August 16, 2015
This article is an in-depth exploration of options to purchase real estate, a powerful tool for real estate developers to “kick the tires” of real estate before committing to buy, and an important right in tenants to purchase their property — rather than continuing to lease.
NOTE: this article exploring the distinction between Options, Obligations and Rights of First Refusal.
An option to purchase real estate typically places the prospective purchaser completely in the driver’s seat of a transaction — giving him the unfettered option to purchase real estate, usually at a fixed price. So, the operative language for an option to purchase may look like this:
Purchaser [tenant] has the exclusive right and option to purchase the real property described on the attached Exhibit A during the term of this Agreement [Lease] for the price of $__________________.
There are several key considerations to options for both parties and then several components that should be addressed in a written option to purchase agreement.
In addition to fixed-price options, the parties could agree upon all sorts of formulas for establishing the price, including:
- If the option to purchase will extend out over a period of years, a CPI or inflation adjustment may be appropriate;
- If the building is a multi-tenant facility, it may make sense to base the purchase price on gross or net income divided by a cap rate, or some other formulation;
- Parties frequently base option prices on an appraisal, or multiple appraisals, to ascertain value at the time of the exercise. Regardless of how “fair” or “objective” this may seem, appraisals on commercial buildings can vary widely based upon the appraiser and the assignment he has been given. Appraisals are also very expensive; and
- Finally, please resist the temptation to agree upon “market value” or “an agreed price” at the time the option is exercised, for “an agreement to agree to something later is no agreement at all.”
Get it in writing
As this article explains, the statute of frauds in each state will govern an option to purchase agreement — and as such it must be in writing and signed by the party against whom you want to enforce it, or as far as the law is concerned, the claimed transaction simply did not happen.
Contracts many times act as options
Most commercial contracts to purchase real estate are really options when you think about it. What I mean by this is that the contingencies to the buyer’s performance typically are so open-ended in commercial purchase agreement, that the buyer can simply “opt” to buy or not buy before the close of a due diligence period. Thus, following the line of thinking above, does it make sense for the buyer to have some “hard, forfeited money in the game to obtain this valuable right from a seller? It’s at least something to consider.
An option is a contract when it has been exercised
Conversely, once a buyer exercises his option to purchase real estate, he is then obligated to purchase the real estate and the seller is bound to sell. Thus, the instrument — upon its exercise — becomes exactly the same as a contract to purchase. The question is thus, on what terms?
Because it may be too late to negotiate key contract terms after the exercise of the option, all of the components of a purchase contract should be called out in the option. These should include, at a minimum: (i) quality of title, (ii) closing date, (iii) date of possession, (iv) tax and rent prorations, etc. In a lease, many times the “option to purchase” is relegated to a single paragraph or section, but even if so, these contract provisions (along with the other components noted below) should be carefully addressed in that one paragraph.
Free-standing option or part of another instrument?
Often, an option to purchase is a component of another instrument — usually a lease — or it can be its own freestanding “option to purchase agreement.” In leases, options to purchase is most common in situations in which the tenant is occupying the entirety of the real estate. Further, an option to purchase can be an important component of sale-leaseback agreements and build-to-suit arrangements, both of which can be viewed as, at least in part, financing vehicles. Regardless of the genesis and context of the option to purchase, the matters set forth in this blog entry are appropriate for consideration.
As to free-standing option agreements, it is common that the buyer of the option pay the seller a sum of money or other consideration for the option. First, this is required under the contact principle of “consideration.” Without something paid for the promise to sell, the contract may fail for lack of consideration. Further, as the option gives the buyer the open-ended right to sell or lease the property to others once he exercises the option and buys the property, it provides substantial value to a buyer — this is something the seller may not want to just give away.
On the other hand, the seller may not be overly anxious to force a significant price for the option, as it is an effective way of marketing a property through a qualified developer that otherwise might sit unused and unsold for years.
The option period
During the option period, the seller is unable to convey clear title to a third party (because it would be subject to the option in the buyer), and the buyer typically performs his due diligence, markets the property for sale or lease to third parties, obtains zoning and other regulatory approvals, and obtains his financing.
Commonly, an option to purchase is for a fixed period of time. So, for example, if the option is part of a lease with a three-year term, the option would run concurrent with that three year-term, or perhaps need to be exercised no later than 90 days preceding the lease expiration. In the case of a term that runs concurrent with a lease, consider (i) options to renew and (ii) holdover periods. How will the option be handled during such periods as well? Some proposed language:
The term of this option will run from the execution of this Agreement through December 31, 2020.
– or –
Tenant may exercise this option throughout the term of the Lease and any extension or renewal hereof, provided that it must be exercised no later than 90 days prior to the expiration of this Lease. The option is not effective during any holdover period.
