Property call option agreements are a great tool for improving the value of someone else's property or land before paying for. Current property market conditions have opened up new opportunities for investors and developers.
If you’ve ever used a call option agreement to acquire a property or development site then you’ll know that the longer the option period granted by the seller the better.
Of course, one of the great benefits of acquiring property under option is you do not need to settle on the property for some time into the future which means you can improve the value of the land or property before paying for it.
For example, one of my developer partners obtained a call option for $2.5m on a site in Port Macquarie, spent some money on obtaining council approvals for a land subdivision and subsequently had the land valued at $6.5m ...before settling with the owners.
In a hot market, the vendor would may have insisted on cash buyers only with settlement in 30 days.
The key to his success was obtaining a long option period which gave him sufficient time to obtain council approvals and, in turn, know exactly how many land lots would be approved in this land subdivision.
Not only did this reduce his approval risk but also there were no holding costs while all the regulatory approvals were obtained.
So how did he do it... and... how can you?
Read on a find out....
A call option allows the buyer and seller to enter into an agreement whereby the buyer has the right (but not the obligation) to buy the property on the agreed terms within the option period.
Why is a long call option period more desirable?
The simple answer: It gives you more time to get more certainty. Time is a developer's best friend.
When buying a property with the intention of adding value through development or renovation, a developer needs time to get council approvals which can take 12-18 months depending on the size of the project.
The developer may also need to obtain pre-sales in many cases which helps obtain debt funding (on better terms) to settle the site with the land owner. So the more time the developer has the more they can de-risk the project before committing to settling on the development site or property.
$6million in 'manufactured' equity
In another project I am involved in, 6 home owners agreed to an 18 month call-option in exchange for a price of $14mil. At the time the combined value of their properties was $7mil. Before settlement with each owner, the amalgamated development site with the new DA was subsequently valued at over $20mil.
Imagine creating $6mil in equity (less DA costs etc) prior to settling the land. It certainly improved the LVR for obtaining debt funding to settle the site.
Why would a seller offer a long option period?
There are many reasons a long (18months?) option period could also work for the vendor.
For example, perhaps they aren't ready to move just yet (if the developable property is their personal residence) or you agree to give them a new property in the development so they can stay where they are. Of course, at can also come down to as something as simple as money. More money paid at settlement in exchange for more time.
There are other benefits that may warrant the use of an option versus selling on the open market. Keep in mind the following benefits to the seller should they decide to take their property to the open market rather than do a deal directly with you.
The benefits of selling privately
As for dealing with agents in selling on the open market, keep the following in mind when discussing the above benefits with the landowner.
Why they may want to avoid selling on the open market
How to persuade a seller to agree to a long option period?
What is a call option?
Okay, let's get into how we negotiate a longer option period to give you all the time to create value and equity without ever owning the development site or property.
But first: A call option gives the developer the right (but not the obligation) to buy a property at a predetermined price and on specific terms before the option period expires.
This means the developer effectively controls the land without owning it and without paying for it.
The two types of Option Contracts
Call Option - gives the buyer the right but not the obligation to buy a property for a certain price and under specific conditions within the option period.
Put Option - gives the seller the right but not the obligation to make the buyer buy their property for a certain price and under specific conditions within the option period.]
In the beachfront example above, the developer obtained development and building approvals, pre-sold 50% of the end units and secured funding all before settling with the landowners.
Once all the council improvements were successfully obtained and sufficient pre-sales to prove the appetite for this product in the local market, the value of the site rose above $20mil.
At that point the developer could have opted to on-sell (assign) the option to another developer before settling with the landowners and pocketing some big coin. Contrast that with the developer who may have paid $7mil in cash 3 years earlier without any certainty that they would obtain the the requisite regulatory approvals to ensure profitability of the project. Obtaining some pre-sales also helps ensure the GRV in the feasibility is realistic.
Anyway, $7mil a lot of money to tie up for very little certainty.
What if it went wrong?
There were some complexities to this project that very nearly derailed it. There always are issues as any developer will tell you. The developer may in time realise that the project is not as feasible as originally thought (sales slow down, costs go up). In the current market this is occurring more often due to the rise in buildings costs which are making some projects unprofitable.
