§ 24.04 Purchase Options

• Jurisdiction: United States
• Publication year: 2022

§ 24.04 Purchase Options¹

[1]—Introduction

A purchase option is the right given to a tenant, by contract, to acquire, for consideration, the fee of the building or project in which the premises are located. The option may accrue either at certain designated times during the lease term or may be continuous throughout with the purchase or acquisition fee appropriately adjusted. Purchase options may give the tenant considerable leeway to capitalize on a profitable leasing transaction. Purchase option prices may be set either during the contract negotiation or by appraisal at the time the option is exercised.

The following example illustrates a provision setting out a purchase option.

Purchase. At the end of the fifth (5th) year of the Lease, Tenant shall have an option to purchase the Building in which the Premises are located at the lesser of: (i) the fair market value of the building which is based on buildings of comparable size and character in the city in which the Building is located; or (ii) $[insert dollar figure].

[2]—Comment

For many decades, this author has assumed that practitioners and landlords knew that when an option to purchase was granted in a commercial lease, the parties had to tend to the housekeeping issues of the effects on the Landlord & Tenant (L&T) relationship. A specific example is where the parties had to tend to the effects of the common law of equitable conversion or evolution from lease and L&T relationship to vendor and vendee under a purchase contract, even when an election to purchase process did not call for the execution or negotiation of a contract of sale. This assumption was shattered in 2015, when in a period of three months this author was asked to be an expert witness in two large malpractice cases against significant law firms for their failure to protect the landlords in commercial leases they drafted containing options to purchase by the tenants. One was a case involving more than $28 million against the law firm lease drafter for its failure to preserve the rent payment and other performance obligations, such as payment of real estate taxes and maintenance and operating expenses. To understand the cases of concern, it is helpful to understand the typical option to purchase concepts contained in commercial leases.

The typical text of options to purchase in commercial leases of the 1970s and 1980s generally followed one of two formats. The more common type of clause was for the lease to recite an option to purchase with procedures, notices and timelines for the election and the execution of a form of contract of sale that was generally fully negotiated during the lease negotiation and attached as an exhibit to the lease. At election, the down payment was to accompany the notice of election along with the execution by the tenant of the fully negotiated contract of sale. Generally, title condition, permitted exceptions, and title insurance commitments were in place at the election time. The option text would also prescribe time periods for issuance of the notice of election, payment of the down payment if not with the notice, appraisal or valuation or other calculation of the purchase price, the executory interval between affecting the notice of election of the option and the closing, and such items as the title deliverables and conditions. Such old clauses would also specify that until the closing, all the terms of the lease and L&T obligations to pay and perform would remain unchanged.

The second type of option generally followed the former model and set forth the similar procedures for notice, payment and timing. However, this second tye of option allowed for a period of negotiation of the contract for purchase after the election was affected and would also have fall back procedures in case the parties could not agree to the contract provisions or terms. Under both option election models, the author experienced additional transactional delays for alterations, title insurance, discovery of property condition, as well as title clearing and environmental remediation. In short, most options to purchase would have built in time lags between election of the option, obtaining financing, implementing discovery, obtaining a survey and title insurance and execution of a purchase or closing type documentation. Such time lags were frequently elongated by disputes over valuation and, in many cases, by litigation. This period between successful implementation of the option to purchase and the closing of title to the property will be referenced to here as the executory interval.

For many transactions, the executory interval would elongate for other financial reasons or due to delays in determining the market value of the purchase price or because of party or third-party claims, litigation and injunctions. In some instances, the executory interval instances ran on for years. When a purchase option for property is exercised under a commercial lease, it seems that it is not always clear to some folks (as evidenced by the many requests for expert testimony in malpractice cases) what exactly happens to the L&T relationship between the parties and among superior interest holders such as ground lessors and lenders. There does not seem to be clarity about the impact of the change in the L&T relationship on such continuing duties as rental payment, lease maintenance and other performance obligations of the tenant, or on the rights and obligations of the property owning landlord. If the L&T relationship is impacted by the election and effectuation of the option to purchase, then the interests held by the former landlord and tenant change and the insurance rights and assurances may as well change along with the interests of the parties in condemnation or with the impact of a casualty. In short, if the lease does not contemplate a change in the relationship and the duties upon election of the option, many things can change without textual attention and determination.

This brings us to the big practice question of what happens upon effective election of an option to purchase under a lease until the time of closing of title to the property if the clause does not address continuation of the lease terms and performance obligations of the parties. Does the lease continue with the tenant paying rent, insuring and maintaining the property, and being responsible for restoration in the event of damage of casualty destruction or is there a relationship and contractual void created from the effective option election until the closing of title to the purchased property? Or does the common law doctrine of equitable conversion still control where the L&T relationship in effect changes to a contract vendor-vendee type of relationship? And if so, how does this impact the continued use and control of the property and the economic interests related to ownership and obligations? As one may suspect, there is a whole body of Real Property Law 101 that we all learned in the first year of law school and that we never again figured to be important. This comment provides a reminder of that hornbook body of law.

Under the common law doctrine of equitable conversion, once the tenant exercises the purchase option in a lease, unless the text of the lease provides otherwise, the lease and L&T relationship "converts" into a purchase and sale agreement or executory contract. The landlord becomes the contract or title vendor (or the seller) and the tenant becomes the contract vendee (or the buyer). The lease is effectively dissolved or merged into the purchase and sale agreement. The tenant then is no longer required to pay rent on the property or perform the other L&T obligations, such as handling insurance, maintenance, repair, compliance with laws, and so on. During the executory interval, especially if it is extended, significant rent payments to the landlord would stop and other fundamental obligations benefiting the landlord and required by other superior interest holders would be extinguished. The economic loss or impact on the landlord and other superior interest holders would be significant. In addition to common law recitations, many states have current case law that has adopted this view. As a result, the tenant's legal, financial, and economic implications can be vast and complex, and are essentially that the tenant is not required to perform as a tenant after election of the option. This is an important area of purchase options under commercial leases about which many practitioners have not been aware of when drafting office leases. What follows are some examples of jurisdictional treatment of commercial leases containing purchase options and the impact on the parties upon election or failure of election, along with practice and procedure pointers. This is not intended to be a jurisdictional survey, so only a few illustrative cases are reflected and analyzed. Rather, it is intended to be a commentary on commercial leasing options to illuminate for the practitioner the dangers of such options, along with practice tips raised by selected cases.

[3]—Case Studies

[a]—Richard Barton Enterprises, Inc. v. Tsern

[i]—Case Summary

The issue in Richard Barton Enterprises, Inc. v. Tsern² was whether the lessor (Tsern) had the duty to repair the premises in question, a commercial building space in downtown Salt Lake City, once the lessee (Barton) exercised the option to purchase under the lease. The Utah Supreme Court found that the general rule is that a lessee's exercise of an option to purchase terminates the lease and all future obligations under the lease.³ If the court finds that there was an obligation to repair the property before exercise of the option occurred, then the lessor will still be held liable for damages.⁴ Tsern's obligation here was to repair an elevator, which was included in the contract for the sale of the premises.⁵ The obligation to repair the elevator existed before Barton exercised the option to...