In the Spotlight: Options to Purchase in Retail Leasing

From a tenant-buyer's perspective, the attraction of obtaining an option to purchase in its lease is obvious: control without commitment. The tenant can enjoy the benefits of using the property, knowing it can walk away when the lease expires, while being assured that it can acquire the property in perpetuity if it becomes strategically attractive to own the underlying fee interest. Therefore, the tenant should focus on making the lease terms that describe how to exercise the option and close the purchase as clear and efficient as possible. A well-crafted option clause will allow the tenant to avoid becoming bogged down by process or uncertainty in the future, especially if the landlord-seller becomes reluctant to part with the land, while ensuring that there is adequate time to conduct due diligence prior to closing.

The landlord-seller has a broader range of issues to consider before granting an option to purchase. Is the tenant at hand so critical to the shopping center or development project that it is necessary to agree to a potential loss of control of the leased premises? Does the rent sufficiently reflect the value added to the tenant's leasehold interest by a purchase option? Outparcels and single-tenant properties with a long term triple-net ground lease are attractive assets to passive investors in real estate. The landlord cannot assume it will have latitude to field other offers during the lease term, even if the tenant does not intend to purchase the property.

Drafting Considerations

Once the parties have agreed to include a purchase option in the lease, they might not have agreed on any specifics other than a statement in the letter of intent that “Tenant shall have an option to purchase the Demised Premises.” In these instances, it will be the attorneys' responsibility to flesh out key terms such as the purchase price and any conditions under which the option will be deemed waived by the tenant, thereby allowing the landlord to sell the property free and clear to a third party. Landlord's counsel should also seek a degree of control over what the tenant can build on the property after the sale.

Determining the purchase price can be tricky because the value of the property at the time of exercise may vary wildly from its value at the beginning of the lease term. The location of the property may have become more desirable because of extensive successful development in the surrounding areas, or the neighborhood may have deteriorated. The property could become environmentally contaminated or undergo other changes to the physical condition of the site. For these reasons, it is common for the landlord and tenant to agree in the lease to base the purchase price on an appraisal rather than set a fixed price. When drafting, it is important to structure the appraisal scenario in an efficient manner that will lead the parties to an agreed price.

Merely requiring that the landlord and tenant choose a “mutually acceptable” appraiser to value the land leaves open the possibility that the parties will not be able to agree. Taking an approach that allows each party to select an appraiser, who then jointly select a third appraiser to appraise the land or determine which party's appraised value is more accurate, is more likely to bring closure by driving the parties to work together to reach a settlement on the purchase price if they are concerned about being on the losing end of the appraisal selection.

The landlord's counsel should also clarify whether the client is better served by some other sales mechanism. For example, a landlord may prefer to grant only a right of first offer or a right of first refusal. These two rights differ from an option to purchase because they do not give a tenant an unconditional right to purchase the property. Instead, they allow the landlord to sell to a third party if the tenant does not agree to purchase the property at a specified price.

In a right of first offer, the landlord determines a market price it believes a third party will pay, and offers the property to the tenant at that price before marketing to any third parties. If the tenant declines the offer, its purchase right is waived, although it is common to reinstate the right of first offer if the price at which the landlord is willing to sell the property drops significantly below the price that the landlord offered to the tenant. In a right of first refusal, the landlord has to expend additional time and effort by negotiating price and terms with a bona fide third party, and then offer the tenant the opportunity to purchase the property on those same terms. Understandably, it may be difficult to convince an outside party to invest time in negotiating a purchase contract when a right of first refusal is in place because the tenant can defeat the deal by stepping into the shoes of the interested buyer.

When the subject property is a portion of a broader project that the landlord will continue to own and operate, such as a shopping center outparcel, the landlord's counsel should specify in the option clause any restrictive covenants that will be necessary to ensure that the property is operated in a manner compatible with the shopping center. Any restrictions on the use of the property that are contained solely in an unrecorded lease agreement may not be enforceable by the landlord after the sale unless they have been placed of record against the subject property prior to closing. Use restrictions and exclusives, architectural approval rights and sign criteria should be included in a recorded REA or in the conveyance deed at closing.

