In commercial and residential leases, declarations, purchase agreements, and other instruments, parties variously create (i) options, (ii) obligations, and (iii) what are referred to as right of first refusal, but actual terms of each of those “rights” may depend on the phraseology in the document.
As an opening proposition, unless specifically defined by statute or case law — or the legal document itself, words and phrases as used in legal documents have the ordinary and common meaning ascribed to them in the English language. Frequently, as is addressed in this article on condominiums and landominiums, words simply mean what we say they mean — the legal document defines the meaning of terms, perhaps other than what the typical colloquial meaning.
Let’s start with “options.” Tenants may negotiate the following common types of options in a lease:
- Option to purchase at a fixed or variable price;
- Option to expand the leased premises;
- Option to contract (reduce the size of) the leased premises;
- Option to terminate the lease early, perhaps with a buy-out price paid to the landlord; and
- Option to renew the lease for a number of terms after the initial term.
Conversely, a Landlord, commonly seeks a right or option to relocate the tenant to another space to give him flexibility to lease out his building as he best sees fit.
As a general rule, all of these options are as enforceable as the base lease — the tenant or landlord can really impose upon the other party significant burdens from these options, especially as the passage of time makes exercise one or more of the options valuable. For example, imagine that a tenant today could negotiate a current “fair market value” option to purchase for the ten buildings in which he rents for a period of ten years. Invariably at least one of those buildings may rise in value, while others may fall. The tenant has a tremendous advantage of being able to buy the one that has risen in value after the price was negotiated, while ignoring the remainder in which it has fallen or stayed the same.
Some considerations for options:
- What are the terms of the option?;
- How and when must the option be exercised?;
- What if tenant is in default under the lease, can he still enjoy that right?;
- What if tenant formerly was in default, but has cured it, does the option spring back to life?; and
- Is the option binding upon future buyers of the property?
I am surprised at how often tenants and landlords overlook the choice when negotiating a lease to include in that instrument an obligation in the tenant to buy the property at a fixed or calculated price at or before the end of the term.
Many times as a client is explaining the business terms of a transaction to me, they say that they want an “option” to purchase in the contract or lease, when what they are describing to be is a fixed obligation to purchase (or to expand, etc.).
So, explore with the client when they discuss an option what they really mean by that term.
Right of First Refusal
Then we get to the always-confusing-term, “right of first refusal,” and its counterpart that some insist is an entirely different animal and some insist is exactly the same — “first right of refusal.” And then something called a “Right of First Offer.”Huh?
Under a classic “right of first refusal,” it typically proceeds like this: Tenant is in a building and is happy to be the tenant. But tenant might someday like to buy the building, or may not want a landlord different than the original one.
Thus, they hum along for years under the lease, but the lease provides that if landlord receives an offer to purchase the property that he is otherwise inclined to accept, landlord must offer the building to the tenant on the same terms as that third party offer, before accepting that offer, and give to tenant, say, a week to decide if he wants to buy on those terms or not. This right in the tenant is what I would refer to as a classic “right of first refusal.”
Some important considerations when negotiating a right of first refusal:
- Does the underlying offer have to be an arms length offer from a bona fide purchaser?
- Should we have some fail-safe terms that are fixed in the tenant’s rights — such as 90 days to close — so that that the very terms of the buyer’s offer would not make it impossible for the tenant to accept and perform.
- If the routine is followed — offer from third party, option in tenant to exercise, and the tenant declines to exercise the right — but the third party contract does not happen (either is not signed or is not closed), what then occurs? The parties should be clear whether the “right” again springs to life or whether it expires.
- How long does the tenant have the right to exercise the right, and how does he communicate that to the landlord? What happens if that procedure is not tightly followed? Is the landord then free to sell the property without the right in place.
- And, finally, if a third party buyer buys the property, does the right of first refusal then spring to life when that buyer tries to sell the same building to yet another party? Could we, for example, say that the option is extinguished if the landlord sells the building to a third party?
And to make you tear your hair out, I have seen contracts that say that “tenant will have the Right of First Refusal to buy the real estate for $1,000,000.” Huh? That’s maybe an option to purchase, but not a “Right of First Refusal.”
And to really confuse things, we have had a lease with both an option to purchase and a right of first refusal. Wow. What if a third party offer comes in at a price above the option price? That triggers the “right of first refusal” in the tenant, but does it extinguish the option to purchase? If not, the tenant could just buy the property at the lower price, and turn around and sell the property to the third party buyer for the offer price, and pocket the profit (and deprive the landlord of that margin). Ouch for the landlord.
Right of First Offer
Then the animal “Right of First Offer.” This article explains that as:
With the right of first offer, a business partner or tenant is granted the right to make the first offer on a business or property. The seller is free to accept or reject the offer, and the seller is always free to return to the buyer if he can’t get a better deal.
I candidly don’t have any idea what that means, as any buyer has a right at any time to make an offer to buy a business or real estate. They don’t need someone’s permission to make an offer.
This article says a “Right of First Offer” springs to life when the landlord decides to sell a property. Then, you must give tenant first negotiating dibs before offering it to the marketplace generally. OK, that makes some sense, but it is still a pretty weak right.
First Right of Refusal
And how about “First Right of Refusal.” As this article seems to say, it seems like the same thing as a “Right of First Refusal.” I also have seen the use of this term more like the “Right of First Offer” — give me first negotiating rights before offering the building on the market generally.
Instruments other than leases
This blog entry addresses options, obligations and rights of first refusal in the context of the landlord/tenant relationship, as that is most frequently where we see these arise. But they can just as well be present in corporate buy-sell agreements, limited liability company operating agreements, or even in free-standing documents that have no other terms. In the case of the latter, the holder of the option should carefully consider the issue of giving consideration for the grant of the right from the owner of the asset.
First, landlords should be cautious about giving these various rights to tenants — and moreover assuring that it is not granting overlapping rights to more than one party. What if, for example, three different tenants in a building want a right to purchase, or two tenants have rights to expand into the same premises?
Second, all of these rights tie up a landlord operationally and may be obstacles to concluding a sale of the building to a third party.
But with those caveats, a landlord can provide significant value to a tenant by adding flexibility for his operational needs, thus allowing additional momentum to a landlord to fully rent his property.