What is an Option Agreement?
An option agreement in the context of a real estate contract is essentially an agreement (i) between an optionor (the seller) and an optioneer (the buyer), (ii) where the optionor confers on the optioneer the right to purchase from the optionor a parcel of real property, and (iii) the option is supported by consideration to be paid to the optionor (the consideration may be refundable or non-refundable, and is usually a small percentage of the purchase price) and a period of time in which the option period is valid (the option period). Holding an option agreement gives the optioneer the exclusive right to purchase the property, free from the optionor selling other options during the option period. During the option period, the optionor must only sell an option to purchase the property during the option period. The option will specify an option fee to exercise the option and the price, a description of the real property, the triggering event, if any, that will terminate the option, and a period of time in which the option is valid . Other potential benefits of a lease option include potentially lowering the sales price.
Typically, an option is used as part of a land development transaction involving a parcel of real property. The optioneer enters into an option with the optionor to purchase property at a designated price. This gives the optioneer a reasonable time to consider the purchase and if he is satisfied, he can exercise his option to buy the option without having to identify him for financing purposes. Sometimes the optioneer obtains financing through a third-party loan when he chooses to exercise the option. During the option period, the optioneer may want to try to obtain a buyer for the property. An alternative option is that the optioneer may assign the option to another buyer. If the option is assigned, the assignor remains primarily responsible for the payment of the option but the option is deemed to have been exercised by the assignee when the assignee purchased the property. If the optionor does not designate a time period within which the optioneer must exercise the option, the option is valid for a reasonable time.
Elements of Option Agreements
An option agreement has very few essential components, but the most critical of these components are that the option is given in exchange for some consideration (in the form of a fee paid to the seller), and that the buyer has the right, but not the obligation, to purchase a property at the end of the option period. Under the terms of an option, a buyer typically will pay the seller an option fee in exchange for the consideration to purchase the property within a specified period of time. The agreement then becomes a binding contract for the sale of the property only if the buyer chooses to exercise its option to purchase the property.
The duration of an option agreement can vary, depending on the desires and goals of the parties, but are frequently five years or greater. The parties to an option should also be prepared to discuss and even make binding agreements about the price and other material terms of the purchase agreement during the option period. These agreements to such terms frequently take the form of an option exercise, or an agreement of sale in connection with the actual exercise of the option. The option term should also include if and how the option may be assigned, what happens to the option fee if the buyer does not exercise its option, and other default provisions. Typically, the seller will have a right to retain the option fee deposit as liquidated damages for a default by the buyer if the buyer fails to consummate the sale following the exercise of its option.
What’s In It for Buyers and Sellers?
An advantage of option agreements to a buyer is that they provide a legally binding right to purchase land at a certain price within a set time frame. This gives the buyer comfort knowing they have time to negotiate and arrange financing before finalizing the deal. If the option is accepted, it becomes a contract just like any other offer to purchase agreement.
Another benefit to a buyer is that they can negotiate the purchase price before spending money on the polling fees to conduct their due diligence (lending and environmental). The purchaser can then terminate the deal if the results of the due diligence are not satisfactory, or enter into an amending agreement or a new agreement including a new date and price.
Also, default by the grantor of the option means the grantee has the right to commence an action for specific performance or to obtain an order for damages or compensation without having to prove the value of the land is diminished.
A seller, giving consideration to the up-front fee for the option (which remains payable to the seller if the option to purchase is not exercised by the buyer), may be more willing to accept the offer. It allows the seller to remain in the driver’s seat and control the terms of the offer but also allows the seller to negotiate the final sale price before he/she spends money on their due diligence.
How Option Agreements are Distinct from Purchase Agreements
Unlike a standard real estate purchase agreement or sales contract, an option agreement is entirely different from a purchase agreement. An option agreement is not an agreement to buy or purchase or sell even though it has the same effect as entering into a purchase agreement in that the owner of the property or land is agreeing to sell the land to you or the buyer assuming the "option" to purchase the land under that agreement.
