LEASE AGREEMENT REFERENCE GUIDE 530: STRATEGIES FOR THE FAIR MARKET VALUE OPTION TO PURCHASE $24.95
STRATEGIES FOR THE FAIR MARKET VALUE OPTION TO PURCHASE
The Pro-Tenant Option To Purchase The Premises For Fair Market Value And Right Of First Refusal
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 most large tenants with good leverage try to negotiate an option to purchase their premises in all their leases as a matter of policy.
The landlord might be inclined to agree to the option if the lease is otherwise sweet enough, or forced to if the tenant will not do the deal without an option. Many fixed price options are calculated based upon the landlord's development cost for the building 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 win.
Fixed Price Problems
Unlike the option clause that follows (with an option price based upon the fair market value of the property), most first generation option clauses contained a fixed price for the property. In fixed price option clauses, this means that the landlord and tenant agreed upon the property's value as of the execution of the lease. During the term of the lease, only three things could happen to the property's value--it could increase, stay the same, or decline.
The tenant would exercise the option if the property's value increased during the term of the lease. This would give 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 declined during the term of the lease, then the tenant would almost certainly let the option lapse. If the property's value stayed the same as when the lease was executed, and roughly equaled the fixed purchase price under the option, the tenant would probably not exercise without a monetary gain, unless it liked the location of the building or other factors associated with the property motivated its exercise.
When the property value increased over the term of the lease (i.e., over and above the fixed purchase price contained in the option), an exercise of the option would do little for the landlord's good humor. In the landlord's view, the tenant was enriching itself with the landlord's real estate. Many landlords who found themselves in this situation resisted the tenant's exercise of the option in court. They would claim the option was unenforceable for a variety of reasons, that the option violated the rule against perpetuities, or anything else that they or their counsel hoped would be persuasive to a judge. The combination of an increase in property value and a fixed price option has generated much litigation and case law concerning options to purchase.