What’s the Difference Between an Option and a Right of First Refusal in Real Estate?
Real estate terminology can be confusing, but it is important to understand the differing meanings of similar terms because those differences can affect your rights and responsibilities. In our office, we are sometimes asked about the difference between an “option” and a “right of first refusal” in the real estate context.
What is an Option to Purchase?
An option is also sometimes called an “option to purchase” or an “option contract.” An option is a type of contract, which means in order for it to be enforceable, each side must give something of value (“consideration,” in legal terms). The owner of the property (the “optionor”) gives a potential buyer (the optionee) the exclusive right to buy the property under certain terms during a specific time period. The optionee pays a premium for this option.
The optionee can choose to exercise their option to purchase at any time within the specified period. The optionor, however, cannot withdraw the option to purchase until the option period expires. If the value of the property increases during the option period, the optionee may choose to exercise the option and pays the previously agreed-upon price for the property. If the value of the property decreases, the optionee may decide not to exercise the option. In that case, the optionor keeps both the property, which they can sell to someone else, and the money paid for the option to purchase.
A real estate option has advantages for both purchasers of residential real estate and investors. Let’s say you want to build a home in a certain area. Lots are going fast, but you don’t yet have the financing you need. If you can purchase an option, you can secure the right to buy the property you want while you pin down financing. If the property value rises, you not only have the lot you wanted, but you will pay less for it than you would have had you waited (assuming it was still available). If the property value falls, or you find an even better lot, or you can’t obtain the needed financing, you can walk away without having lost too much money.
An investor might purchase an option to buy land in an area desirable for commercial development. If she buys the property outright, she risks not being able to find developers or other investors to pay what she wants for the land. With an option to purchase for a specific price in hand, an investor can seek out developers. If she finds she will be able to turn a profit, she can exercise her option. If not, she can let the option period expire.
What is a Right of First Refusal?
A right of first refusal (ROFR) also gives a potential purchaser the right to buy certain real estate, but under somewhat different circumstances than an option to purchase. A right of first refusal requires the owner of the property to sell it to the holder of the ROFR under the same terms as with another party. As with an option to purchase, the holder of the ROFR has the right, but not the obligation, to purchase the property if the owner decides to sell. If the property owner decides to sell, but the holder of the ROFR declines to exercise their right, the owner may then sell the property to another purchaser.
Rights of first refusal are common in lease agreements, either as part of the agreement or a stand-alone agreement. For example, let’s suppose you owned a coffee shop and rented a storefront in the busy shopping district of town. Your customers know where to find you and there’s a lot of walk-in traffic, so you would hate to lose the location if the owner ever sold the building. The owner is not interested in selling right now, though, so you can’t buy the building and guarantee you will be able to stay there.
If you can get the owner to give you a ROFR, though, you will have the first opportunity to buy if he ever does decide to sell. It’s not (yet) an option to purchase, because there is no guarantee that the property will ever come up for sale. If the owner does decide to sell, the right of first refusal becomes an option to buy. In short, an option requires the property owner to sell if the optionee wants to buy; a ROFR does not compel the property owner to sell unless and until they are ready to.
Like an option to purchase, a ROFR is a contract that requires consideration from both parties. Both options and ROFRS must also:
- Be in writing;
- Contain a description of the property;
- Be signed by the parties.
If you are interested in buying or selling real estate and need help drafting an option to purchase or a right of first refusal, please contact The Law Offices of Dana M. Kyle to schedule a consultation.