An option agreement is a unilaterally binding agreement. It is one whereby if the buyer (the tenant) pays the agreed upon option fee to the seller, the buyer has the unilateral right to exercise the option (or not to exercise the option). If the buyer exercises the option, then he purchases the property. If not, then the seller has received the option fee.
A standard purchase agreement is an entirely new agreement that contains a slew of legal terms and conditions that is presumed to be mutually binding on both parties. A seller and a buyer agree to the same terms and conditions on the same piece of real estate or property.
Steps to Preparing an Option Agreement
The steps of a "typical" process for drafting an option agreement include consultation between the parties and their counsel, discussing the respective initial positions of the parties, and discussing what terms may be up for negotiation (e.g., purchase price, timing, conditions, etc.). Following this initial stage of discussions and preparation by counsel of an initial draft of the agreement, terms which are unique to that particular property will be negotiated.
As a starting point, parties should consider and be prepared to discuss the following points, which may be material points of negotiation:
- for how long the option will be good (i.e., the "option term");
- the amount of the purchase price;
- the duration of the parties’ obligations to keep open the possibility of closing the sale, including the period of time to close the sale after the option is exercised by the optionee;
- whether the parties will agree on the right of first offer as to the sale of the property;
- whether the parties may agree to reductions in the purchase price during the option term in conjunction with granting extensions of the option (which may be acceptable to both parties given that a lower purchase price may offset the holding costs of the buyer);
- the penalties to be paid upon default;
- whether notice to the seller of any litigation against the property will be provided or not;
- whether the optionee will be permitted to assign its rights under the option agreement to a third party;
- if the optionee brings the property into compliance with any applicable current laws prior to the expiration of the option term , whether future development may be built.
The parties should also consider the following factors when negotiating the option agreement:
- When will the option price be agreed upon? Will it be at the time the option is granted, when the option is exercised or when the parties enter into a purchase and sale agreement?
- If the optionee spends money for option consideration (often requried by the Optionee) will they get a credit toward the purchase price?
- What is the state of the market when the option is paid for and exercised?
- If the optionee seeks financing, how does this impact its ability to proceed with the option? Will the property have to be adapted for uses consistent with lenders or investors?
- Does seller have the right to approve or disapprove of the financing structure in order to protect its equity in the property?
Potential Pitfalls of Option Agreements
Option agreements, like any other agreement, are not perfect. The relative lack of formality, and Sophia’s reluctance to sell land subject to an option agreement, expose both parties to risk. For example, if the leasehold title is registered under the Land Registration Act 2002 that would mean that the overriding interest held by Sophia could be protected at the Land Registry after the option was exercised, provided that Sophia gave it effect. Where the title is not registered, Sophia could find herself in the position where a third party had entered into the contract with Jonathan. Normally, the rights of the third party would have priority over the interest of Sophia, even though they held only subject to the option agreement. It is possible that Jonathan could sue Sophia for selling the land without giving notice to him and this would depend on the terms of the headlease, but this is an object lesson in the dangers of using option agreements and the pitfalls that could potentially arise.
Sophia may not have thought through what will happen if Jonathan does not pay for the share of value in the property when he on-sells his interest to someone else. For example, if Jonathan obtains an agreement to on-sell and pay 14 days later, he could have sufficient time to on-sell his option interest and recover the consideration within the 14 day timescale. This again is a danger to Sophia and the only way that she can guard against this is by making sure that the agreement to acquire the property by Jonathan is given effect within the same timescale.
At any time after Jonathan has been granted the benefit of an option, Jonathan could unilaterally determine the option and chose not to pay Sophia for her interest. The risk here is that Sophia could be stuck with a tenant whose reversionary interest may well have been worth more than the leasehold interest granted to Jonathan. In order to avoid this, and also to ensure that she does not lose the income from the headlease, Sophia should provide that Jonathan’s rights under the option agreement will be subject to this provision of the headlease. She should also consider whether or not she wishes to agree not to recreate leases without Jonathan’s consent.
