Leasing Review - Purchase and Leasing Options

Christopher J. Huntley
Originally published on the NAIOP Minnesota online blog.

The illusive purchase or leasing option contained in many a lease has probably caused more lawsuits than any other lease provision. Landlords like these provisions as they please their tenants, help to close deals, and may lead to money down the road. A landlord that is considering granting such a right should be wary of doing so as options are usually not worth the hassle or the potential liability. If a landlord does grant such a right, the landlord should always use special care in drafting the language that grants the option so as to avoid many of the potential pitfalls associated with these rights. Failure to do so will likely result in future headaches and perhaps litigation.

Types of Options

There are two general categories of options granted in leases: purchase options and leasing options. The former grants the tenant with the right to purchase the landlord’s property under certain conditions. The latter allows the tenant to lease additional space in the landlord’s building, usually adjacent to the tenant’s existing space. Within each of these categories, however, are numerous subcategories. The most common are straight purchase or leasing options that state that the tenant can either lease a specific space or purchase a specific parcel within a definite timeframe and at a specific price or rental rate. Assuming that the terms of the purchase or lease are included in the option language, few problems arise from such options as the landlord and tenant know their rights and obligations.

The more complicated and problematic options are rights of first refusal and rights of first offer. Rights of first refusal generally state that if the landlord receives a bona fide third party offer to rent a defined premises or to purchase a specific parcel, the landlord must present the same offer to the tenant for the tenant’s acceptance or rejection before entering into any agreement with the third party. Rights of first offer are similar except that the tenant is the one making the initial offer to the landlord once the landlord informs the tenant that it is willing to sell or lease, and the landlord must either accept or reject the tenant’s offer before it can market the property or premises to third parties. Rights of first offer and rights of first refusal are where most of the problems arise as they are frequently poorly drafted and ambiguous. Very often tenants believe that they have not been given the opportunity to exercise their rights and landlords believe that they have given their tenants an opportunity to exercise their rights and the tenants are simply impeding their deal.

Drafting the Option

First and foremost, a landlord should think twice before granting such an option, especially if the tenant is not giving additional consideration for such an option. These options may lead to strained relationships, disputes, and litigation, and very often interfere with a landlord’s ability to sell its property or lease out space. The benefits for such options very rarely outweigh the costs unless they are granted to an anchor tenant or other tenants that have the ability to draw other tenants to a property.

Second, the option language must be specific and unambiguous. Minnesota courts will not enforce options that do not include the most significant terms (e.g. an option that fails to state what the future rental rate or purchase price will be, or fails to specify the manner in which such terms will be determined with any certainty). The language should include the most significant monetary terms, set forth a precise timeframe and the manner in which the option can be exercised, and should include any limitations in exercising the option (e.g. precluding a tenant from exercising an option if it defaults under the lease terms).

Rights of first offer and rights of first refusal have additional issues that need to be addressed. Most lawsuits that arise out of rights of first offer are from situations where the landlord rejects the tenant’s offer and then subsequently accepts a bona fide third party offer that includes terms more favorable to the third party than what the tenant had presented to the landlord, which leaves the tenant believing that the landlord circumvented the tenant’s rights. Landlords that face a tenant with a right of first refusal have a similar problem when a landlord presents a third party offer that the tenant rejects, but the landlord subsequently changes the deal with the third party. The tenant usually insists that the landlord has an obligation to present such an offer to it before the landlord accepts the offer provided by the third party, and the landlord’s position is usually that the tenant was given its chance and now the option has expired.

Language in the lease that grants the option rarely addresses what the landlord’s obligation is to its tenant when the terms that the landlord has agreed to with the third party do not match what the tenant was offered, and the lease rarely helps the landlord avoid the dispute that subsequently arises. To avoid this scenario the lease should expressly set forth the limited scenarios when the landlord is obligated to present the third party offer to their tenant. The landlord should set out a precise and specific method for presenting offers and rejecting them, and should further state that the landlord has no obligation to present any additional offers to its tenant once the tenant rejects an offer despite any changes in the terms unless the monetary terms vary by more than ten percent of what the landlord originally presented to the tenant. Such language may seem harsh to the tenant, but at least the rights of the parties will be unambiguous.

Tenants and tenants’ brokers should also be wary of tricks that a landlord may attempt. Tenants that have been granted rights of first refusal should always require that the option language expressly limit offers that trigger the option to those coming from unrelated third parties. Absent such language, nothing would prevent a devious landlord from presenting an offer received from a related third party (usually under common ownership) that contains unfavorable terms in an attempt to eliminate any rights that the tenant may have. A tenant would face a situation where it either has to accept a below market purchase price or above market rental rate or risk losing its option.

Presenting an Offer

An additional problem area for landlords is when they present third party offers to their tenants. A landlord that presents an offer to a tenant will often not present all of the material terms due to laziness, oversight, or simply because the terms have not yet been worked out. Such a mistake can often be fatal as the tenant was not given a true offer and therefore will not lose its option if it rejects the offer. This can be a difficult situation for landlords as a landlord will rarely work out all of the intricate details of a deal before it is ready to present the offer to the tenant as it does not want to invest the time and money on negotiating with a third party if it will be forced to deal with its tenant in the future. Regardless, a landlord should bite the bullet and finalize all material terms before presenting the offer to the tenant. Even if the landlord is not obligated to do so under the lease, an upset tenant may derail a deal and prove difficult to work with over the remaining term of the lease, and the landlord may find itself facing a costly lawsuit brought by a tenant claiming that it was not presented all of the necessary terms.

This article addresses only some of the many problems that a landlord faces when it has granted an option. The truth is that even the most masterfully drafted lease language can still lead to problems. A landlord should seriously consider engaging a real estate lawyer before granting such an option, while drafting the lease language, and while entertaining offers to lease or purchase. A dollar spent today could prevent spending ten dollars in the future.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.