RPLR May 2018

 

             Options to Purchase in Leases: When Do Payments of Rent Convert to Payments of the Price?

                                                                 Roger Bernhardt

Petrolink, Inc. v Lantel Enters.

After a tenant has exercised an option to purchase that was included in its lease, is it required to continue making the rent payments required by its old lease, or does it instead owe the contract payments of the new price that are now (or will be) required under the option, especially when the new purchase price is in dispute and may require (time-consuming) litigation to be resolved? Petrolink, Inc. v Lantel Enters. (2018) 21 CA5th 375 demonstrates that that issue can be somewhat tricky.

In Petrolink (reported at p 77), a 10-year lease of vacant land had been executed in December 1998. That lease contained nine options to renew; more importantly, the lease also contained an option for the tenant (ultimately Petrolink, as assignee) to purchase the property any time after 10 years for the fair market value of the property.

In August 2011, Petrolink exercised its purchase option, but it and the lessor disagreed as to the value of the property ($1.6m vs $320k). The trial court—utilizing an independent appraiser—determined, four years later (in September 2015), that its value was $889,854. Petrolink was willing to pay that amount, but wanted a credit for the rent payments it had made from the time it had sought to exercise its option until the date of the judicial decision—about $400,000. The trial court held that Petrolink had properly exercised its option, but denied Petrolink any such credit for its rent payments, and Petrolink thereupon appealed.

The court of appeal held that Petrolink was entitled to a credit for the rents it had paid, but that this was only half of the story—because Lantel (landlord, optionor, and vendor) was “entitled to some amount of compensation to account for the fact that it did not have use of the purchase funds” until the entry of judgment. 21 CA5th at 388. The nearly $890,000 price to be paid to Lantel in 2018, after judgment, would be worth considerably less than if that amount had it been paid in 2011, when the option was exercised. Thus, for the court of appeal, the trial judge had made two mistakes:

·       Failing to give Petrolink credit for the rent it had continued to pay after it had exercised its option; and

·       Failing to offset against that credit the loss that Lantel had suffered from being paid the price it was owed four years late.

How Did the Trial Judge Go Wrong?

The appellate opinion concludes that the trial court made an obvious mistake in holding that Petrolink continued to owe rent after it had exercised its option, because “[t]he exercise of the purchase option extinguished the lease. No further rents could be due.” 21 CA5th at 387. If Petrolink did not owe rent after it had exercised its option, it deserved a credit for all rental payments it continued to make pay to Lantel thereafter.

The rule to that effect is well settled. Once Petrolink had elected to exercise its option to purchase Lantel’s property, it ceased to be a tenant and became instead a purchaser; it thereupon owed Lantel the purchase price, but not the lease rent. “Unless there was an express agreement in the lease that required the lessee to continue to make rent payments after the exercise of the purchase option, no further rents were due.” 21 CA5th at 386.

However, there is another equally clear rule in California: “Until [the optionee] pays the purchase price he is a tenant, not a vendee in possession.” 42 Cal Jur 3d §183. Under that rule, “The relation of lessor and lessee and the liability of the lessee for rent continue until a tender of the purchase price.” 42 Cal Jur 3d §183. This is clear when proper exercise of an option to purchase requires a simultaneous performance of some other act, such as payment of cash. “Where the lease makes the down payment of the purchase price a condition to the exercise of the option, the relationship of landlord and tenant and the liability for rent continues until there has been a tender or offer to pay the required amount.” Miller & Starr, California Real Estate §34:117 (4th ed). Since Petrolink had not tendered the purchase price to Lantel, the rent payments it subsequently made to Lantel after it had exercised its option were mandatory, and thus did not entitle it to any credit (against the price) for making them.

This distinction between rent and price payments may be tricky. One can easily conclude that a tenant whose option to purchase requires payment of a price of, say, $1 million, has not properly exercised its option if it has not made that payment—and thus has not properly converted the lease into a purchase contract—with the result that the tenant continues to owe the rent reserved in the lease. But not all options in leases are so neatly worded. If the option price, for instance, is the fair market value of the property, rather than some fixed amount, does a tenant’s election to exercise its option to purchase—before that fair market value has been determined—mean that its lease has been converted into a contract, or not?

In Petrolink, the court of appeal concluded that the trial court had come down on the wrong side of that distinction, because it had already found that the option to purchase had been properly exercised. (“Ultimately, the trial court determined that Petrolink validly exercised the purchase option, and ... the exercise of the purchase option caused the lease to cease to exist, and in its place was formed a contract for purchase and sale, which meant that Petrolink possessed the property as a vendee, rather than a lessee.” 21 CA5th at 386.) But the trial judge didn’t think that was the case, opining that use of fair market value rather than any fixed price mattered. The trial court “viewed the purchase and sale contract as not being enforceable until the court determined the fair market value of the property.” 21 CA5th at 387. (Miller & Starr seem to conclude the same, opining that “When the lease-option does not expressly require a payment of money by the tenant-optionee as a condition for the exercise of the option, the tenant may exercise the option by giving a timely notice and without a payment on account of the purchase price. The payment of the purchase price relates to the performance of the sales agreement after the option is exercised, but it does not relate to the exercise itself, which is merely the acceptance of an offer.” Miller & Starr, California Real Estate §34:117 (4th ed). Indeed, when fair market value is what is owed under a purchase option, how can an optionee accompany its exercise of the option with a tender of payment?)

In this case, the rent/price distinction was rendered somewhat inconsequential by the second holding of the appellate court, i.e., that the lessor was entitled to some compensation for its delayed receipt of the purchase price, but given the appraiser’s belief that the rent had a monthly bonus value of $1000, that overage would make a difference over the five years that the litigation endured.

In most cases, it will be clear to the parties and their attorneys precisely what is required to effectively exercise an option to purchase in a lease, and a lessee will naturally know whether the effect of such exercise is to replace the preexisting liability for rent with a new obligation to pay the purchase price or not, and to act accordingly, e.g., to exercise its option sooner or later. That decision will often be driven by a comparison of the option price to the fair market value of the property. As optionor, rather than optionee, a landlord will not, of course, have a comparable choice to make (although Petrolink suggests that it is possible for a lease to provide that a tenant’s rent liability continues even after it has exercised its purchase option, but that may be more hypothetical than real).

More to Think About

What the Petrolink decision should remind attorneys about is that a decision to exercise an option to purchase in a lease (and when to do so) may depend not just on a consideration of the comparative values of a leasehold or estate in fee, but also on an analysis of the payments that are to be thereafter made. So—one more issue to advise your tenant client to think about with regard to the option you have included in its lease.

41 Real Property Law Reporter 66 (Cal CEB May 2018), © The Regents of the University of California, reprinted with permission of CEB.