Maybe the developer could not secure the level of pre-sales originally thought possible which may indicate to prospective lenders that there is low local market acceptance and the project is too risky for them.
As a result, they simply do not exercise the option and may lose their option fee but this is likely a minor cost compared to tying up capital for 18 months or embarking on a doomed project.
The developer may secure better funding terms when given the time to optimise the feasibility based on the pre-sales and buyer feedback.
So the benefits of a call option are obvious.
Introducing "data-driven" call option agreements
Let’s get into the meat of this.
In essence we are going to use property market data, and the negative market sentiment in general, to emulate what my developer partner did in the example above i.e. negotiate a longer option agreement based on the facts and supporting market data.
One of the challenges in a booming market is land owners are conditioned to believe their land is the next undiscovered gold mine and their price expectations match this. That's why we don't want to be looking for sites in a hot market.
Rather, target areas where demand for property meets supply i.e. in a balanced market.
By using property data to target the most suitable areas, it’s more believable to the landowner when you justify why you believe a longer option period is fair.
Luckily Boomscore subscribers have the ability to scan and score 15,000 suburbs to help them put together an argument for a longer option period.
Boomscore incorporates 9 property market supply and demand indicators into an algorithm that calculates the ratio of demand to supply for both unit and houses in 15,000 suburbs. This removes the idea that there is only one property market (spoken about in the media) but rather 15,000 micro markets all with their own supply and demand dynamics.
What if you were to target those suburbs where the data not only supports a profitable development in the future but a greater ability to secure a site on a long option today?
If there are any option short sellers reading this article I'm sure this is getting very exciting.
THREE steps to securing a longer option period?
The process starts with a simple question: do you know the suburb where you wish to secure the call option in or not? When you do, you need to check that the market data support the terms you seek.
STEP 1 - identify balanced suburbs
You can either check the Boom Score for a location you are already interested in by using Boomscore Suburb Profiler or head over to Boomscore Hotspot Finder to find suburbs that are neither booming nor busting. We want to be negotiating in a market where prices are neither rising nor dropping i.e. a balanced market.
A balanced market is a market where the demand for property matches the available properties for sale in that market.
In Boomscore, these are suburbs that have a score of between 41-60 out of 100 and are categorised as a "healthy" market.
Stash Property subscribers can see their preferred location's Boom Score in the opportunity search screen. Don't forget to click on the Boomscore link to assess the suburb supply-demand data behind the summary score.
The key outcome in step one is to cherry-pick a handful of locations that have a balanced demand to supply ratio. You can use Boomscore to find these location within a defined radius of capital CBD or any other area you select on a google map.
This on its own, however, is not enough. The data behind the summary Boom Score can tell a very different story between two suburbs with the same score.
STEP 1 - check the data trends
This is where we get to the data-driven part of the data-driven call option strategy.
You want to be negotiating for a site in a market that is balanced today but has the chance of having a higher demand to supply ratio (Boom Score) in the future when it’s time to on-sell the option or undertake the development.
WARNING: Two suburbs with the same Boom Score might not be equal when examining the trend in their Boom Scores.
As you can see below, Suburb A and Suburb B are both 'balanced' markets with a Boom Score of 55/100 today, however, Suburb A is trending up meaning demand is growing faster than the corresponding supply.
The opposite is true for Suburb B. For some reason the ratio of demand to supply is dropping meaning demand is dropping relative to supply. It's your job to know why before negotiating a longer option period and/or then flicking this option on to a developer.
SUBURB A : Boom Score is improving over time. This could be a 'buy' indicator.
SUBURB B : Boom Score is declining over time. This could be a 'sell' indicator.
In step 2, the aim is to convince the landowner that the market is balanced, demand for property in their suburb is not crazy hot like it’s 2021 and that you will need more time to establish the demand levels in the market. You may need the time to prove this demand potentially with some pre-sales.
Likewise, you could argue that you need to get some confirmation (DA approval) from the council if you intend flicking the call option with a DA.
Fo you think the landowner would be ready to give you a long option now simply because you have illustrated that they are not in a booming location and that the media headlines are shouting doom and gloom? Possibly. But I doubt it.
There’s more to do: let’s build the case for this further in step 3.
