Real estate contracts - Options and rights of first refusal

Learning Outcomes

This article explains the distinct features of option contracts and rights of first refusal (ROFRs) within the context of real estate transactions. After reading this article, you will be able to differentiate between these two types of agreements, understand their formation requirements, including consideration, and analyze how they are exercised or triggered. You will also understand the application of the Rule Against Perpetuities to these interests and the remedies available for breach, preparing you to tackle related MBE questions effectively.

MBE Syllabus

For the MBE, you are required to understand specific types of real estate contract provisions that create future purchase rights. This involves analyzing their creation, validity, exercise, and termination. You should be prepared to:

• Define and distinguish option contracts and rights of first refusal (ROFRs).
• Analyze the consideration requirements for option contracts under common law.
• Identify the requirements for valid exercise of an option (e.g., timing, manner).
• Determine when a ROFR is triggered by a seller's actions.
• Analyze the requirements for the valid exercise of a ROFR (e.g., matching the third-party offer).
• Apply the Rule Against Perpetuities (RAP) to options and ROFRs.
• Identify remedies for breach of an option contract or ROFR.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. An option contract for the sale of land requires which of the following to be irrevocable for the stated period?
   1. A writing signed by the optionor only.
   2. Consideration from the optionee.
   3. A statement that the offer is firm.
   4. Recordation in the county land records.
2. A landowner grants a neighbor a right of first refusal (ROFR) to purchase the landowner's property for 300,000ifthelandownereverdecidestosell.Later,thelandownerreceivesabonafideofferfromathirdpartytopurchasethepropertyfor300,000 if the landowner ever decides to sell. Later, the landowner receives a bona fide offer from a third party to purchase the property for 300,000ifthelandownereverdecidestosell.Later,thelandownerreceivesabonafideofferfromathirdpartytopurchasethepropertyfor320,000. What must the landowner typically do?
   1. Sell immediately to the third party.
   2. Offer the property to the neighbor for 300,000.c)Offerthepropertytotheneighborfor300,000.
   3. The ROFR is void because no consideration was paid.
3. Which interest is generally subject to the common law Rule Against Perpetuities?
   1. An option to purchase held by a current tenant within the lease term.
   2. A possibility of reverter.
   3. A right of first refusal granted to a specific, living individual.
   4. A right of first refusal granted "to the grantee, its heirs and assigns."

Introduction

Beyond standard purchase agreements, real estate contracts can involve unique mechanisms granting potential future purchase rights. Two important types tested on the MBE are option contracts and rights of first refusal (ROFRs). While both create potential purchase opportunities for the holder, they function differently. An option gives the holder the power to compel a sale on predetermined terms within a set timeframe by exercising the option. A ROFR, conversely, gives the holder the right to match a third-party offer if and when the owner decides to sell on those terms. Understanding their distinct formation, exercise, and termination rules, particularly regarding consideration and the Rule Against Perpetuities, is essential.

Key Term: Option Contract An agreement where an owner (optionor) gives another party (optionee) the right to purchase property at a fixed price within a specified time, usually supported by separate consideration to make the offer irrevocable during that period.

Key Term: Right of First Refusal (ROFR) A contractual right granting the holder the opportunity to match the terms of a bona fide third-party offer to purchase property, if the owner decides to sell. The owner is not obligated to sell, but cannot sell to a third party without first offering it to the ROFR holder on the same terms.

Option Contracts

An option contract creates a power of acceptance in the option holder (optionee). The owner (optionor) makes an offer to sell on specific terms and separately promises to keep that offer open for a specified period.

Formation

1. Offer: There must be an initial offer specifying the essential terms for the sale of the property (parties, property description, price, closing date).
2. Irrevocability Promise: The optionor must promise to keep the offer open for a certain time.
3. Consideration: At common law (which governs real estate contracts), the promise to keep the offer open must be supported by consideration from the optionee. This makes the offer irrevocable during the option period.
   • The consideration for the option itself is separate from the purchase price of the property. Even nominal consideration (e.g., $10) is often sufficient if paid or recited, though courts may inquire into adequacy if it seems like a sham.
   • MBE Distinction: Do not confuse this with the UCC Firm Offer rule (§2-205), which applies to sales of goods and allows a merchant's signed, written offer stating it will be held open to be irrevocable without consideration for up to three months. This rule does not apply to real estate options.

Exercise (Option Contracts)

The optionee exercises the option by accepting the initial offer before the option period expires.

• Method: The option contract usually specifies how the option must be exercised (e.g., written notice, specific payment). Strict compliance with these terms is generally required.
• Timing: Acceptance must occur within the time stated in the option. The "mailbox rule" generally does not apply to option acceptances; acceptance is typically effective only upon receipt by the optionor before the option expires.

Rule Against Perpetuities (RAP)

Options to purchase land are generally subject to the common law Rule Against Perpetuities.

