cars was nearly perfect. Despite being used vehicles, he removed most of the risk from the purchasing process.
Buying land is a lot like purchasing a used car, except the wear and tear has evolved and compounded over millions of years. The potential hazards, risks, issues, oversight, and regulations are exponentially more complicated.
What is a Land Option?
In real estate, negotiating a land option is the closest you get to a test drive.
In a land option, the buyer establishes an agreement with the seller to defer full payment until after some level of due diligence is complete. The extent and duration of the due diligence are negotiable. A purchase price might be set, but the buyer is able to take possession of the land, request permits, initiate inspections, and perhaps even presell the land before paying in full.
Some of the most valuable parts of a land option include:
- Land options improve cash flow because you can lock in a purchase price and possession of the land while deferring payment until later.
- Land options reduce risk because you can ensure the land passes inspections and receives permits before paying in full.
- Land options reduce risk by allowing buyers to lock out competitors while gathering more information. If they don’t like what they learn, they can back out without losing their full investment.
- Land options increase speed by allowing buyers to spread their capital across many potential land deals and prioritize deals that clear diligence faster.
Without a land option, a buyer would fully purchase a plot of land (usually with cash or debt financing) before proceeding with permitting, inspections, and sales. What happens if the land has defects or regulatory limitations? The money has been spent but the property will not be functional for the buyer’s need. It’s a big risk for the buyer.
With a land option, the risk and responsibility are shared between buyer and seller. Instead of paying the full purchase price upfront, the buyer agrees to pay a smaller portion of the total price, until they ensure the land is suitable for their needs.
For example, during a real estate development project in Mexico, we optioned 8 acres of land. Our initial payment to the landowner was 10% of the purchase price. Between the time of signing our land option agreement and paying our remaining balance, we were able to finalize the master plan, source vendors, and initiate building permits. We even conducted a marketing event on the property and presold the 100+ homes we intended to build.
So, not all land purchases will proceed with full purchase. Throughout the pre-construction and permitting process, information could arise that reduces a buyer's appetite to purchase the land.
Given the number of decisions and costs within a real estate project, a few costs could blow the budget for an entire project. Death by a thousand cuts.
- Significant rock removal estimates.
- Soil Study results reveal too high preparation costs.
- Increased costs due to land elevation.
- Discovery of pollutants.
- Disputed title or ownership issues.
The Bigger Picture
Land options on a single piece of property can be helpful, but the real power comes at scale. Instead of considering one 8-acre lot, imagine a real estate developer involved in purchasing ten or twenty lots. Not only would managing cash flow be a nightmare, but the land is largely an unproductive asset while pre-construction tasks are underway. A significant amount of value would be sitting idle, like cash stored under a mattress.