Hello everybody. In light of a new decision issued on March 15, 2018 by the California Court of Appeal about lease “options,” it is timely for this month’s article to reexamine them.
In this new case (Petrolink v. Lantel Ent.) the appellate court was presented with a lease agreement that gave the lessee an option to purchase the property from the lessor at a price equal to “the fair market value based on an appraisal.” The lease did not specify a specific amount for the purchase or who would perform the appraisal.
The tenant timely exercised the option to buy but the landlord then refused to sell the property, contending at trial that because the purchase price was not specified, the option was not valid.
To hedge his bets and not to be in default under the lease, the lessee continued to make the rental payments of $3,735.00 per month from the time of his exercise through the time of trial.
During trial, the tenant asked the judge to determine that the option was valid because the purchase price was to be fixed at the fair market value. The lessee also asked the court to award back to him all of the rent he paid after exercising the option.
Before reading further, please ask yourself two questions:
1. Do you believe that the option was too vague as to the purchase price to allow the lessee to purchase the property? Please reread the option verbiage (it’s in the second paragraph of this article) before answering.
2. Should the tenant be allowed to recoup all of his rental payments that he made (if
Before responding to those two questions, let’s first discuss some aspects of a lease “option.”
The Nature of an Option
An option is an agreement between at least two parties whereby the “optionor” (i.e., the person giving the option) empowers the “optionee” (i.e., the person receiving the option) to exercise (or choose not to exercise) a right under a contract. In a real estate context, options often involve the right of a tenant to extend or renew the term of a lease or the right of the lessee to purchase the property during the lease term.
Generally a real estate lease option must contain the following elements: (1) the names of the parties, (2) a description of the property to be acquired, (3) the price (whether fixed or objectively ascertainable) that the optionee is given to acquire the property, (4) the time and manner of payment, and (5) a statement of the rights the optionee acquires relative to the property.
With respect to options given by lessors to lessees to extend the initial term of the lease, disputes generally arise over the issue of how much the rent will be in future years once the tenant exercises the option. If the option fails to provide an objective basis by which the rent can be determined, then the option will be void or unenforceable. For example, consider the following provision: “Lessor grants to Lessee an option to extend the term of this Lease for an additional five years under all of the same provisions and conditions, except for the rent which shall be
determined by mutual agreement at the time of the exercise of the option.”
Such a provision is merely an agreement to agree. It provides no ascertainable standard by which anyone, including a court, can determine what the rent is supposed to be. So it is an unenforceable option. (Etco Corp. v. Hauer 161 C.A.3d 1154)
Thus, a clever, if not unscrupulous, landlord who wants to make it appear to the tenant that the landlord is conferring an option might use the preceding language, knowing that the court will not enforce the provision.
On the other hand, if the option does not specify the amount of the new rent but provides a basis by which the rent can objectively be determined, then the option will be enforceable. As an example, the following provision would be upheld: “Lessor grants Lessee an option to extend the term of this Lease for an additional period of five years under all of the same provisions and conditions, except for the rent which shall be the reasonable rental value as of the time of the exercise of the option.”
The preceding provision is enforceable because the reasonable rental value could be established by the testimony of brokers, appraisers or other experts in the field. Of course, the best way to provide certainty and lessen the likelihood that litigation will ensue is for the parties to specify the exact rent or to provide that the rent will increase by some specified mathematical formula. One such formula would be for the rent to increase by the same percentage that the Consumer Price Index increases over a stated period of time. Of course, landlords should be cautious to specify which CPI will be used as there are many different ones. Another problem with options is the timing for their exercise. If the option does not specify the exact time for exercise, then a “reasonable” amount of time will be allowed. (Allen v. Smith 94 C.A.4th 1270) The problem, obviously, is that the parties may differ in opinion as to what constitutes a “reasonable” time, and that disagreement may lead to litigation. An even greater problem arises where the date specified for the exercise of the option falls on a Saturday, Sunday or legal holiday. In most fields of the law, where the last date to perform an act falls on such a date, there is a statute (i.e., C.C.P. Section 12a) which extends the right to perform the act until the next business day. For example, assume a tenant is served with a 3-day notice to pay rent or quit on Wednesday, May 2, 2018. The third day will fall on Saturday, May 5, 2018. The tenant will then be allowed until Monday, May 7, 2018 during which to pay his rent. (Lamanna v. Vogner 17 C.A.4th Supp. 4)The law is different with respect to an option. In the important case of Gans v. Smull (111 C.A.4th 985), the court held that no statute governs the exercise of an option to extend a lease. Thus, if the lease sets forth a 60-day deadline for the exercise of the option, the tenant must exercise the option on or before the 60th day, even if the 60th day is a Saturday, Sunday or legal holiday. That is a huge trap for the unwary, including attorneys. I estimate that 99 lawyers out 100 would erroneously opine, if asked, that the deadline for the exercise of such an option would extend to the next business day following the weekend or holiday. In the context of leases, the same rules apply regardless of whether it contains an option to extend the term or an option to purchase the property. No grace period is statutorily imposed for the exercise.