Avoiding Unintended Consequences During Exercise and Closing of the Option

When contained in a retail lease, options to purchase often create a contractual situation in which the parties do not have the same degree of direction regarding performance as a standard land purchase and sale agreement. Moreover, the terms of the option as agreed to in the lease agreement may no longer be satisfactory to the parties after the passage of time. These factors may lead the parties, during the exercise and closing of the option, to perform in ways that are contrary to the option clause as written. This conduct can negate the contract terms or expand the parties' contractual obligations, thereby making it difficult to determine what parts of the original option remain binding.

If problems arise between the parties, counsel involved have to pay particular attention to issues of whether their client's conduct has profoundly changed what would otherwise be clear contractual language subject to well-settled rules. When the client's course of performance negates contract terms or expands an obligation, the rules are suddenly different. Any belief that the original option terms remain unchanged is a dangerous assumption that can lead to lengthy and expensive litigation and increase the client's exposure to damages.

For example, consider a clause that states that “time is of the essence” with respect to the closing date and other dates for performance. It sounds simple and clear-cut. But if the parties do not act as if the deadlines are truly critical, how much reliance can counsel or a client place on a time-is-of-the essence clause in a lease or contract?

If the timelines for exercising the option, conducting and completing due diligence, or closing the sale of the property are not followed to the letter, the landlord-seller may believe that the option has been waived by the tenant-buyer, while the tenant-buyer may argue that the landlord-seller waived the time-is-of-the essence clause by acting in a manner that implied the date of performance was not critical to the transaction. This situation may occur when the landlord-seller indicates it is taking action to address property conditions that have been objected to by the tenant-buyer, such as physical or environmental conditions or title matters, but thereafter fails to indicate that it has completed its remedial actions and is ready and able to perform through the delivery of a deed to the seller.

A delay in reaching agreement to the purchase price during the appraisal process is another circumstance that may put the transaction off-schedule. If the parties continue to indicate by their conduct that they intend to perform the sale and purchase of the property after the passing of the original deadline, the time-is-of-the essence clause may be impliedly waived as a matter of law.

In these instances, even if the parties stop communicating for an extended period of time, it is a mistake for the landlord-seller to conclude that the tenant-buyer has abandoned the purchase option and that it is free to sell to another buyer. In fact, a court may rule that entering into an agreement to sell to a third-party buyer constitutes an anticipatory breach of the tenant's option to purchase, thereby exposing the landlord to damages.

So What Are the Parties (and Their Counsel) to Do?

Once an option to purchase in a lease agreement has been exercised, and especially if problems of performance occur, real estate practitioners should consider the following important points:

• A course of performance that varies from the strict terms of the purchase option clause can result in a significant alteration of the parties' rights and obligations. Counsel needs to study the legal effect of the course of performance seriously and advise the client accordingly.
• Undertaking a performance not expressly required by the option clause can have important legal consequences. It may be a better move for a seller to reduce the purchase price rather than undertake to address the buyer's objections in order to avoid a lengthy delay in closing.
• Do not assume that a failure of the parties to communicate, even for a long period of time, means that the option has been abandoned. Abandonment ordinarily requires clear and convincing evidence and it may not be possible to satisfy that higher evidentiary standard with only evidence of non-communication.
• Do not assume that a seller is free to sell the property to someone else merely because of the buyer's silence. The decision to sell the property to a third party buyer should be made carefully, and preferably only after receiving written evidence of unequivocal repudiation of the option to purchase from the tenant-buyer.
• If a landlord-seller believes that it is truly ready and able to perform ' and wishes to put the burden on the tenant-buyer to close and pay the purchase price ' counsel should notify the tenant-buyer's counsel that the landlord-seller is ready to perform, and then deliver an original of a properly executed and notarized deed that can be recorded, along with all other documents that are customary or expressly required by the contract.
• If a tenant-buyer expects to close, but believes closing may be delayed for a considerable time or that litigation is possible, it must ensure it maintains the funds needed to pay the purchase price in reserve throughout the lengthy closing process and the life of the litigation.
• If an agreement specifies that time is of the essence, the parties should act as if that is the case. In other words, if the parties do not treat deadlines as critical, do not expect that a judge will.

