How Option Fees & Earnest Money Work in Real Estate Deals

Real estate investing comes with a motley of financial constructs and contractual jargon that can sometimes confuse even the most experienced investors. Understanding the difference between option fee vs earnest money can be the difference between successfully executing deals worth millions – or losing your investment.

Whether you're looking to break into real estate investing or streamline existing acquisition structures, proper comprehension of option fees, earnest money, and call options paves the path to carefully securing assets while optimizing flexibility.

We'll clarify and demystify these three terms integral to commercial real estate (CRE) transactions, explaining exactly how each works, when to consider them, and their comparative benefits and drawbacks. We’ll cover the following:

  1. Understanding option fees
  2. Exploring uses of earnest money
  3. Delving into call options
  4. Decision drivers and due diligence
  5. Aligning options with investment goals

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1. Understanding option fees

Let’s start by defining what an option fee, sometimes called an option consideration, means in the context of a CRE purchase deal. An option fee refers to a sum of money paid for the exclusive right to buy a particular CRE asset within a fixed option period without any obligation to follow through on actually purchasing the property.

It buys an amount of time to secure financing, complete due diligence, or assess markets without the risk of losing the deal to another buyer.

Typically, you buy 7-10 days to remove the property from the market. Within this option period, CRE investors have the right to do an inspection and appraisal.

Option fees allow sellers to gauge how serious investors are while giving them valuable exclusivity during the evaluation period. Usually around 1% of the purchase price, option fees offer certain advantages over other structures.

For large CRE transactions, an escrow agent facilitates the option fee payment transfer and holds the funds until either closing or expiration of the diligence period. They ensure the process meets proper contractual and regulatory requirements.

The fate of the option fee money committed depends entirely on whether the buyer completes the purchase by the expiration date in the contract. If the buyer closes the deal as agreed, the fee often applies to the down payment or closing costs.

However, suppose the buyer decides not to acquire the asset after the seller has taken their property off-market. In that case, the seller keeps the option fee as compensation for the diligence period exclusivity.

2. Exploring uses of earnest money

Earnest money and option money often incorrectly get used interchangeably. Earnest money refers to a deposit paid to demonstrate one’s good faith and serious intent to complete a CRE acquisition. It is meant to provide some assurance of performance on the buyer’s part.

These good faith deposits are usually held by a title company or escrow agent during the transaction in a separate escrow account on behalf of the parties involved. If the purchase isn't completed, the contract outlines specific conditions regarding whether the earnest money gets refunded to the buyer or released to the seller, depending on which party defaulted.

According to Brenda Fontaine, founder of Fontaine Family and author of “The Limitless Real Estate Leader” advises investors, “If, however, the deal falls through for some reason, the buyer may not get that money back.  One reason to work with a buyer's agent is that agent will work with a buyer client to protect their earnest money deposit.”

option fee vs earnest money

Earnest money typically ranges from 1% and up to 5% of the asking price, and demonstrates an investor's serious interest in a property rather than mere casual curiosity, according to business media company Forbes Advisor.

However, unlike an option fee granting temporary exclusivity, earnest money usually becomes non-refundable at some point, providing recourse if the buyer backs out unexpectedly.

Innovative services like Duckfund provide customized financing solutions to help accelerate and simplify the earnest money process for investors. Duckfund offers a “sign now, pay later” option for securing deals, giving more flexibility to CRE buyers.

3. Delving into call options

In real estate, a call option refers to a contractual agreement giving the buyer the right but not the obligation to purchase a property at a predetermined price. In return for being granted this right, the option buyer pays a fee to the seller, who must honor the call option per the contract terms about the exercise date, strike price, etc.

Call options are extremely useful in CRE deals since they enable controlling a prime asset for an extended period of time without needing an entire capital outlay upfront to close the purchase immediately. Aspiring investors can wait for ideal market conditions or the completion of development projects.

If things don’t work out as planned, they can simply let the call option expire.

Duckfund's call option structure allows clients to secure commercial real estate deals without fully committing capital upfront. Duckfund sets up and funds an LLC that makes the offer and pays the earnest money while signing an option agreement granting clients the right to purchase the entity from Duckfund for the deposit amount before due diligence expiration.

This empowers the client to control the acquisition during the diligence period without tying up their balance sheet or limiting their ability to compete in bids that require earnest deposits in short timeframes.

Based on their further home inspection of the property fundamentals, the client can either exercise the call option to take over the LLC or let it lapse.

4. Decision drivers and due diligence

Having understood the core differences between earnest money and option fee deposits, and where call options come into play – how do savvy CRE investors decide what works best for them when acquiring assets?

First, it’s worth mentioning that earnest money can be credited back. “It depends on the specifics of a purchase contract, and how the purchase process unfolds. Which party is responsible for a deal falling through is one of the biggest factors that determines whether an earnest deposit is refunded”, according to David Luke, SVP of Capital Markets at CommLoan.

option fee vs earnest money

Second, investors must carefully evaluate whether they want exclusivity for further inspection or wish to indicate a serious commitment to closing the real estate transaction. Factor in timelines, financing contingencies, real estate market conditions, and the willingness to risk.

The relative sizes of both the deal and the deposit matter, too. Earnest money amounts to a higher upfront payment than option fees.

It is also critical to exercise due diligence around contract terms related to forfeiture, closing extensions, and deposit release or refund conditions. Investors will want to ensure these structures optimize both flexibility and deal security per their requirements. Assess all scenarios – what happens if more time is needed for paperwork or if property issues arise?

5. Aligning options with investment goals

As investors navigate option fee vs. earnest money and call options, they have to think strategically about what best aligns with their CRE investing objectives and risk-return expectations. These options cater to different priorities – maybe they want to tie up a listing temporarily or benefit from future price appreciation through built-in contractual rights.

The financial and market analysis should inform what strategic combination of option fee vs. earnest money, call option, or standard purchase contract works optimally, given CAP rates, cash flow, debt paydown, occupancy rates, and surrounding neighborhood trends at that asset. An experienced commercial real estate agent or financial advisor can also provide invaluable assistance.

6. Four best practices for CRE investors

Here are some best practice tips around these three instruments to incorporate into your CRE investment toolkit:

  1. Consult both financial and legal experts when negotiating option fees vs. earnest money or call options to balance both return prospects and risk management.
  2. Prior to signing option contracts or releasing non-refundable deposits, conduct an exhaustive due diligence process covering all physical, financial, and legal aspects of the property.
  3. View option money or earnest money not just as percentages but as real money at stake – be prepared to lose those deposits if things don't work out potentially.
  4. Homeowners looking to invest in commercial real estate can utilize call options to optimize flexibility as they allow controlling a lucrative listing through contractual rights instead of a substantial upfront capital outlay.

By mastering these intricacies around the difference between earnest money and option fees, you strengthen your investment ability to tap into the enormous wealth-building potential of commercial real estate while mitigating key risks. Consult a realtor for more information about brokerage services to assist with your commercial real estate investment.

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Option fee vs earnest money vs call options takeaways

  • An option fee, typically around 1% of the purchase price, provides time to secure financing and conduct due diligence.
  • Earnest money demonstrates the buyer's good faith and serious intent to complete the acquisition.
  • Earnest money ranges from 1% to 5% of the purchase price and usually becomes non-refundable at a certain point.
  • A call option grants the buyer the right, but not the obligation, to purchase a property at a predetermined price.
  • Duckfund offers financing solutions to streamline the earnest money process and provide flexibility in securing deals.

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