What is an Option to Purchase?
An Option to Purchase contract is essentially an agreement to buy or lease on specific terms at a later date. Typically seen in real estate, an option may be in the form of a courtesy offer to a tenant, giving them the first chance at buying a property, prior to any sale occurring on the open market.
This is a right, rather than an obligation, and grants time for the purchaser to make an informed decision about a potential purchase before committing to a full sale or lease .
In many industries the agreement may give an investor an opportunity to invest in a business under specific circumstances, and it provides the seller with an option to gauge the commercial or residential viability of a location prior to purchasing the property.
The land contract offers a form of reassurance, though it could also act as a disincentive for both parties if the investment does not pay out, but it is there to protect both the purchaser and the vendor from changing requirements that could be costly for both.
Benefits of an Option to Purchase
An option to purchase contract has several advantages for buyers. First, it is a way of securing a low purchase price by enabling buyers to make a binding offer after any market price down turn occurs. It is also easier to make it subject to financing than a firm sale agreement because a firm sale agreement with a condition only gives the buyer a few days to arrange financing whereas an option purchase gives the buyer six months to find financing.
Second, a builder may be willing to enter into an option to purchase because it does not have to open up its show suites for several months. The builder also does not have to start construction until it is clear that the subdivision sales are strong.
Third, an option to purchase gives a purchaser time to see how serious a builder is and how well that builder sells. It may be easier to get favourable adjustments or allocations of parking stalls with a builder that is not yet committed. The first builder to complete may be the most expensive.
Fourth, an option to purchase agreement may be easier to terminate. While the buyer will typically lose its deposit, the buyer can walk away and not worry about it. The seller also will typically prefer to terminate the contract so that it can sell elsewhere.
There are several advantages for sellers. First, sellers can control the price. For example, builders can still look attractive in price even when the market drops-as long as the buyer does not buy a similar home built by the same builder for a lower price. By putting a restriction on the purchase price in an option to purchase contract, the seller can plan around what it considers to be its best price.
Second, sellers can dispense with show suites and minimize holding costs until they have an acceptable sale. In the meantime, they can work on designing more dramatic show homes without worrying about losing prospective buyers.
Third, an option to purchase is a contractual structure that allows the seller to address market issues. For example, the seller can insert a deadline for termination of the sale if a certain number of similar homes have been built and the price is below a certain level.
Fourth, some sellers may offer to build a home for a buyer who has an option to purchase even before the buyer has decided to purchase the unit. The mortgage company will probably not agree to give the buyer a mortgage until the buyer has signed an agreement. This could be because the bank will not have the necessary documents to create impressed mortgages such as: a certified home inspector’s report, a boreal tape, utility plans, engineering drawings, CHOA registration, etc.
How an Option to Purchase Works
An option to purchase can be a useful tool in low-revenue industries where you want to secure space prior to making a major investment. They work fine so long as you can actually demonstrate performance. When executed properly, the option to purchase contract (also known as a lease with option to purchase) will allow you to secure space before you actually commit to operating in it.
An option to purchase contract conveys the right to purchase not just a piece of real estate, but a lease contract at a specified price, for a specified term, when the option is exercised. Therefore, at a minimum, the terms of lease term, base rent, CAM, and charges the seller is willing to pay must be negotiated.
The option to purchase contract works like this. You sign and record a lease with option to purchase. It generally provides that you will lease the space for 1, 5 or even 10 years. However, instead of the rental amount going up over time, you have the right to purchase the property at the end of the term. If you do not exercise the option, the landlord has taken the risk of not being able to lease the space to another tenant at a higher rental amount. The expectation is that you will exercise the option and pay the property above market rent for the first 5 years.
A lease cannot be modified if the modification is not reduced to writing. For example, many landlords will delay executing a lease in order to obtain a letter of credit and giving a tenant an "extra inning" under a lease with side letters. If the tenant refuses to extend the lease, this may be grounds for termination of the lease.
However, with an option to purchase contract, the amount you are paying for the space is more than fair market value for space you are obtaining in the lease. Therefore, sometimes an option to purchase contract can be used to modify a lease. For example, if you have a 15 year lease and you want to terminate that lease after 10 years, you may have the landlord convey the option to purchase the remaining term of the lease for a certain price.
Key Elements of an Option to Purchase Contract
The terms of an option to purchase contract must be mutually agreed upon by both the buyer and seller. These terms include the option fee, the option term, the purchase price, the title requirements, the survey requirements, the financing, the timing of the sale, and the conditions/contingencies to the sale.
Option Fee: In exchange for the right to purchase the property, the seller is entitled to receive a fee from the buyer. The money paid for the average option fee is typically a small portion of the final purchase price of the property. Payment of the option fee is usually made at the time of signing the agreement.
Option Term: The dates for which the option to purchase is offered are termed the option term. This defines how long the buyer has the exclusive right to purchase the property. The option term usually ranges from 30 days to six months. The terms, conditions, and price of the sale can be extended by mutual agreement of the parties.
Title Requirements: Title requirements set forth in the contract determine the state of the title required to close the transaction. Depending on the local standards, options may require the delivery of an Owner’s Policy of Title Insurance or a Commitment for Title Insurance that meets the Title Company’s requirements. Title is usually delivered when the transaction is closed. Title should also be free and clear of all mortgages, liens, and encumbrances, unless otherwise agreed upon by the buyer and seller.