STEP 3 - analyse the individual indicators
Given the demand to supply ratio (Boom Score) is calculated using 9 different indicators, let’s further examine some of the indicators that are more aligned with targeting suburbs suitable for property development and for the purpose of securing a longer option period.
Remember, you will use Boomscore for both analysing the market to justify a long option period, however, you also need to balance this with ensuring that the ratio of demand to supply for your (or you end buyers) end product is in your favour. It’s pointless securing an option for a site that will result in completed properties that nobody wants (low demand).
Days on Market (DOM)
Days on market indicates how long on average it takes for units or houses to sell based on when they were first listed for sale and then sold.
If the landowner can see properties sell very quickly in their area then they may be less inclined to give you a lengthy option period.
If properties generally take a long time to sell then you could argue for more time to test the market with local agents and factor in more time - a longer option period - to test the market for pre-sales.
Of course, you will have established using the charts in Boomscore that the trend in DOM is in your favour so you don’t mention this to the landowner. You also don’t want to be on-selling an option to a developer who can see their new stock will take longer than average to sell.
So the trend data can help both market the option to an incoming buyer and give you peace of mind that the target area is improving.
Stock on Market Percent (SOM%)
SOM% is a measurement of the number of properties listed for sale relative to all the properties in the location. The lower this percentage the lower the supply to meet market demand.
You want to ensure there is sufficient competition to show the vendor that there is quite a lot of properties for sale and that you need more time to ensure your development application reflects what the market wants so you can beat the competition.
A high SOM% also tells the vendor that they may not rationally expect a high premium in a market with a lot of supply.
Market Absorption Rate (MAR)
Property media may say the market is 'cooling' and the used examples of how the number of properties selling at auction has dropped from 80% to 40%. They may say there is more supply and less demand because the number of listings on the property portals has increased by 30% and the number of sales has dropped by 20%.
The market absorption rate gives more meaning to what the number of listings and the number of sales in a market actually mean. On their own, each indicator is meaningless but when you examine the ratio of listings to sales it's easier to understand what this means.
You could visit the property portals and observe how many properties were listed versus how many were sold in the same period, however, Boomscore has done this for you.
The market absorption rate is calculated by dividing the average number of sales per month in an area by the total number of properties available for sale in the area.
Remember, the data is not always flawless particularly at the suburb level. There may be few sales in a given month in a thinly traded market. Perhaps the estate agent incorrectly entered the sale date which is used to derive the days on market.
So it’s important to make sure the indicators corroborate one another.
For example, if the SOM% is very low but the DOM is very high then something is wrong. Why would properties in an under-supplied market be taking so long to sell?
Remember there are 9 indicators in Boomscore which may have different meaning depending on your overall strategy e.g. 'call option to renovate and hold' or 'call option to obtain council approvals and sell to developer'.
What to consider in a declining or booming market
Call options in a rising market
When the market is rising, many vendors will be reluctant to lock in a long term call option because they may feel the market value of their property may exceed the option price in the future. In a declining market, this can be an advantage to the seller because a fair market price today may be more than the market value when the option is due.
Call options in a declining market
Buyers might be reluctant to offer a premium when there is uncertainty about how much prices for sites and the completed product might drop in the future.
The benefit to buyers in a declining market is sellers should be more likely to accept that they cannot expect a premium for their unimproved land and will be more likely to offer better terms (e.g. longer option period) in exchange for an above market price for their unimproved property.
The danger of offering too much for a site in a declining market is you don't know how much property prices may drop in the area by the time your project is completed. Your end buyer will factor this in when calculating the project GRV and ultimately the RESIDUAL VALUE (the maximum they can pay for a site after factoring the total development costs (TDC), profit margin and Gross Revenue Value (GRV) or total revenue from sales.
The importance of the Ratio of Demand to Supply
Gathering your ‘arguments’ begins and ends with quantifying supply and demand for property in the location of your target site. If demand is high with low corresponding supply then you’re still operating in a hot market.
If, however, you target a location where the ratio of demand to supply is ‘balanced’ but likely to increase in the future (after you have locked down the call option agreement) then you are off to a great start.
Now over to you...
With a solid understanding of the Boom Score market data, hopefully this will make it easier to secure your next call option on terms that give you the time to craft a profitable deal to develop or on-sell. With some practice you’ll start seeing deals that others will not.