Other times, the period within which the option must be exercised hinges off of the due diligence period. So, if a buyer has six months to physically inspect the property and to obtain his zoning and other regulatory approvals for a new intended use, then the option period may run 60 days beyond the close of that due diligence period. A problem, especially for a seller, with this approach is that if it is not clear that the buyer has to proceed with diligence with his inspections and regulatory approvals and there is no closed-end date for that due diligence period, then the option date never arrives, and title to the property is perpetually clouded until the buyer makes up his mind — which he may not be motivated to do.
We address that issue in this blog entry: Advanced commercial real estate: Seller beware, the contract that doesn’t end. Typically language that bases the option period on due diligence inspections would not be used within a lease. So, some proposed language for freestanding option to purchase agreements:
This option may be exercised by buyer up to sixty days following the close of the Due Diligence period as the same is defined in Section 3, above.
In any event, to properly draft an option to purchase, the period of time, or formula for determining the period of time, within which buyer has to exercise the option should be clearly stated.
Perhaps where many options “fall down” in the drafting is in clearly explaining what the buyer must do to exercise the option, and that the option is then forfeited if not exercised within that period of time. When, where and how the option should be exercised and when and how the option expires for non-exercise (or otherwise) are important components of the drafting of an option to purchase instrument. Again, some proposed language:
This option may be exercised on or before the Expiration Date by buyer delivering to seller written notice of the exercise of the option by hand delivery or certified mail.
What then happens if the option is not exercised within the option period? The instrument should make clear that the option then expires and the buyer/tenant has no right to purchase the subject property. Some model language:
If buyer [tenant] fails to exercise the rights granted by this option as and when provided for herein, then this option will be deemed to have expired, and buyer [tenant] will have no right to purchase the property. Time is of the essence as to the option period, and the exercise of the option as provided herein.
Special lease provisions
When an option to purchase is contained in a lease, some special matters should also be considered. For example, what if the tenant falls into default in the payment of his rent? Landlords frequently want to either revoke option rights completely upon one default, or more likely suspend the tenant’s option rights during the period of any default. Thus, the grant of the right may be preceded by the language: “So long as tenant is not then in default of any of its obligations hereunder.” Other things to consider with options built in to leases are:
- The due diligence inspections usually are not needed as the tenant is familiar with the property, and indeed may be the cause of conditions present at the property; and
- Tax proration issues can be complicated if the tenant is paying the taxes as a part of his lease payments.
Title and recording
And as is addressed in this article on tenant’s rights in a receivership, the title to the property in which rights are granted by the owner is important. For, if the property is subject to a pre-existing lease, mortgage, option to purchase or other instrument that precedes the new option to purchase, then the new option to purchase is likely to be subject to the right of the tenant or grantee in that prior instrument.
- In the case of a mortgage, the mortgagee can wipe out that later-granted option with a foreclosure proceeding.
- In the case of a tenant, the option to purchase would be subject to the tenant’s rights, which may well be under a long-term lease.
- In the case of another optionee, the pre-existing option may take priority over the new one, thus defeating the right to purchase in the later instrument.
Now, to be clear, the seller of the option may have liability to the buyer for breaching the agreement, but for a buyer that has paid, say, $100,000 for the “rights” to buy a building, a worthless claim against an insolvent seller will be little consolation.
So, how does a buyer under an option, whether a tenant or a buyer under a free-standing option agreement, proceed with assurance that his option rights will take priority over the claims of others:
- Perform a title exam and visually inspect the property as to tenants or other occupants (say, a neighbor with an encroachment) who may have pre-existing rights;
- Get written subordination agreements from those with superior rights to the option to purchase or clarify that they do not have superior rights, such as through an estoppel certificate; and
- Once priority is established through those first two steps, record the new option to purchase so that the world is placed on notice of the priority of the rights created by that instrument.
An option to purchase can be seen as a casual commitment by both the buyer and the seller, because it may appear preliminary to a transaction actually transpiring. But, in reality, it usually grants powerful rights to the buyer that, once exercised become a binding contract. Further, from the buyer’s perspective, before paying significant sums for property optioned or investing monies in due diligence work, it behooves the buyer to carefully consider and then address superior rights of others in the property.
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If you need assistance with properly framing an option to purchase agreement, as buyer or seller, we encourage you to call any member of our real estate transactional team, Chris Finney (513-943-6655), Isaac Heintz (513-943-6655), Rick Turner ((513-943-5661) or Tracy Hawkins (513-943-6667). For litigation support regarding a dispute over an option to purchase, contact either Justin Walker (413) 943-6660) or Brad Gibson (513-943-6661).
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Finally, here are some good articles for additional reading on options to purchase real estate: