Also in this Issue:
-Stock Options: The Basics
-A Brief Guide to Stock Option
Taxation and a Few Illustrations
-Gifts of Stock Options for Estate
Planning Purposes
TIPS AND TRAPS FOR OPTIONS IN REAL ESTATE CONTRACTS
by Jonathan Rivin rivin@ddrs.com
Frequently, options are included in real estate purchase and sale contracts and leases. Less often, mortgages, deeds of trust and other real property contracts contain options. An option is simply an offer to sell or lease on specified terms, irrevocable for the term of the option. Options are used for many reasons, including due diligence, speculation, assemblage, positioning for exchanges, to substitute for an agency relationship, as part of buy/sell arrangements in partnership or corporate agreements, as an alternative to partnership or as an element of financing.
This article assumes a working familiarity with real estate options and discusses some of the less obvious advantages and defects in their operation.
Material Terms. An option contract must be in writing and must contain all material terms of the purchase or lease transaction. Without a description of the parties, the property, the price and the method of payment, the optionee’s right to enforce the contract is jeopardized. While tempting, since it is "only an option," bare bones drafting of the option contract will preclude later negotiations over issues which, while not a bar to enforcement, would ordinarily be included in an ordinary agreement, such as representations and warranties, conditions of title, allocation of costs. TIP: Treat negotiation of the option agreement equivalent to negotiation of the full-blown purchase or lease agreement.
Separate Consideration. If separate consideration is not received for a purchase option, then the option is not enforceable, i.e., the offer may be revoked. The consideration can be slight, and courts seem to go to great lengths to find adequate consideration (use of a car has been held sufficient), but if the only consideration is a fully refundable payment, the option probably cannot be enforced. Note that no separate consideration is required if the option is contained in a lease; the lease terms are considered sufficient consideration. TRAP: Negotiating a fully refundable option price may be self defeating, giving the optionor the right to walk away from the deal.
Ongoing Negotiations. An attempt by the optionee to renegotiate the deal terms or to exercise the option on different terms will not serve to terminate the option or as a rejection of the irrevocable offer. The option remains in effect for its term. TIP: There's nothing to lose (except good will) by attempting to renegotiate the deal terms during the term of an enforceable option.
Non-Refundable Deposit. Many sellers utilize option agreements to alleviate any question that a non-refundable deposit really is non-refundable. In a standard purchase agreement with a buyer’s due diligence period, retention of a deposit after termination of the agreement by the buyer is arguably a penalty, since the buyer has not breached any obligation. The standard purchase agreement can be drafted to denominate such payments as "liquidated damages," but, again, without a breach, there is some question as to the seller’s ability to retain the deposit. A non-refundable option payment is equivalent to liquidated damages in a purchase contract, if the seller waives all other remedies. If the option payment is too great, however, the contract may be recharacterized as a purchase agreement. TIP: A non-refundable deposit paid as option consideration can be retained without concerns about breach of contract and penalites which arise under a purchase contract.
Time and Manner of Exercise. Time is always of the essence in an option agreement, so an optionee who fails to exercise within a clearly stated term generally will not be able to avoid termination of the option. The optionor, however, must give notice of late or otherwise faulty notice, or it will be deemed to have waived the strict requirements for exercise. In extreme circumstances, a court may give the optionee some leeway, using its equitable power to prevent forfeiture. TIP: Be sure to calendar the operative dates of any option to avoid inadvertent lapse of the option or de facto extension of the option.
Matching the Terms in a Right of First Refusal. In many cases, a third party’s offer will contain terms which the holder of a right of first refusal cannot match exactly, e.g., personal credit qualifications or unique consideration, such as exchange property. In matching the terms of a third party offer, the holder of the right of first refusal is required only to provide "reasonably equivalent value." TRAP: Don't assume that a right of first refusal is defeated by a "unique" offer; find alternatives to put the optionor into a reasonably equivalent position.
Option to Convert Debt to Equity. A mortgage or deed of trust giving the lender the right to convert the loan to an equitable interest in the property may have benefits for both lender and borrower, substituting for a partnership agreement. The lender receives a fixed return as a debt holder, but has the right to participate as an equity holder if the project is successful. The borrower obtains favorable financing terms and does not have the oversight of a partner during the project. There are legal hazards to be considered, such as potential loss of priority in a bankruptcy and recharacterization of the option as an equitable mortgage. TIP: Consider a convertible mortgage as an alternative to partnership arrangements.
Issues in Negotiating Lease Extension and Expansion Options. An option to extend a lease term or lease additional space for a rent "to be agreed upon" does not create an enforceable option, because there is no objective basis for determining the rent. Creating a procedure for determining "fair market rent" is frequently the solution to the problem of unknown future levels of rent, and arbitration is often the method for resolving questions of the market rent. The landlord will want to require that the new rent will be no lower than the existing rent and will want the market rent calculation to apply to the highest and best use for the premises, without consideration of concessions or rents paid by equity tenants and extension tenants. The tenant will want the right to revoke its exercise of the option if the rent as determined is unsatisfactory. TRAP: An extension or expansion option with rent at "market" leaves many key issues unresolved and may lead to litigation.
Options provide a great deal of flexibility in real estate transactions. They should be considered as alternatives to various other contracts, but should be carefully negotiated so that disputes about their intent and effect are avoided.
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