Option Agreements In Real Estate Leases Require Careful Drafting

• Posted on: Nov 17 2017

Many leases provide for a tenant’s option to purchase the subject real property.  The recent case of Blackburn Food Corp., et. al. v. Ardi, Inc., et. al., (Sup. Ct. Suffolk Co. October 25, 2107), illustrates the importance of, inter alia, careful drafting when dealing with real property purchase option agreements.

The plaintiffs in Blackburn entered into a ten-year lease for real property.  The lease contained an option, which, if exercised within the first three years of the lease, permitted plaintiffs to purchase the property for $975,000 provided they were not in default of their lease obligations.  A rider to the lease provided that if the option was exercised, the plaintiffs would receive as a credit against the purchase price, a sum equal to the amount paid in base rent for the first three years of the lease ($144,000) and the purchase price paid by plaintiff for the ongoing restaurant business operated at the property ($150,000) (the “Credits”).

The option provides:

Provided tenant is not default of this Lease Agreement, it shall have the Option to Purchase the Premises for the purchase price of Nine Hundred Seventy Five Thousand ($975,000) Dollars subject to the terms herein.  Tenant shall receive a credit against the purchase price in the amount of base rent actually paid for years 1, 2 and 3, exclusive of taxes, insurance and utilities…together with the total “Key Money” paid ($150,000.00).  The option to purchase shall terminate thirty days prior to the end of Year 3 unless earlier terminated by Tenant’s default under this Lease Agreement.

Thereafter, the parties executed a supplemental rider extending the option period by one year making the option exercisable for the first four years of the lease.  The supplemental rider, which did not address whether the Credits would be applied to the purchase price if the option was exercised in the fourth year of the option period, provides:

Landlord/seller and Tenants/purchasers agree that the option to purchase is an exclusive option of tenants/purchasers and this exclusive option period shall expire 30 days prior to Year five (5) of the Lease Agreement. (Emphasis supplied by the Court.)

When plaintiffs exercised their purchase option in year four and requested Credits totaling almost $300,000, the defendants balked; arguing that while the option period was extended for one year, the right to receive the Credits expired at the end of year three.  Plaintiffs brought suit against Defendants based on their refusal to sell the property to the plaintiffs for anything less than the full purchase price.  Plaintiffs complaint contained a cause of action for specific performance of the contract at the option price of $681,000 and a cause of action to recover any rent paid after exercising the option.

The case was tried after summary judgment was denied to both parties because the “option language was reasonably susceptible of more than one meaning.”  At trial, plaintiffs presented several witnesses and defendants presented none.  The Court credited the unrebutted testimony of plaintiff Blackburn that he believed that “the option extended to five years the credit for rent paid in the first three years.”  The Court found plaintiff’s interpretation to be “consistent with the written agreement” because the supplemental rider “merely extended” the original option for an additional period of time and that “[t]here is no language in the supplemental rider regarding the purchase price for the [C]redits, and nothing in the supplemental rider regarding the purchase price or the [C]redits, and nothing in the supplemental rider indicates that the Blackburns would not receive the [C]redits if they exercised the option in year four or five of the lease.”

The Court found defendants’ interpretation of the lease riders related to the options to be inconsistent with some of the exhibits introduced at trial as well as with accepted principals of contract interpretation, holding that:

A lease, like any other contract, is to be enforced in accordance with the expressed intention of the contracting parties.  In the context of real property transactions, where commercial certainty is a paramount concern and where, as here, the instrument was negotiated at arms length between sophisticated, counseled business people, courts should be extremely reluctant to interpret the agreement as impliedly stating something that the parties have neglected to specifically include.  Hence, courts may not by construction add or excise terms, nor distort the meaning of those used, and thereby make a new contract for the parties under the guise of interpreting the writing. (Citations omitted.)

The Court recognized the settled principal that strict adherence to the to the terms and conditions of the option agreement is necessary to validly exercise an option to purchase real property and found that plaintiffs so complied.  The Court also found that plaintiffs proved that they had the financial wherewithal to purchase the property and, thus, were “ready, willing and able” purchasers.  Accordingly, the plaintiffs prevailed on their specific performance cause of action.

The plaintiffs, however, failed on their second cause of action, which was to recover such rent as was paid after exercising the purchase option.  The Court explained the law in this regard as follows:

When, as here, a tenant exercises an option to purchase real property pursuant to a lease, the relationship between the parties is converted to that of a vendor and vendee, and the landlord-tenant relationship merges with the vendor-vendee relationship.  When a merger has occurred, the owner of the property is not entitled to an award for use and occupancy of the premises from the vendee in possession unless the parties clearly intended a contrary result.  An intention to deviate from the general rule and to avoid a merger may be directly expressed in the agreement or may be inferred from a medley of factors such as the terms of the agreement, the circumstances of its making, and the subsequent behavior of the parties.  (Citations omitted.)

The Court found that numerous provisions in the lease and certain language in the parties’ “stipulated statement of the facts”, were sufficient to establish that the merger was avoided and, accordingly, the landlord-tenant relationship survived the plaintiffs’ exercise of the option.

TAKEAWAY

Great care must be taken when negotiating and drafting leases and option agreements to ensure that the signed documents clearly reflect the agreement of the parties.  The Court in Blackburn found the parties’ option agreement to be ambiguous and, thus, a trial was required to determine the contract’s meaning.  The fact that the supplemental rider did not specifically state that the Credits would not be applied to the purchase price if plaintiff exercised the option between years three and four cost the defendant/seller almost $300,000.00.  The Court’s decision indicates that the result could have been avoided by simply incorporating language into the supplemental rider stating that while the option period was extended by one year, the Credits would not be applied if the option was exercised between years one and three.

Similarly, specific language within the lease was sufficient to avoid the merger of the landlord-tenant and vendor-vendee relationships that would have otherwise operated to relieve plaintiffs of their obligation to pay rent once they exercised their right to the option.  While it remains unclear to what extent the relevant language was negotiated, vendees and their counsel should be mindful of the merger issue and refrain from incorporating into option agreements, language that may operate to avoid the merger and, therefore, continue vendee’s rental payment obligations subsequent to exercising any rights under option.

Tagged with: Business Litigation, Commercial Litigation, Contract Interpretation, Option Agreements, Real Estate Law