Contents of Main Description

Enforceability
Examples
   Conservation Organization Seeks to Buy Property but Needs to Raise Money
   Conservation Organization Wants to Establish New Preserve if It Can Acquire Critical Land
   Conservation Organization Donates Land to School District for Nature and Seeks to Ensure Proper Use
   Joint Venture
   Purchase Price for the Property
   Market Value to be Determined
   Fixed Purchase Price
Comparison of Option Agreement with Agreement of Sale with Contingencies
   Avoid prolonged negotiation
   No implied obligations
   Equitable ownership
Recording the Option
Proper Exercise

Enforceability

Options to purchase, lease or otherwise transfer real estate interests are enforceable under Pennsylvania law so long as the option agreement is in writing; is supported by consideration, or a legally sufficient substitute for consideration; is exercised strictly in accordance with its terms; and the material terms of the purchase or lease are sufficiently described in the option agreement for a court to enforce a mutually binding agreement of sale or lease upon exercise.

Examples

A few examples of uses of option agreements follow.

Conservation Organization Seeks to Buy Property but Needs to Raise Money

An owner of two tracts critical to the mission of a conservation organization is unwilling to sell during his lifetime.  Besides his attachment to the property, the owner calculates that his life expectancy is perhaps ten years at most and his tax basis in the property is zero.  He would like to see the property conserved but not at a significant loss to him or his heirs.  The conservation organization proposes granting an option to purchase either or both of the tracts at a fixed price based upon current market value.  Each option is to be exercised, if at all, within the five year period following his death.  Owner is willing to grant an option to purchase but only at fair value as of the date of his death and only if closing occurs within nine (9) months from his date of death.  The compromise that is agreed upon is as follows:

• The purchase price for one tract is fixed at current market value but, if exercised, conservation organization must close within nine (9) months of his death or lose both options.  The sale is not expected to generate any taxable gain for the estate and is expected to provide sufficient cash to discharge federal estate tax when due.  The conservation organization has a specific funding target to achieve and, although there is a risk the owner may die at any time, they hope to have sufficient time to obtain funding commitments from governmental sources and to plan and implement a campaign to raise funds from private donors.  The campaign will not be announced publicly until after owner's death; however, during the interim, the conservation organization will quietly seek pledges from major donors and funding sources.
• The purchase price for the other tract is to be established by appraisal as of the date of death.  The period for exercise is up to two years after owner's death with another 90 days after exercise to close.  The conservation organization successfully negotiates the right to extend the option period and closing date if benchmarks for funding commitments are met at certain intervals.  Not only does this give the conservation organization additional time but also a sense of urgency in its appeal to donors:  the option will be lost, and the property will be exposed to the market, unless these benchmarks are achieved.
• The option contract provides that the option price will be adjusted to reflect the grant of a conservation easement on either or both of the tracts either during the owner's lifetime or within nine months after his death.  The option has not only furnished the conservation organization with the opportunity to purchase, if it can raise the necessary funds, but it has also opened a dialogue with owner about other ways conservation planning can work with his estate planning objectives.

Conservation Organization Wants to Establish New Preserve if It Can Acquire Critical Land

A conservation organization has identified as a high priority the acquisition of a certain large tract of land for a new preserve.  The tract is near, but does not abut, a state forest.  A smaller tract must be acquired to provide the contiguity that will be critical to obtain funding from governmental sources.  Preliminary discussions with the owner of the large tract have been promising but the conservation organization fears that, if it commits to purchase the large tract (which will become public knowledge), the owner of the intervening tract will realize that his land is the missing link and hold out for a purchase price far above market.  The conservation organization adopts the following strategy:

• It temporarily discontinues discussions with the owner of the large tract and engages an agent, not identified with the conservation organization, to offer the owner of the intervening tract $5,000 for the grant of an option to purchase, exercisable within one-year at a fixed price reflecting current value.  The conservation organization is not identified as the beneficiary of the option but the option contract is freely assignable.
• The option is a significant benefit to the conservation organization -- for the relatively small investment of $5000 it has purchased time -- up to one year to negotiate a mutually agreeable transaction with the owner of the large tract -- and control of the critical parcel required to achieve contiguity with the state forest.  If for whatever reason the acquisition of the large tract fails to occur, the conservation organization's loss is capped at $5000.

Conservation Organization Donates Land to School District for Nature and Seeks to Ensure Proper Use

A conservation organization donates land to a school district for use as a nature preserve to be improved with an environmental study center.

•  A restrictive covenant limiting use will give the conservation organization the right to petition the court to enjoin any other use.
• In addition to the restrictive covenant, the conservation organization can retake ownership of the property if the transfer is conditioned upon compliance with the use restriction.  See Reversionary Rights.
• If, the school district needs compensation for its investment in the environmental study center, then a purchase option is the tool that will give the conservation organization the ability to unwind the transaction if circumstances change while protecting the investment of the school district.

