Real Property Sales: Know Your Options (Option Contracts, Rights of First Refusal, and Rights of First Offer)

By: Kyla Rowe

Estimated reading time: 6 minutes

California attorneys assisting clients with real property sales should be aware of the types of option contracts their clients may encounter. Read on for an overview of the most common types of option contracts, and some strategic considerations when deciding which type is best for the sale.

An option contract is a unilateral offer by one party (the “optionor”) to buy property from or sell property to another party (the optionee). (County of San Diego v. Miller (1975) 13 Cal.3d 684, 688.) If the option contract is based on legal consideration, the option is usually irrevocable (meaning the optionor cannot revoke or otherwise terminate the contract at will, except in circumstances agreed to by the parties); otherwise, an option contract made without consideration is merely a continuing offer that can be revoked at any time before acceptance. (See Torlai v. Lee (1969) 270 Cal.App.2d 854.)

Option contracts can be standalone agreements, or they can appear in clauses within, or exhibits to, other agreements (such as a lease). Option contracts relating to the purchase and sale of real property fall within the statute of frauds and therefore must be in writing. Note, however, that an option contract does not transfer an interest in property. Therefore, an optionee does not have rights and remedies afforded to real property interests, such as specific performance or antideficiency laws.

Once an optionee exercises its option, a bilateral agreement is created for the purchase and sale of the property. Thus, the option agreement must contain the material terms and conditions to create an enforceable contract, and should sufficiently describe the parties’ rights and obligations for both the exercise of the option, and for moving forward with the purchase and sale transaction.

Common Types of Option Contracts

The term “option” is often used to describe many different situations (some of which are better described using other terms). The most common types of “options” in real property purchase and sale transactions are:

Option

In a typical option, the optionor gives the optionee the exclusive right to buy the property under certain terms during a specific time (the “option period”). The optionee pays consideration (typically called an “option fee”) which is not refundable. The optionee can exercise the option at any time during the option period; the optionor cannot withdraw the option until the option period has expired.

Right of First Refusal (ROFR)

In a ROFR, the optionor agrees to sell the property to the optionee under the same terms as set forth in a third party’s offer (which has not yet occurred). Thus, if the optionor decides to sell the property and receives an offer, the optionee, by exercising the ROFR, can essentially step in as the purchaser under the terms of that offer. If the optionee declines to exercise the ROFR, the optionor is then free to sell the property to the other purchaser.

Right of First Offer (ROFO)

A ROFO is similar to a ROFR, except the optionee’s exercise of its right occurs earlier in the process. If the optionor decides to sell the property, it notifies the optionee that it is ready to sell, and the optionee has a certain amount of time to make an offer. If the optionee makes an offer, the optionor is free to accept, reject, or counter it, just like a regular purchase and sale transaction. If the optionee declines to exercise the ROFO, the optionor proceeds to market the property to potential purchasers as they wish.

Strategic Considerations

Often, the decision of how to structure an option in the real property purchase and sales context hinges on the perceived value of the property, and whether that value may change (and in what direction) during the option period.

In a typical option contract scenario, if the property value increases during the option period, the optionee is in a strong position because it can exercise their option to purchase the property at the previously agreed-upon (lower) price. (For this reason, sophisticated property owners will often include “fair market value” language in the purchase price term of the option.) However, if the optionee determines that the option price is higher than the property value, it can just not exercise the option. Thus, the potential purchaser (optionee) tends to prefer a typical option arrangement because it gives them maximum flexibility and puts them in control of the decision.

A ROFR (or ROFO) can be more attractive to a property owner because it does not compel them to sell the property at any time – it merely directs them to first consider the optionee if they choose to sell. However, the ROFR/ROFO can be a hindrance to the marketing/negotiation period when putting a property up for sale, since it is not tied to a specific period (like a typical option). Both the ROFR and ROFO are lingering rights that may occur sometime in the future, or may never occur at all.

A property owner typically prefers a ROFO to a ROFR because the right is exercised (and extinguished) before the property owner spends valuable time and money preparing, marketing, and collecting offers on the property (and if the optionee’s offer is attractive enough, the property owner can skip that process entirely).

There are many reasons a party might prefer one type of option to another, based on the parties, property, and transaction details. For instance, a particular type of option might allow a party to assemble multiple parcels, position itself for an exchange transaction, or buy time for a financing contingency. An option in a sale-leaseback transaction might be attractive from a tax standpoint as well.

Understanding the differences between the types of option contracts is paramount to structuring these rights, as is using clear and correct language to describe them. As with any contract, an option contract is subject to the customary rules of construction. (See, e.g., Goodwest Rubber Corp. v. Munoz (1985) 170 Cal.App.3d 919.) In a dispute, courts will look to the intent of the parties in determining what type of option actually exists, regardless of what title the contract has.

For more detailed information about option contracts in the real property purchase and sale context, see CEB’s California Real Property Sales Transactions, chapter 8.

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