Conclusion

When preparing or negotiating a lease that will contain an option to purchase, counsel must inquire extensively about the intent of the respective clients in order to document a clause that will accomplish their respective goals. Failure to do so may result in a property that cannot be readily acquired or sold without extensive delay, or even litigation. Once the tenant exercises its option to purchase, if an issue arises that may signal a lengthy delay in closing and possibly litigation, the transactional attorneys on each side of the deal would likely benefit from consulting with a litigator to assess the client's rights and obligations and assist in crafting a strategy that either results in a closing and avoids litigation altogether, or at least avoids pitfalls that can impair the client's case once litigation begins.

Scott A. Miskimon and Michael R. Thornton are partners at Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, L.L.P. in Raleigh, NC. Mr. Miskimon chairs the firm's real estate litigation group, and his practice includes transactional disputes and land-use and zoning litigation. Mr. Thornton is a commercial real estate lawyer and represents REITs and institutional owners of shopping centers and malls in leasing, acquisitions and dispositions, and financing matters.

When finalizing a term sheet for a new lease, an option to purchase may seem like an easy, last-minute throw-in item to request or to agree to readily. Even during the drafting process for the actual lease agreement, it may be tempting to address only the basics in the option-to-purchase clause in order to leave more time for issues that are more contentious in a typical retail lease. Unfortunately, this approach often results in a bare-bones “agreement to agree” that leaves the individuals responsible for exercising and closing the purchase option years later without sufficient knowledge of the intent of the original parties that made the deal. On the other hand, the intuition to avoid a full-blown purchase and sale agreement to address every possible contingency seems valid when the primary transaction at hand is a lease of the subject property.

This article identifies issues to consider when dealing with options to purchase; whether and how to grant or request an option in the first place; important issues to include in the terms of the option clause in the lease agreement; and how to manage a client's conduct when the parties who have inherited the original lease have been left in a no-man's land of unfinished thoughts and vague suggestions about how to exercise and close the purchase option.

Initial Decisions

From a tenant-buyer's perspective, the attraction of obtaining an option to purchase in its lease is obvious: control without commitment. The tenant can enjoy the benefits of using the property, knowing it can walk away when the lease expires, while being assured that it can acquire the property in perpetuity if it becomes strategically attractive to own the underlying fee interest. Therefore, the tenant should focus on making the lease terms that describe how to exercise the option and close the purchase as clear and efficient as possible. A well-crafted option clause will allow the tenant to avoid becoming bogged down by process or uncertainty in the future, especially if the landlord-seller becomes reluctant to part with the land, while ensuring that there is adequate time to conduct due diligence prior to closing.

The landlord-seller has a broader range of issues to consider before granting an option to purchase. Is the tenant at hand so critical to the shopping center or development project that it is necessary to agree to a potential loss of control of the leased premises? Does the rent sufficiently reflect the value added to the tenant's leasehold interest by a purchase option? Outparcels and single-tenant properties with a long term triple-net ground lease are attractive assets to passive investors in real estate. The landlord cannot assume it will have latitude to field other offers during the lease term, even if the tenant does not intend to purchase the property.

Drafting Considerations

Once the parties have agreed to include a purchase option in the lease, they might not have agreed on any specifics other than a statement in the letter of intent that “Tenant shall have an option to purchase the Demised Premises.” In these instances, it will be the attorneys' responsibility to flesh out key terms such as the purchase price and any conditions under which the option will be deemed waived by the tenant, thereby allowing the landlord to sell the property free and clear to a third party. Landlord's counsel should also seek a degree of control over what the tenant can build on the property after the sale.

