Category Archives: Residential Real Estate

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.

Variable price

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.

The exercise

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.

Non-exercise

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.

Conclusion

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 transnational team, Chris Finney (513-943-6655), Isaac Heintz (513-943-6655), or Rick Turner ((513-943-5661).  For litigation support regarding a dispute over an option to purchase, contact Brad Gibson (513-943-6661).

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Finally, here are some good articles for additional reading on options to purchase real estate:

Option Contracts for Buying & Selling Real Estate from Lawyers.com >>

Who Really Needs a Real Estate Option Contract? from Realtor.com >>

Consider the Consequences of Your Options from the CCIM Institute >>

In most circumstances, real estate law is a remarkably simple discipline: (a) read and understand the contract (or deed or declaration) and (b) the order of recording is the order of priority.  Now, these rules are not always followed, but they give us a general framework within which to practice.

However, two curveballs in real property rights are what we refer to as “adverse possession” or a “prescriptive easement.”

Adverse possession

An owner of land owns his property as against the claims of all others — it’s a pretty simple concept.  But in most states actual ownership can be “taken” from the owner — without a court proceeding — through “adverse possession.”  In Ohio the timeframe is 21 years and in Kentucky  it is 15 years.

In law school, we learn the acronym: O-C-E-A-N to describe the five claims the claimant must establish by a preponderance of the evidence to establish adverse possession.

• Open
• Continuous
• Exclusive
• Adverse
• Notorious

The idea is that the claimant must in all manners have acted as the owner of the property, and have openly asserted to the world, continuously for the period of time in question, his ownership of the property.  This is a very tough standard, indeed.

A typical fact pattern we see as to adverse possession claims is that a claimant mows the law, trims the bushes, or operates an ATV across the disputed property (in fact owned by the neighbor) for a prolonged period of time.  The actual owner of the land comes to our firm to express concern about these activities.  Now, other than the public liability concerns for such activities (what if someone gets hurt!), there is a risk that the user will someday claim ownership of the land via adverse possession.  How do we prevent this?

It’s actually pretty simple to fix this.  If the user is using your land with permission, then the claim is by its nature not adverse.  So, I advise clients to send to their neighbors using their land a certified letter granting revokable permission for the use in question:

• “Hey, I’ve noticed that for the past 10 years you have been cutting the grass on an acre of my property.  I wanted you to know how much I appreciate this and to give you permission to keep cutting my grass, until I change my mind.”  

It’s magical.  With one simple and polite letter, sent via certified mail and saved in a permanent place, you have eliminated any potential adverse possession claim, as long as it is sent before the 21 years (in Ohio) or 15 years (in Kentucky) lapses..

Now, there are many other issues with establishing an adverse possession claim:

• What if there were multiple owners over that 21-year period of time?  That is OK as far as an adverse possession claim goes, but it presents a proof issue.
• What if others have also used the land?  Then at best it is a prescriptive easement claim (see below).
• Is “who pays the tax bill” dispositive as to an adverse possession claim?  It is persuasive, but not dispositive.
• Can a tenant assert an adverse possession claim?  No, their occupancy is by its nature permissive, not adverse.

Prescriptive easement

A prescriptive easement claim is asserted and analyzed in the same manner as an adverse possession claim except:

• The interest asserted is an easement interest, not a fee simple (ownership) interest;
• The “E” from the acronym OCEAN is eliminated; the use does not need  to have been exclusive to establish a prescriptive easement claim.

The result of a successful prescriptive easement claim is not ownership of the disputed property, but rather establishes a non-exclusive easement to use the land in question for a specific purpose.  So, a shared driveway area or a common utility line would be classic examples of a claimed prescriptive easement.

How claim is asserted

I suppose neighbors could just acquiesce to the adverse possession of another, and lawyers and judges would not need to be involved, but that’s not typically how we see it working.  The way we see adverse possession asserted is that one neighbor sues another neighbor either (a) to stop an offending use or (b) to ask the Court to declare ownership of the subject property via adverse possession.  Because of the very long timeframes involved, the proofs can be difficult on each side.  Cases in which physical improvements have been built long ago are the easiest to establish an adverse possession or prescriptive easement claim.

Conclusion

The moral to this story is that a property owner cannot simply sit on and ignore his property rights; he must vigilantly defend them, lest their ownership just evaporate by his neighbor’s use of his property.  It does happen.

Most of the times this occurs in a commercial setting, it can be expensive and even interrupt operations of the business.  In the residential setting, most of these claims seem to settle as a result of the small value of the land at issue versus the tremendous cost of litigating.

I link below to few articles on adverse possession for further reading.

Adverse Possession Law >>

Adverse Possession: When Trespassers Become Property Owners >>

What Is the Difference Between Adverse Possession and prescriptive easements >>

If you become a party to an issue involving adverse possession or prescriptive easements, let the professionals of the Finney Law Firm “make a difference” for you.

 

Oral settlement agreements are enforceable as a general legal proposition.

We addressed in this blog entry the relatively absolute principle that the statute of frauds requires agreements relating to the purchase and sale of real estate be in writing and signed by the party who one intends to sue.  But when it comes to resolving disputes, especially litigation, that rule is thrown out the window.

This sounds like some legal double-speak, but even though the sale of real estate requires signature, the settlement of a dispute regarding the purchase and sale of real estate does not.  The statute of frauds does not apply to settlement agreements.

So, when parties are involved in litigation, and settlement discussions ensue, all things said and agreed to in oral conversations are enforceable as a matter of contract.  Further, this rule applies when matters are pre-litigation.

Many times when my client is involved in a dispute, the other party asks whether they can have settlement discussions alone, without the attorneys involved.  I like the idea, as it can permit the parties to overcome obstacles to settlement that the attorneys cannot.  But the problems with this approach, as I explain to my clients, are twofold: (i) first what the client may say that hurts his case or agree to that could resolve the case on terms he does not agree and (ii) even if my client does not say anything precipitous, the other party could claim he did.  And then we have an argument about proof of what was or was not said in that private meeting.

As a result, I frequently require a written agreement signed by both parties before such a meeting promising that (i) no agreement will be binding unless and until it is memorialized in writing and signed by both parties, and (ii) anything said in such a meeting with not be used or referenced in any way in the litigation proper.

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.

Options

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?

Obligations

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.

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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.

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Conclusion

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.