• Violation: An option granted "to A and his heirs and assigns" without a time limit likely violates the RAP because it could theoretically be exercised by remote descendants long after any lives in being plus 21 years.
• Exceptions:
  • Options held by a current tenant to purchase the leased property during the lease term are generally exempt from the RAP.
  • Rights of first refusal are sometimes analyzed under the RAP, but often under the Rule Against Restraints on Alienation instead (see below). Modern trend favors the restraints analysis.

Worked Example 1.1

Owner offers Buyer the option to purchase Blackacre for $200,000 at any time within the next 60 days. Buyer pays Owner$100 for this option. Thirty days later, Owner receives an offer from Third Party to buy Blackacre for $220,000 and notifies Buyer that the option offer is revoked. Buyer immediately sends Owner a written notice exercising the option. Is there a valid contract for the sale of Blackacre between Owner and Buyer?

Answer: Yes. An option contract was formed. Owner made an offer to sell Blackacre with specific terms. Owner promised to keep the offer open for 60 days, and this promise was supported by consideration ($100) from Buyer. Therefore, Owner's offer became irrevocable for the 60-day option period. Owner’s attempt to revoke within the 60 days was ineffective. Buyer validly exercised the option by accepting the initial offer within the option period.

Rights of First Refusal (ROFRs)

A ROFR (also called a preemptive right) creates a conditional right to acquire property. Unlike an option holder, a ROFR holder cannot compel the owner to sell. The ROFR only becomes active if and when the owner decides to sell to a third party.

Triggering the ROFR

The ROFR is typically triggered when the owner:

1. Receives a bona fide, acceptable offer from a third party to purchase the property; and
2. Decides to accept that offer.

The owner must then offer the property to the ROFR holder on the exact same terms offered by the third party.

Exercise (ROFR)

• Matching Offer: The ROFR holder must typically exercise the right by agreeing to match all material terms of the third-party offer. Minor variations may be permissible depending on the jurisdiction and the specific ROFR language.
• Time Limit: The ROFR agreement usually specifies a time within which the holder must exercise the right after receiving notice of the third-party offer. Failure to exercise within that time extinguishes the right for that specific transaction.

Rule Against Perpetuities (RAP) / Restraints on Alienation

• RAP Application: Jurisdictions are split on whether ROFRs are subject to the RAP. Many courts find that they are, especially if granted "to heirs and assigns" without a time limit, as they could theoretically be exercised remotely.
• Restraints Analysis: An increasing number of courts analyze ROFRs under the Rule Against Unreasonable Restraints on Alienation instead. Under this analysis, a ROFR is valid if it is reasonable in terms of duration and price mechanism (e.g., requiring a match of a market-based third-party offer is usually reasonable). A fixed-price ROFR lasting indefinitely is more likely to be considered an unreasonable restraint.

Worked Example 1.2

Landlord includes a clause in Tenant's 5-year lease stating: "Tenant shall have the right of first refusal to purchase the leased premises." Three years into the lease, Landlord receives a bona fide offer from Buyer for $500,000 cash, closing in 30 days. Landlord notifies Tenant of the offer. Tenant responds, "I accept, but I need 90 days to secure financing." Has Tenant validly exercised the ROFR?

Answer: Likely no. To exercise a ROFR, the holder must typically match the specific terms of the third-party offer. Buyer offered cash with a 30-day closing. Tenant's response proposed different terms (financing contingency, 90-day closing). This constitutes a counteroffer, not an acceptance matching the third-party terms. Tenant has likely failed to validly exercise the ROFR.

Exam Warning

A key distinction is that an option creates the power to compel a sale by accepting an existing offer, while a ROFR merely creates the right to receive an offer on the same terms as a third party if the owner decides to sell. An option contract requires consideration to be irrevocable at common law; a ROFR does not require separate consideration beyond being part of a larger agreement (like a lease) but must be reasonable.

Remedies

• Option Contracts: If the optionor refuses to sell after the optionee validly exercises the option, the typical remedy is specific performance, compelling the owner to convey the property. Damages may also be available.
• ROFRs: If the owner breaches the ROFR by selling to a third party without first offering it to the holder, the holder may seek specific performance (forcing the owner, and potentially the third-party buyer if they had notice, to convey the property to the holder upon matching the terms), an injunction against the sale, or damages.

Key Point Checklist

This article has covered the following key knowledge points:

• An option contract requires an offer, a promise to keep the offer open, and, at common law, consideration for that promise.
• Options give the holder the power to compel a sale by accepting the offer within the specified time.
• A Right of First Refusal (ROFR) gives the holder the right to match a third-party offer if the owner decides to sell.
• A ROFR does not compel the owner to sell but restricts their ability to sell to a third party without first offering it to the holder on the same terms.
• Options must be exercised strictly according to their terms, especially regarding timing (mailbox rule usually inapplicable).
• ROFRs require the holder to match the material terms of the third-party offer.
• Both options and ROFRs can raise issues under the Rule Against Perpetuities, though ROFRs are often analyzed under the Rule Against Unreasonable Restraints on Alienation.
• Specific performance is a primary remedy for breach of both types of agreements.

Key Terms and Concepts

• Option Contract
• Right of First Refusal (ROFR)