Survey Requirements: A survey confirms the actual measurements of the property boundaries and demonstrates the location of the improvements in relation to the property. Survey requirements specify whether a survey is required. If a survey is required, the contract specifies when the survey must be received.
Financing: The financing terms state whether the buyer or seller will be responsible for obtaining financing. The contract can state how long the buyer has to obtain financing. If financing is not obtained within the stated time period, the buyer may terminate the contract without any penalty. If financing is not obtained within the stated time period, the buyer should consider another option if the purchase of the property is important to him/her.
Timing of Sale: The closing date is the date and time at which all the documents required for the transaction will be signed, delivered, and recorded. The closing date will determine the deadline by which the buyer must obtain financing and by which the seller must deliver the title and survey. The timing of when the closing occurs can be important for tax purposes. It can also limit the amount of time a buyer has to obtain financing.
Conditions/Contingencies to Sale: The conditions/contingencies require certain actions by one or both parties before the sale can be completed. The parties need to make sure the conditions are written in concrete to protect their interests. If a condition is not fulfilled, the contract can be terminated and the earnest money returned to the proper party. Conditions may include obtaining financing, completing the survey, completing an inspection, obtaining approval by a Condominium Association or Homeowner’s Association, etc.
Once the option contract terms are mutually agreed upon, both the buyer and seller should sign the agreement and deliver it to the other party. If the seller wishes to keep the property from being sold at this time, and the buyer is not ready to purchase, an option to purchase is a perfectly legal and appropriate step.
Legal Considerations and Safeguards
Just like any contract, an option to purchase agreement will be governed by the common law. The more complex the agreement terms, the more likely a party may want to consider an application for advice and direction from a court. If the option to purchase agreement covers residential land, there are statutory requirements that increase the risks for the seller. In addition, if you are buying from a minor, there are strict application requirements to protect them. An option to purchase is a contract. It has all the usual elements of a contract: agreement, consideration, capacity, intention, consent, legality, and certainty . There is a further requirement that an option to purchase land (as opposed to personal property) be in a writing signed by the person granting it. You can use Option Agreement forms that we may have available through the our Legal Forms Store, or you can prepare your own as per the Rules of Court.
The above terms may not be suitable for complex land sales. Our lawyers are experienced in drafting these agreements and can draft one that contains all legal protections. We will usually recommend that you get independent legal advice first.
We can also help you collect post-dated cheques, withhold deposits, register the option to purchase, and clarify the obligations of both parties. Whatever your options, we are here to help.
Common Applications and Examples
A real estate option is a common use of an option to purchase contract. Under this type of scenario, a real estate owner may wish to sell the property they currently own and purchase a new property. Their current property may not even be on the market yet, but they have their eye on a piece of land or a structure that would better serve their needs. An option to purchase contract from the owner of the replacement property may allow them to make an offer contingent on their ability to close on the sale of the other property first.
For example: Tom owns an office building in downtown Toronto that he leases to several businesses. Tom has decided to expand the building and wants to tear it down and build a larger structure. Bill owns an empty piece of land in the city that would serve as a better site for the needed expansion, and is willing to sell it to Tom for $2 million.
However, Tom needs to have the proceeds from the sale of his old building in order to purchase the new property, but he does not have a buyer secured at this time. Bill knows the land has a fair market value of $2.5 million, and is firm about the $2 million price tag, because he figures even if Tom can’t follow through on his purchase the land will be quickly snapped up. So, Bill and Tom enter into an option to purchase contract for the $2 million price tag.
The contract sets out a closing date one year from the date of signing. Prior to the closing, Tom puts his building on the market. Just over six months later he enters into a sale of that property with Mary, who will be taking possession of the premises in roughly nine months.
At that point, Tom goes back to Bill to exercise the option. There are still a few months left in the contract, but Bill recognizes the benefits and Tom improves his sales price due to the vacant offices. Tom uses the proceeds from the sale to complete the purchase of the new property.
Another common use for an option to purchase contract is in business acquisitions. A business may be looking to expand its current operations but need some time to fulfill the necessary due diligence requirements. A vendor may also be wary of selling their business to only one potential purchaser, and want to know that a contingent sale will be available if a better offer comes later.
The formation of corporations, the dissolution of partnerships, the purchase or sale of a business are all common scenarios where this type of agreement can reduce risk and provide opportunities within in the transaction.
Potential Drawbacks and How to Avoid Them
Failure to exercise the right: The option to purchase contract should set out the procedure for providing notice of exercise of the right. It is often overlooked but very important to do this to ensure no ambiguity as to what is to be done and when. For instance, the time period in which the notice has to be provided and whether the notice can be given by email, fax or only by registered mail.
No disclosure of defects by vendor: If there are material latent defects in the subject-matter of the contract, i.e . , the property subject to the option to purchase contract, or if there are defects in the title, the vendor must disclose the existence of such defects or it may render the seller liable for any costs that the purchaser would have incurred had the vendor disclosed the defects and/or make the vendor liable for any change in value of the property attributable to the vendor’s failure to disclose the defects or entitle the purchaser to rescind the option to purchase contract.
Variable consideration: As a contract which is a unilateral offer to sell, the option to purchase the property is a unilateral contract. There can be no modification or amendment of a contract unless by the consent of both parties. Any changes to the amount of consideration which do not expressly indicate that it is at the future time of the formation of the contract, would have the effect of amending the contract and will be binding on both the parties.
