Purchase and Repurchase Options — Good or Bad?

In recent years, some syndicates offered to the public contained repurchase or purchase options. The syndicator or seller reserved the right to repurchase the property which he is selling to you and your co-investors. Sometimes the lessee has the option to purchase the property.
What is meant by a purchase or repurchase option? It is the right of one party to buy the property. Note that it is a right—not an obligation. The terms of the option are determined by the option agreement and are set forth in your brochure. For instance, a syndicator may reserve the right to purchase the property from the syndicate at any time between the 5th and 15th year after the syndicate comes into being. Such an option will contain the price which a syndicator must pay if he decides to exercise the option. The option could state that for every year during which the syndicate owned the property, the buyer would have to pay a 4% profit on each participant's investment. Thus, if the syndicator buys the property after 7 years, he will have to pay a price sufficient to pay each investor 28% above the amount invested. (7 x 4%).

As we said before the option is not an obligation to buy on the part of the person who owns that option. It is a one-sided affair. That person has the right to buy your property. He is under no obligation to do so. Naturally, the owner of such an option will only exercise it if it is profitable for him.

How Purchase Options and Repurchase Options Affect the Value of Your Investment

Let us see how such a purchase option affects the growth potential of your investment. Suppose the syndicate has bought a property for $1,000,000. It paid $200,000 cash and gave a mortgage for $800,000. The syndicator has the option to repurchase the property. He must pay a price which will give you 4% profit on your investment for every year the property was held. Five years after the property was bought, its value increased 20% to $1,200,000. If the syndicator exercised his option, —and you may be almost certain that he will do so in this case—he has to pay a price which will give you 4% per year profit on your investment or 20% for the five years during which the syndicate owned the property. The total cash investment of all investors was $200,000. Therefore, the syndicator must see to it that the investors get $240,000. This means he can buy for $1,040,000 a build- ing worth $1,200,000, ($240,000 cash over the mortgage of $800,000.) You and your co-investors together make a $40,000 profit on a $200,000 investment. The syndicator makes a $160,000 profit. He did not run any risk. If the value of the building had gone down, he would not have exercised his option. Furthermore, that profit is made at the expense of the investors. If the syndicator had not had this option, the increase in value would inure to the benefit of all investors. Their investment, instead of being worth 20% more, would have doubled in value.

The example does not take into consideration that the mortgage would probably have been reduced over the five years during which the property was owned by the syndicate. This may be a source of an additional substantial profit to the syndicator, particularly on motels and bowling alley propositions where mortgages reduce very quickly. Suppose that the property did neither go up nor down in value at all, but that $200,000 of the mortgage indebtedness was paid off during the five years. If the syndicator had an option to repurchase which provided merely that he has to pay a sum which would give the investors a profit of 4% per year, he could now buy this property for $840,000. $600,000 was the amount of the mortgage. $240,000 would be used to repay you and your co-investors and to give you 20% profit on your investmerit. In this instance, the syndicator could buy your property for $840,000. Only $600,000 remains due on the $840,000. He could buy it at $160,000 below its value and realize a profit of $160,000 at the expense of you and your co-investors.

These examples show the disastrous effect which purchase and repurchase options may have on the growth potential of your investment. Options are a one-way street, but you will always be facing the wrong direction. If the value of the property goes down, the option will not be exercised and you may lose your investment. If the value of the property goes up, the option will be exercised and someone else will get the lion's share of the profits realized on your investment, and he will get it without taking any risks.

Do not believe that we are talking about things which may appear in the brochure but do not really happen. A number of syndicators have exercised their options and repurchased properties sold to syndicates several years ago. Scrutinize your brochure for any purchase or repurchase option or agreement, and examine its terms. Make sure you understand how the terms affect the growth potential of your investment.

Next: What Factors May Stunt the Growth of Your Investment