The Answer to the Two Questions
As discussed above, if an option provides that the price will be at the fair market value at the time of the exercise, then the option will be enforceable even though the parties might not then agree upon the fair market value.
With the testimony of qualified appraisers, the Court can determine the market value and compel the lessor to convey the property to the lessee at the market value as determined by the court. That is what happened in the Petrolink case. The lessee’s appraiser valued the property at $320,00 while the lessor’s appraiser testified that the fair market value was$1,615,000. (What an incredible difference!)
After adjustments, the trial court determined that the FMV was $889,000 at the time the lessee exercised the option.
With respect to whether the lessee was entitled to a refund of the rents it paid from the time it exercised the option until the time of trial, the trial court said “No.”
However, on appeal, the appellate court said “Yes.” It then reversed the lower court’s decision in that regard and held that the tenant was entitled to a refund of all of the rents it paid. The Court of Appeal’s reasoning was that the moment the lessee exercised the option to purchase the property, the lease automatically terminated and a contract for the purchase and sale came into existence. When the lessor then refused to sell the property to the lessee, the lessor itself was in breach of the option agreement.
As the Court of Appeal said, “Unless there was an express agreement in the lease that required the lessee to continue to make rent payments after exercise of the purchase option, no further rents were due.”
To avoid legal disputes, the legalese of lease options should be very clear and contain definite terms relative to the option, particularly with respect to the rent which will be charged during the extended term of the lease or the purchase price which will be paid in order to acquire the property.
Stating that the price will be the fair market value of the property is sufficient, but may lead to litigation if the appraisals differ. One appropriate “appraisal” method of fixing the purchase price is for the lease to provide that the lessor and lessee shall each engage their own respective appraisers to value the property. If the two appraisers can then agree on the value, that will become the purchase price. The lease would also provide that if the two appraisers do not agree, the appraisers would then mutually select a third appraiser. That third appraiser then values the property. Then, of the three appraisals, the two that are the closest together are averaged (i.e., the midpoint between the two) which then becomes the option purchase price.
Additionally, landlords may want the lease to provide that the tenant will continue to owe and pay the monthly rent through the date of the close of escrow. Tenants will want just the opposite to be stated in the lease, namely, the rent abates upon the tenant’s exercise of the option.
In any event, the best advice is to ensure that the terms of the option are specific and definite in order to eschew future disputes between the lessor and lessee and avoid ending up in expensive litigation.
Dale Alberstone is a prominent litigation and transactional real estate attorney who has specialized in real property law for the past 40 years. He has been appointed to periodically serve as a judge pro tem of the Los Angeles Superior Court and is a former arbitrator for the American Arbitration Association. He also testifies as an expert witness for and against other attorneys who have been accused of legal malpractice.
Mr. Alberstone has been awarded an AV rating from Martindale-Hubbell. An AV rating reflects an attorney who has reached the heights of professional excellence and is recognized for the highest levels of skill and integrity.
The foregoing article was authored in April 2018. It is intended as a general overview of California law and may not apply to the reader’s particular case. Readers are cautioned to consult an advisor of their own selection with respect to any particular situation.
Questions of a general nature are warmly invited. Address correspondence to Dale S. Alberstone, Esq., ALBERSTONE & ALBERSTONE, 1900 Avenue of the Stars, Suite 650, Los Angeles, California 90067. Phone: (310) 277-7300.