P4. Options and Rights of First Refusal

When letting properties to tenants’ agents are often asked to include a clause giving the tenant the right to purchase the property at a later date, but usually during the period of the tenancy. Many letting agents are unaware that there are two very different ways of doing this and they accordingly misinterpret the steps that must be taken for the tenant to exercise his rights. The two alternatives are to give the tenant either a right of first refusal or an option to purchase.

Agents often presume that these are just two different ways of saying the same thing with the result that the right may not be properly exercised, leading to major problems later.

The Difference Between an Option and a Right of Refusal

An option to purchase is a right given to a tenant which he can exercise during the time allowed to him in his lease. Usually, if a proper clause is inserted in the contract, it will give him the right to purchase the property at any time during the lease provided he gives written notice of his intention to purchase not less than thirty days before the expiry of the lease. The value of an option is that the landlord is obliged to sell the property to the tenant once he chooses to purchase it and complies with his obligations.

A right of first refusal does not allow a tenant to choose to purchase the property at his sole discretion. It may only be exercised if the landlord elects to sell the property during the term of the lease (or any other period specifically stipulated in the lease). In this case, the landlord must first allow the tenant an opportunity to purchase the property before concluding a sale with another purchaser. The landlord must notify the tenant of his intention to sell and the tenant, once again, must comply with his obligations if he wants to buy the property. In this case, the landlord can still decide not to sell to any party including the tenant and advise the tenant accordingly. He is not bound to the obligations applying to options to purchase.

Fixing the Purchase Price of the Property

It is obvious that the two rights are very different in terms of their obligations and agents must exercise care in allowing either of them to a tenant. In the case of an option, if the parties do not agree on the purchase price beforehand and fail to state it when recording the option, the right is useless and cannot be enforced. This is one of the drawbacks of granting an option to purchase – the landlord must fix the purchase price upfront and may not change it later even if market conditions have substantially increased the property’s value.

With a right of first refusal, the situation is very different and somewhat ambiguous. The law states that, if the purchase price has not been fixed as a condition of the right, the landlord must offer the property to the tenant at a price that a third party is prepared to offer for it. The landlord cannot rely on the property’s municipal value or an agent’s valuation of its current market value.

It appears that the only way to comply with the law here is for the owner to first get a genuine offer to purchase at arms-length from a third party and then give the tenant the right to match that offer. Only if the tenant fails to do so may the landlord conclude the sale with the third party.

This appears to be highly irregular in that the landlord is being compromised in terms of his alternative purchaser. He must obviously inform the third party of the tenant’s pre-emptive right, knowing that this may discourage the former from putting in an offer at all. However, irregular this may be, it seems to be the way our courts have generally interpreted the law here.

How to Properly Handle these Rights

What must rental agents do to prevent trouble afterwards if either right is ignored or not properly exercised? With an option, the ideal answer is to draw the eventual deed of sale upfront inclusive of all its ancillary conditions (such as the date of occupation, whether the landlord will provide an electrical certificate, how the purchase price will be paid, etc.). This makes the final contract certain.

It is not signed at the time the lease is concluded (it must not be signed upfront!) but is attached to the lease agreement as an annexure and is only initialled by each party. The value of this is that all the terms of the sale have already been concluded before the lease is even signed. Otherwise, as often happens, when the tenant decides to exercise his option, he may find that the landlord will disagree with him on the finer details of the contract and its ancillary conditions.

The lease simply needs to say that if the tenant does want to exercise his option, the draft agreement attached to the lease contract will become the actual sale agreement between the parties.

With a right of first refusal, agents need to exercise considerable care. Here the law, as has already been seen, is somewhat inconsistent and is not what common sense might suggest it should be. Invariably sellers and agents think they must first go to the tenant, fix an asking price (if one has not been determined in the lease agreement), and then oblige the tenant to sign a sale agreement within a chosen period of time (once again, if one hasn’t been fixed in the lease agreement).

In a recent case, the tenant was unable to meet the landlord’s asking price (which was genuinely market-related) and the landlord duly sold the property to a third party. After this the tenant came back, objecting that the correct procedure had not been followed and that she now wanted to exercise her right. The matter became complicated when her alternative offer did not match the first one completely (though it did comply with its fundamental terms) and the matter ended up in the courts, putting both parties to considerable expenses and costs with the seller having to pay damages to the third party to get his sale to her subsequently cancelled.

Avoid giving Rights of First Refusal

In the latter case, the lease agreement simply stated that a right of first refusal was given to the tenant without saying anything further. No time was stipulated for the exercise of the right and no provision was made for determining the purchase price. Numerous complications duly arose afterwards. The same would apply to any mention of an option to purchase if nothing more was stated. It is best to avoid giving rights of first refusal in view of the ambiguities in the law.

Always give the tenant an option to purchase as this is a certain right he can exercise, and make sure the purchase price is stated and a time fixed for the exercise of the option. Preferably, as already suggested, draw the final sale agreement, and attach it as an annexure to the lease contract which the parties must only initial to confirm that it contains all the terms and conditions agreed to between them.

If the landlord insists, he is only willing to give a right of first refusal and the tenant accepts this, make sure the determination of the purchase price (or its pre-agreed amount) and the manner in which the right must be exercised are clearly stated in the lease agreement. Otherwise, the common law principles will apply and, as has been seen, this can create difficulties and problems for the parties and, possibly, the agent as well.

Compare listings