Determining the purchase price can be tricky because the value of the property at the time of exercise may vary wildly from its value at the beginning of the lease term. The location of the property may have become more desirable because of extensive successful development in the surrounding areas, or the neighborhood may have deteriorated. The property could become environmentally contaminated or undergo other changes to the physical condition of the site. For these reasons, it is common for the landlord and tenant to agree in the lease to base the purchase price on an appraisal rather than set a fixed price. When drafting, it is important to structure the appraisal scenario in an efficient manner that will lead the parties to an agreed price.

Merely requiring that the landlord and tenant choose a “mutually acceptable” appraiser to value the land leaves open the possibility that the parties will not be able to agree. Taking an approach that allows each party to select an appraiser, who then jointly select a third appraiser to appraise the land or determine which party's appraised value is more accurate, is more likely to bring closure by driving the parties to work together to reach a settlement on the purchase price if they are concerned about being on the losing end of the appraisal selection.

The landlord's counsel should also clarify whether the client is better served by some other sales mechanism. For example, a landlord may prefer to grant only a right of first offer or a right of first refusal. These two rights differ from an option to purchase because they do not give a tenant an unconditional right to purchase the property. Instead, they allow the landlord to sell to a third party if the tenant does not agree to purchase the property at a specified price.

In a right of first offer, the landlord determines a market price it believes a third party will pay, and offers the property to the tenant at that price before marketing to any third parties. If the tenant declines the offer, its purchase right is waived, although it is common to reinstate the right of first offer if the price at which the landlord is willing to sell the property drops significantly below the price that the landlord offered to the tenant. In a right of first refusal, the landlord has to expend additional time and effort by negotiating price and terms with a bona fide third party, and then offer the tenant the opportunity to purchase the property on those same terms. Understandably, it may be difficult to convince an outside party to invest time in negotiating a purchase contract when a right of first refusal is in place because the tenant can defeat the deal by stepping into the shoes of the interested buyer.

When the subject property is a portion of a broader project that the landlord will continue to own and operate, such as a shopping center outparcel, the landlord's counsel should specify in the option clause any restrictive covenants that will be necessary to ensure that the property is operated in a manner compatible with the shopping center. Any restrictions on the use of the property that are contained solely in an unrecorded lease agreement may not be enforceable by the landlord after the sale unless they have been placed of record against the subject property prior to closing. Use restrictions and exclusives, architectural approval rights and sign criteria should be included in a recorded REA or in the conveyance deed at closing.

Avoiding Unintended Consequences During Exercise and Closing of the Option

When contained in a retail lease, options to purchase often create a contractual situation in which the parties do not have the same degree of direction regarding performance as a standard land purchase and sale agreement. Moreover, the terms of the option as agreed to in the lease agreement may no longer be satisfactory to the parties after the passage of time. These factors may lead the parties, during the exercise and closing of the option, to perform in ways that are contrary to the option clause as written. This conduct can negate the contract terms or expand the parties' contractual obligations, thereby making it difficult to determine what parts of the original option remain binding.

If problems arise between the parties, counsel involved have to pay particular attention to issues of whether their client's conduct has profoundly changed what would otherwise be clear contractual language subject to well-settled rules. When the client's course of performance negates contract terms or expands an obligation, the rules are suddenly different. Any belief that the original option terms remain unchanged is a dangerous assumption that can lead to lengthy and expensive litigation and increase the client's exposure to damages.

For example, consider a clause that states that “time is of the essence” with respect to the closing date and other dates for performance. It sounds simple and clear-cut. But if the parties do not act as if the deadlines are truly critical, how much reliance can counsel or a client place on a time-is-of-the essence clause in a lease or contract?

