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When a Tenant Exercises an Option to Purchase, When Does the Obligation to Pay Rent End?

Some commercial leases provide the tenant with an option to purchase the real property.

When the tenant exercises such an option, does the tenant’s obligation to pay rent cease immediately?  Or does it continue until the purchase eventually closes (even if there is litigation over the option that delays closing)?  Or some time in between?

As clarified by a recently published opinion from California’s Fourth Appellate District — Petrolink, Inc. v. Lantel Enterprises — it all depends on what the lease says (or doesn’t say).

Facts: tenant exercises the option to purchase, but the parties can’t agree on price

Petrolink, Inc. leased a parcel of undeveloped property from Lantel Enterprises.  The lease included a provision allowing Petrolink to purchase the property at its fair market value at any time after the initial 10-year term had elapsed.  The option was phrased as follows:

Right to Purchase.  As long as the Tenant is not in default of this Agreement, Tenant will have an option to purchase the property at any time after the first Ten (10) years of the lease term at a price equal to the fair market value of the property based on an appraisal.

About thirteen years after the lease was executed, Petrolink mailed a notice to Lantel exercising the option to purchase.

Lantel hired an appraiser who valued the property at $1,615,000, and Lantel demanded that amount from Petrolink in order to complete the sale.

Petrolink hired its own appraiser, who valued the property at only $320,000, and Petrolink offered that amount to Lantel.

Unable to agree on a price, Petrolink sued Lantel for specific performance.

The trial: trial court sets a price; does not allow offsets for rent paid after exercise of option

The trial court conducted a bench trial, in which it heard the testimony from both sides’ expert appraisers, and also from an independent appraiser appointed by the court.

The independent appraiser testified that the fair market value, including “bonus rent” (the difference between fair market rent and the rent due under the lease) totaled $889,854.  Not surprisingly, the court held that the fair market value — and thus, the purchase price — was $889,854.

Petrolink argued that the fair market value should be offset by the rents that it paid from 30 days after exercising the option up to the conclusion of trial, on the grounds that the sale should have reasonably closed by then.  That rent totaled almost $400,000.

The trial court rejected Petrolink’s argument, and refused to offset the purchase price by any amount.  The trial court appeared to believe that the rent obligation continued until the purchase price was conclusively established, which did not occur until judgment was entered following trial.

The Court of Appeal’s opinion: tenant is entitled to offset for rents paid after exercise of option

The Court of Appeal reversed, holding that Petrolink was entitled to an offset for the rents paid following its exercise of the option.

Under California law, the timely and proper exercise of an option to purchase within a lease “transforms” the lease into a binding contract of purchase and sale.  At that moment in time, the lease (and any obligation imposed by the lease — such as the payment of rent) terminate, “unless there is an express stipulation that requires continued rent payments after the exercise of the purchase option.”

Here, the lease said nothing about any continuing rent obligation after the exercise of the option to purchase.  The court therefore held that “after the exercise of the purchase option, no further rents were due.”

Lantel argued that Petrolink’s continued payment of rent after the exercise of the option reflected both parties’ understanding that such continuing rent payments were required.  The court rejected this argument, noting Petrolink’s explanation that it only continued paying rent to ensure that it would not be considered in “default” of the lease in case the trial court ruled that it had not validly exercised the option.

The court remanded the case to the trial court to make adjustments to the purchase price.

Petrolink was entitled to an offset for the rents paid after the time the property should have been conveyed to Petrolink.  The court also held that to achieve complete justice between the parties, Lantel was entitled to an adjustment (a reduction of Petrolink’s rent offset) for the lost use of the purchase money during the period that the purchase was delayed.

In making these adjustments, the trial court would have to determine when the purchase and sale “reasonably should have been performed.”

Lesson

As with all contracts, leases should be written clearly and should anticipate future problems.  In the lease in this case, the option to purchase probably should have provided for an appraisal mechanism (such as binding arbitration) to conclusively determine the value in a streamlined fashion.  The lease also could have clarified exactly when the sale should close, and exactly when the rent obligation would cease.

Otherwise, this case illustrates the default rule that unless the lease says otherwise, the obligation to pay rent will cease once the tenant exercises an option to purchase.

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