Sophia’s mortgagee might be under an obligation to provide Sophia with a copy of his conditions of charging within 21 days of request. Sophia could find herself in the position that collapses due to a fairly trivial matter. For example, if the mortgagee has excluded from payment all sums payable by way of delayed completion costs and Jonathan was to acquire a new lease as a variation under the 1993 Act this could be outside the provisions of an option agreement. As a result, Sophia’s mortgagee could end up having an objection to the transfer and Jonathan’s option falls apart.
The main risk for Jonathan is that he will become legally bound by the option before he has all of the necessary rights to exercise it. For example, Jonathan has agreed that he will grant to a purchaser a 111-year lease at a rent of £1,000 per year for the development of the land. It is possible that the leasehold title will be registered under the Land Registration Act 2002, in which case the outcome of the application to divide the land will take effect after 16 weeks from registration (or some other specified period). If a mortgage is needed to finance the development, Jonathan should ensure that this is entered into as early as he can and provide some form of pre-condition to his right to exercise the option.
Enforceability and Other Legal Issues
To be enforceable, an option agreement must have sufficiently definite terms. A contract to purchase land must contain a description of the property with reasonable definiteness to enable a person familiar with the locality to identify the property. While there is no requirement that the description contain a street address or a parcel number, the greater the degree of mathematical uncertainty, the more definite the attachment must become. In addition, the grantor under an option must have the power to convey the estate which is the subject of the option.
Option agreements are often subject to lawsuits over their enforceability. In one recent Illinois case, the court held that the option was not enforceable because it failed to set forth the property to be conveyed with sufficient specificity. In that case, the option stated that the option consisted of "property located on the north side of Sayre Avenue, approximately 14 acres of vacant land." The option did not contain a street address or parcel number. Because the area described included several contiguous lots and a small portion of someone’s backyard, the court found that it "put a serious burden on a purchaser to identify the property intended by the parties to the agreement." The court further noted that in such cases, "increased mathematical accuracy requires greater precision in the attachment." Notably, the court did not decide whether the parties could use parol evidence to identify the specific parcels covered by the option.
In yet another Illinois case, the option reserved a right of first refusal to the optioner to purchase the property for $2.6 million within 30 days of the optioner giving notice to the optionor that the optioner intended to purchase property similar to the optioned property. The court held that the option constituted an enforceable contract for the sale of land, stating that its terms were sufficiently definite because the structure of the contract virtually assured the seller that the buyer would acquire the property for $2.6 million.
In Missouri, the court held that a real estate broker who has an exclusive listing to sell a property may bind the owner to an option agreement even though the owner did not personally execute the option. The Missouri court stated that by giving the broker the authority to enter into the option with the buyer, the owner had bound himself by the terms of the option.
Some jurisdictions will not enforce option agreements that are combined with other contracts. For example, in Louisiana, courts will not enforce an option agreement if other factors combine to render it merely illusory. Courts in Pennsylvania similarly will not enforce an option agreement if the option is made a part of an unenforceable arrangement. In California, an option will be held invalid if it is part of a single transaction that cannot stand independently.
Common Scenarios In Which Option Agreements Apply
Due to the diversity of the property market, I encounter a varied range of options negotiated regularly across a broad spectrum of property types. Lately, we have seen a number of option agreements registered as encumbrances in favour of retailers. The encumbrances are registered for a significant duration and will be effective for a significant duration after the term of lease comes to an end . In one case, a lease registered as an encumbrance under a Development Agreement allowed the tenant to assign its remaining holdover term to the successor in title of the landlord under the DA, before it could be dealt with by the tenant in accordance with the lease. Another example, which arose in the context of a proposed lease, is one best described as a specialised right of first refusal (ROFO). It requires the landlord to first offer the premises to the tenant at a price based on a specified valuation methodology, prior to the landlord offering it to another tenant.