If the timelines for exercising the option, conducting and completing due diligence, or closing the sale of the property are not followed to the letter, the landlord-seller may believe that the option has been waived by the tenant-buyer, while the tenant-buyer may argue that the landlord-seller waived the time-is-of-the essence clause by acting in a manner that implied the date of performance was not critical to the transaction. This situation may occur when the landlord-seller indicates it is taking action to address property conditions that have been objected to by the tenant-buyer, such as physical or environmental conditions or title matters, but thereafter fails to indicate that it has completed its remedial actions and is ready and able to perform through the delivery of a deed to the seller.

A delay in reaching agreement to the purchase price during the appraisal process is another circumstance that may put the transaction off-schedule. If the parties continue to indicate by their conduct that they intend to perform the sale and purchase of the property after the passing of the original deadline, the time-is-of-the essence clause may be impliedly waived as a matter of law.

In these instances, even if the parties stop communicating for an extended period of time, it is a mistake for the landlord-seller to conclude that the tenant-buyer has abandoned the purchase option and that it is free to sell to another buyer. In fact, a court may rule that entering into an agreement to sell to a third-party buyer constitutes an anticipatory breach of the tenant's option to purchase, thereby exposing the landlord to damages.

So What Are the Parties (and Their Counsel) to Do?

Once an option to purchase in a lease agreement has been exercised, and especially if problems of performance occur, real estate practitioners should consider the following important points:

• A course of performance that varies from the strict terms of the purchase option clause can result in a significant alteration of the parties' rights and obligations. Counsel needs to study the legal effect of the course of performance seriously and advise the client accordingly.
• Undertaking a performance not expressly required by the option clause can have important legal consequences. It may be a better move for a seller to reduce the purchase price rather than undertake to address the buyer's objections in order to avoid a lengthy delay in closing.
• Do not assume that a failure of the parties to communicate, even for a long period of time, means that the option has been abandoned. Abandonment ordinarily requires clear and convincing evidence and it may not be possible to satisfy that higher evidentiary standard with only evidence of non-communication.
• Do not assume that a seller is free to sell the property to someone else merely because of the buyer's silence. The decision to sell the property to a third party buyer should be made carefully, and preferably only after receiving written evidence of unequivocal repudiation of the option to purchase from the tenant-buyer.
• If a landlord-seller believes that it is truly ready and able to perform ' and wishes to put the burden on the tenant-buyer to close and pay the purchase price ' counsel should notify the tenant-buyer's counsel that the landlord-seller is ready to perform, and then deliver an original of a properly executed and notarized deed that can be recorded, along with all other documents that are customary or expressly required by the contract.
• If a tenant-buyer expects to close, but believes closing may be delayed for a considerable time or that litigation is possible, it must ensure it maintains the funds needed to pay the purchase price in reserve throughout the lengthy closing process and the life of the litigation.
• If an agreement specifies that time is of the essence, the parties should act as if that is the case. In other words, if the parties do not treat deadlines as critical, do not expect that a judge will.

Conclusion

When preparing or negotiating a lease that will contain an option to purchase, counsel must inquire extensively about the intent of the respective clients in order to document a clause that will accomplish their respective goals. Failure to do so may result in a property that cannot be readily acquired or sold without extensive delay, or even litigation. Once the tenant exercises its option to purchase, if an issue arises that may signal a lengthy delay in closing and possibly litigation, the transactional attorneys on each side of the deal would likely benefit from consulting with a litigator to assess the client's rights and obligations and assist in crafting a strategy that either results in a closing and avoids litigation altogether, or at least avoids pitfalls that can impair the client's case once litigation begins.

Scott A. Miskimon and Michael R. Thornton are partners at Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, L.L.P. in Raleigh, NC. Mr. Miskimon chairs the firm's real estate litigation group, and his practice includes transactional disputes and land-use and zoning litigation. Mr. Thornton is a commercial real estate lawyer and represents REITs and institutional owners of shopping centers and malls in leasing, acquisitions and dispositions, and financing matters.