Avoiding Purchase Option Pitfalls
 
May 17, 2004
 

Purchase options within retail leases are significant issues and are often highly negotiated. Because landlords often provide prospective tenants with the initial draft of a lease, landlords can try to favorably dictate the terms of purchase options in its initial lease draft. Among other things, a carefully drafted purchase option addresses the following:

• who may exercise the option
• when the option may be exercised
• how the option may be exercised
• what conditions may be required to exercise the option
• what property is applicable to the option
• the purchase price of the property
• what remedies may be available in the event of a related dispute
• when the closing will occur
• how the property will be conveyed

However, despite this drafting advantage, purchase options often fail to fully protect a landlord’s rental income during the period after which a tenant exercises a purchase option and before delivery of the deed. Where a lease remains silent as to a tenant’s liability for paying rent during this period, a savvy tenant, after exercising its option, will refuse to make future rent payments, and in many jurisdictions, including Illinois, the courts will support such refusal.

What is a Purchase Option?

Within a retail lease, a purchase option provision is a right granted to the tenant by the landlord, as owner of the leased premises, allowing the tenant to purchase the leased premises from the landlord at a specified price and time and pursuant to specific conditions. A tenant has the non-obligatory, discretionary power to choose to exercise a purchase option. Depending on the jurisdiction, a purchase option is considered: (1) a contract, (2) a contract and offer, or (3) a unilateral writing, which after acceptance becomes a binding executory contract. Leases containing purchase options are subject to the statute of frauds, and therefore, must be in writing.

Tendering of the purchase price may be required at the time notice is given, or at a later specified time. If the purchase option is silent with respect to the required time of payment, tenants are generally required to tender payment within a reasonable time after notice is given. The purchase price must be expressly set forth in the purchase option and may be the “then prevailing market price” or the price of the property based on a third party appraisal.

If a purchase option is drafted ambiguously, it will be construed against the drafter with a focus on the purpose of the option (i.e., usually benefiting the tenant). Most courts will only enforce purchase options where strict compliance with all conditions of the purchase option has occurred. Though there is some dispute as to whether purchase options can be exercised during a renewal term, nearly all courts agree that a purchase option can only be exercised prior to lease expiration.

The Importance of Strict Conformity with Conditions of a Purchase Option

A purchase option, when properly exercised, serves to extinguish the lease and creates a contract for the purchase and sale of the property, resulting in a transfer of the parties’ relationship from that of landlord-tenant to vendor-vendee. Even if a tenant is in default of the lease at the time the purchase option is exercised, as long as that purchase option was properly exercised in full compliance with the option conditions, the lease is converted to a sales contract, thereby extinguishing the landlord’s right to declare the tenant in breach of the lease. As a result, when exercising a purchase option, a tenant must be careful to strictly comply with all conditions of the purchase option that are set forth in the lease. Failure to strictly comply with all such conditions will inhibit the conversion of the lease into a sales contract, allowing the landlord-tenant relationship to continue pursuant to the terms of the lease. In reiterating this long-standing rule, an Illinois Appellate Court stated that, if a tenant fails to properly exercise a purchase option, and a landlord effectuates a legal termination of the lease, the tenant also loses its right to exercise the purchase option. Conversely, because a lease is terminated once the purchase option is properly exercised, a landlord would not be able to declare a default under the lease as a result of a pre-existing breach. A sure-fire way to avoid these problems is for the landlord to include, as a condition precedent for exercising the purchase option, a provision requiring that tenants not be in default of the lease, and for a tenant to make certain it complies with all conditions set forth in the purchase option provision.

The Ignored 65-Year-Old Illinois Precedent

Continuation of rental payments is often unaddressed in purchase options. Typically, a tenant will continue to pay rent during the time it is in possession of the leased premises through and until delivery of the deed. However, if continuation of rent is not required pursuant to the purchase option, the tenant can suspend payment of rent and, while remaining the legal owner of the leased premises, the landlord will (i) lose its rental income stream for the leased premises and (ii) remain liable for real estate taxes and all other ownership obligations. Under these circumstances, one might ask, “Why do tenants continue to pay rent without express requirement?” and, “Why would landlords continue to utilize leases that lack continued rent protections?”

The Illinois Supreme Court has held that exercising a purchase option extinguishes the lease and creates a sales contract. At such time, the landlord-tenant relationship converts to a vendor-vendee relationship and the vendee becomes the equitable owner of the property. As an equitable owner, unless the lease expressly provides for the continuance of rent prior to delivery of the deed, a tenant is no longer liable to comply with any of the lease requirements, including the payment of rent. Additionally, unless the lease expressly provides otherwise, the vendee, as equitable owner, shall have all rights of equitable ownership, including, but not limited to the right of possession.

Suggested Practices for Drafting Purchase Options

While the term of retail leases may be different, there are several key concepts that should be incorporated into every purchase option provision contained within a retail lease. All purchase options should specify the option purchase price, and whether the option price is a flat rate, or a rate which changes depending upon when the purchase option is exercised. The provisions should also carefully spell-out the type of notice required to exercise the purchase option. Some purchase option provisions require only written notice of the tenant’s election to exercise the purchase option. However, others require not only written notice to the landlord, but also the delivery of additional deposits (such as a previously agreed upon purchase and sale agreement, an earnest money deposit, or delivery of the option purchase price in escrow). It is equally important to specify the time period in which a notice must be provided. For example, can the purchase option be exercised immediately upon execution of the lease, or only in the tenth year of the lease term? Additionally, a carefully drafted purchase option will state whether the purchase option has an expiration date. Transferability of the purchase option is also important to define. Parties often forget to include the terms of the closing, such as the type of the deed of conveyance, closing date, prorations of taxes, CAM, and rental, and establishment of responsibility for ordering title insurance and payment of closing costs. By including these provisions in every purchase option, the parties are sure to limit the number of disputes that could arise in the future when the purchase option is exercised.

In addition to the above-listed issues, that both landlord and tenant will want to address within purchase options, it is imperative that landlords also include the following provisions in their purchase option drafts: (i) tenants should not be in default of the lease at the time the purchase option is exercised and at the time of closing, and (ii) after the exercise of the purchase option but prior to the transfer of title to the property to the tenant, the tenant should be required to continue to pay all base rent, additional rent, and all other obligations due to the landlord under the lease. Similarly, tenants should insist upon inserting provisions into the purchase option allowing tenants to remain in possession of their leased premises after exercise of their purchase options but prior to the transfer of title in accordance with the lease terms.

Conclusion

Both landlords and tenants will want to make certain that their purchase option is carefully drafted. As a tenant, it is imperative to carefully review the purchase option notice requirements prior to exercising the option. A landlord is also well-served by reviewing the tenant’s notice of its election to exercise the purchase option, as well as the purchase option notice requirements and notice provisions of the lease, in order to confirm the option was properly exercised. Careful drafting, together with strict compliance with the terms of a purchase option, will result in landlords continuing to receive rental income and tenants remaining in possession of the leased premises for the time period between the exercise of the purchase option and the delivery of the deed.

For more information, e-mail Michele L. Krause at michele.krause@hklaw.com or Jennifer L. Jackson at jennifer.jackson@hklaw.com, or call toll free, 1-888-688-8500.