Option vs. Right of First Refusal

An option is a right to purchase property at a set price for a fixed period of time, whereas a right of first refusal is a right to purchase property only if it is offered for sale in the future.

Option — An agreement to keep open, for a set period, an offer to sell or lease real property. An option can be used, for example, to give the buyer time to resolve questions of financing, title, zoning, and feasibility before committing the buyer to purchase. Options are frequently used in the land assemblage process. The option must be supported by its actual consideration, separate and independent of the purchase price of the property. Mere recital of consideration alone is not sufficient except in a lease-option in which the provisions of the lease are themselves sufficient consideration to support the option.

An option merely creates a contractual right; it does not give the optionee any estate in the property. At the time the option is signed, the owner does not sell, nor does the buyer purchase, the property. Although the owner is obligated to sell if given notice by the buyer, the buyer is not obligated to purchase. An option to buy is also known as a call; an option to sell is known as a put.   An option must contain all of the essential terms of the underlying contract of sale. A binding contract is created immediately upon the optionee’s decision to exercise the option. Necessary information includes names and addresses of the parties, date of the option, consideration, words granting the option, date the option expires, a statement of purchase price, and principal terms. Often a copy of the purchase agreement is attached and incorporated by reference.

An option agreement often includes a statement as to the method of notice by which the option is to be exercised, provisions for forfeiture of option money if the option is not exercised, and acknowledged signatures of optionor and optionee (only the optionor must sign). Unless prohibited by its terms, the option is usually assignable.   If the option fails to cover all the material terms and leaves room for future agreement, then the option will not be enforceable. For example, if the option agreement detailed the parties, the property, the price, and the method of payment but omitted the interest rate on the purchase money mortgage, a court would not enforce the contract.

Thus, the parties should consult an experienced real estate attorney before entering into an option agreement.   Because a broker often does not earn a commission on an option until the option is exercised, the distinction between an option and a contract to buy and sell has a practical importance. If both parties are obligated to perform, i.e., there is mutuality of obligation, then the agreement is a contract for sale. If just one party is obligated to perform, then it is an option. An option is thus a unilateral contract in which the optionor/offeror promises to make the offer irrevocable for a certain time in return for the optionee/offeree’s performance of payments of the option money. When the optionee gives the appropriate notice of intent to exercise the option, he or she in effect accepts the offer, and there is then a bilateral contract for sale with both parties bound to perform.

The option money is usually applied toward the purchase price, but the parties must cover this point in the option contract itself.   If the optionee does not exercise the option, most options provide that the optionor keeps the option money and neither party is obligated to perform. Time is of the essence in an option agreement; thus the option automatically expires if not exercised before the termination date. Death of the optionor or optionee usually does not affect the option. The optionee or heirs can still exercise the right to purchase. The contract is also binding on the optionee’s heirs and assigns.  An option should be recorded, because the rights of the optionee will relate back to the date of the option and take priority over all intervening rights of third parties with notice of the option. Good title practice requires that a release of option be recorded in the event a recorded option is not exercised. Otherwise, the lapsed option constitutes a cloud on the title. Because of this risk, many options contain a defeasance clause stating that the recorded option will automatically cease to be a lien on the property upon expiration of the option exercise date.

Different types of options include the standard fixed option; the step-up option, where the purchase price increases during set stages of the option period; and the declining-credit option, where the percentage of the option price that may be credited toward the purchase price decreases as time passes (opposite of the full-credit option).

Right of First Refusal — The right of a person to have the first opportunity to either purchase or lease real property. Unlike an option, however, the holder of a right of first refusal has no right to purchase until the owner actually offers the property for sale or entertains an offer to purchase from some third party. At that point, the holder may match the offer. If the owner first offers the property to the party holding the right of first refusal, and this person refuses, then the owner is free to offer to any third party at that price or higher.   In a lease situation, a right of first refusal might give the tenant the right either to purchase the property, if offered for sale, or to renew the lease or lease adjoining space.

This right of first refusal is clearly more advantageous to the tenant than it is to the landlord as this property is less marketable than one without such a right. However, it may encourage the tenant to make improvements that the tenant might not otherwise have made.   Under an option to purchase, the tenant can decide whether or not to exercise the option at a fixed price during the option period. In a right of first refusal, however, the holder can exercise the right only if the owner has offered to sell or lease the property or has entertained a bona fide offer by a third person to purchase or lease the property.

A key to the difference between an option and a right of first refusal is to determine which party has the right to initiate the sale or lease. In both an option and a right of first refusal, the holder has no interest in the land or equitable estate until the option or right is exercised.   In some condominiums, the association of unit owners retains the right of first refusal on any sale of a unit. Some state laws give a right of first refusal to a tenant whose apartment is to be converted into a condominium unit.

Rights of first refusal are common in agreements between partners, shareholders, joint owners (where the ultimate effect is to act as a waiver of the right of partition), landlords, and tenants.