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LEASE AGREEMENT REFERENCE GUIDE 1710: DRAFTING STRATEGIES FOR THE TENANT'S OPTION TO PURCHASE $24.95   |
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Excerpt DRAFTING STRATEGIES FOR THE TENANT’S OPTION TO PURCHASE
This LARG looks at the purchase option. The first article briefly outlines the inherently risky nature of the fixed price purchase option for the landlord. The only way the landlord can profit using one of those is to set the exercise price at a severely inflated value. The better choice for the landlord is a fair market value option, provided fair market value if adequately defined. The Lease Clause Critique features three different purchase options with comment. The Purchase Option—Fixed Price or Fair Market? It is fairly clear that any option to purchase the premises will operate in the tenant's favor. This is particularly true of fixed price options, since the tenant stands to gain a windfall if the property value appreciates over the lease term. That is precisely why many large tenants with good leverage try to negotiate an option to purchase their premises in all their leases as a matter of policy. A landlord might be inclined to agree reluctantly to the option if the lease is otherwise sweet enough, or if the tenant refuses to do the deal without an option. Many fixed price options contain formula purchase prices calculated upon the landlord's development cost for the property plus a healthy profit over the landlord's development and holding period. However, calculating fixed option prices has always been, and will always be, a risky practice for the landlord. It is a gamble on the market that only the tenant can really win. The Vagaries of the Market That’s because the tenant will exercise the option if the property's value increases during the term of the lease. This gives the tenant a gain equal to the value of the property as of the exercise date less the fixed price it was obligated to pay under the option clause. If the property value declines during the term of the lease, then the tenant will almost certainly let the option lapse. If the property's value stays the same as when the lease was executed, and roughly equals the fixed purchase price under the option, the tenant will probably not exercise, unless other factors associated with the property motivate its decision to exercise. A far more palatable approach for the landlord forced to grant a purchase option is to use a fair market purchase clause. These set the purchase price at the fair market value of the property agreed upon between the landlord and the tenant as of the time of exercise. If the landlord and tenant cannot agree upon the fair market value of the property, the clause provides for an appraisal process to determine it. This approach avoids the disputes that commonly arise when a fixed price option is exercised and the property value has increased over the term of the lease. It also makes it easier for the landlord to agree to the option as part of the lease package. Assuming the landlord and tenant can agree upon the purchase price after exercise, or if they cannot, that the appraisal process works fairly, both the landlord and the tenant should be happy with the outcome following the tenant's purchase of the property. The Lease Clause Critique in this LARG features three purchase options with comment. The first two provisions set the purchase price at the fair market value when the option is exercised, or at the value determined by appraisal. The third provision is a “bare bones” pro-tenant purchase option for a stipulated fixed purchase price. Clause #1 gives a ground lease tenant the option to purchase the property for its appraised value, or for the property’s value based upon a capitalization of the amount of the rent payable under the ground lease when the option is exercised. The option was designed as a separate stand alone document to be executed at the same time the ground lease is signed. Clause #2 is also a fair market value purchase option, but was drafted as a section of the lease, rather than as a stand alone agreement. Clause #3 is a fixed price option, and is even more pro-tenant than the first two provisions. It even allows the tenant to assign the purchase option to a third party without assigning the lease itself. (continued)
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End of Excerpt