Joint Venture

A conservation organization joint ventures with an educational organization to acquire land for use as a nature preserve with an environmental study center. If the sale of a conservation easement and forestland to a government agency does not materialize, the conservation organization does not want to remain as co-owner.  If a grant from another governmental agency to build and operate the center does not materialize, the educational organization does not want to remain as co-owner.  Each organization can have an option to make the other buy out its interest (a "put" option) if its project expectations are met. If one defaults on its obligation to purchase under the "put" option, the other can have an option to purchase that interest (perhaps at a discounted price) so as to be in a position to control a sale of the entire ownership to a third-party thereby ending the joint venture.

Purchase Price for the Property

The purchase price for the property (sometimes called the "strike price") can be either fixed in the option agreement or set at a fair market value to be determined if and when the option is exercised.

Market Value to be Determined

An option to purchase at fair market value gives the option holder the freedom to decide when to exercise depending upon project feasibility, availability of funding and market conditions.  The option contract should provide for a mutually acceptable procedure to obtain a fair market value that is fair for both sides.  A commonly used procedure is for each party to obtain its own appraisal then set the price at the midpoint between the two if the first two values fall within a specified range (a difference of perhaps 5%-10%).  If the first two values fall outside the agreed-upon range, then the first two appraisers select a third who will set a price that is within the range of the first two appraisals.  The parties usually share the cost of the third appraiser.

An owner may want the option to purchase at fair market value to be structured so as to convert to a right of first refusal if the owner decides to offer the property for sale during the option period.  The rationale is that a third-party offer establishes market value without the need for appraisals and the device gives the owner a way to release the property from the burden of the option before a sale to a subsequent owner.

Fixed Purchase Price

An option to purchase at a set price may become valuable or worthless depending upon whether property values go up or down during the option period.  The longer the option period, the more risk the owner takes that market conditions may change in the interim and, as a result, the more likely it is that the owner will expect to be paid for granting the option.  The cash paid to the owner for the grant of the option (called "option consideration" or "option premium") will reflect the expectations of buyer and seller concerning future market trends.

Comparison of Option Agreement with Agreement of Sale with Contingencies

A prospective purchaser who is unsure of the feasibility of the project, the availability of funding or other matters can usually negotiate a sales agreement that includes one or more periods of time in which purchaser can elect to terminate without penalty, sometimes for no reason at all, and receive the return of the deposit.  If the purchaser elects to purchase, the deposit, together with interest, is applied to the purchase price. As an alternative, the purchaser can negotiate an option contract and pay a non-refundable premium to seller that will not be credited to the purchase price payable on closing.  If the deposit under an agreement of sale is refundable, and option consideration is not, why would the purchaser negotiate an option contract rather than an agreement of sale?

Avoid prolonged negotiation

One reason a prospective purchaser may prefer an option is to save the time and expense of negotiating a formal agreement of sale when there is a high risk that the project will not come to fruition.  If all the conservation organization wants to do is to get control of one parcel quickly while it pursues an agreement on another parcel critical to the project, then the cost of the option may be offset by savings in time and expense.  The downside to using an option as a quick and inexpensive substitute for a sales agreement is that, unless otherwise provided in the option contract, there is no meeting of the minds between buyer and seller as to the material terms of the sales agreement that goes into effect upon exercise of the option.  Not surprisingly, the lack of agreement on all deal points frequently results in disputes.  A well-drafted option contract will attach the form of agreement of sale that will apply if and when the option is exercised.

No implied obligations

Another reason to use an option contract is to avoid an express or implied obligation in a sales agreement that the purchaser will make a good faith, reasonable effort to satisfy contingencies.  If the project is so tentative that it does not make sense to invest any time or resources into seeking approvals or funding, then the cost of the option must be balanced against those savings.  This is not to say that an agreement of sale cannot be drafted to provide for a feasibility period within which the purchaser can terminate for any reason or no reason but this must be spelled out in no uncertain terms to avoid the implied obligation of good faith in seeking satisfaction of contingencies.

Equitable ownership

A purchaser under an agreement of sale, even if the purchaser has a free right to terminate, is recognized as the equitable owner of the property.  It is unclear what kind of property interest an option contract vests in the holder.  Some courts have held that it is a personal property interest -- a general intangible; on the other hand, an option contract applicable to real estate is recognized as a document properly recorded in real estate records and takes priority over subsequently recorded interests.  A 2009 case decided by the federal appellate court for the 3rd Circuit decided, under New Jersey law, that the holder of an option had a sufficient real estate interest in the property to challenge a rezoning.  It is clear that an equitable owner holds a recognized interest in real property which is entitled to protection under law.  While usually that is a benefit, there are circumstances, for example, a possibly contaminated property, when a prospective purchaser does not want any ownership interest -- equitable or not -- until due diligence investigations are complete.  An option is a useful tool for those purposes.

Recording the Option

The option contract can and should be signed by the property owner in recordable form and recorded in the real estate records of the county in which the property is located.  Option contracts created in Pennsylvania after January 1, 2007 are not subject to application of the rule against perpetuities so there is no longer any need to limit the term to one or more lives in being plus twenty-one years.

The seller may not want the option contract recorded without assurance that it will be removed if not exercised during the option period. The solution is to sign, with the option contract, a recordable release to be deposited into escrow pending expiration of the option period without exercise of the option.

Proper Exercise

The holder of the option must exercise the option, if at all, strictly in accordance with its terms. This is one area of the law in which a good faith effort or substantial compliance is not enough.

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