Commercial Property & Business Leases: Option Agreements as incentives for Commercial Leases

Ambigesh Sivapatham

by Ambigesh Sivapatham LLB (Hons), LLM, Solicitor

16 March 2024

One occasionally comes across a tenant who had taken on a lease where the landlord has promised to sell the freehold of the property to that tenant. When the tenant goes back and requests the sale of the property, the landlord turns up their hands and says that the promise was "subject to contract", not binding, and refuses to sell the freehold. The option to purchase the freehold has been used as a false incentive to entice the tenant to enter the lease.

The tenant could have avoided their disappointment by entering into an option agreement at the time of grant of their lease. Option agreements are an important part of making sure that all promises made between the parties are legally binding.

Landlords, who are taking on commercially savvy tenants should also make sure that their option agreement is watertight.

In the writer's personal experience, the worst situation he had come across was simply a clause at the end of a lease stating something along the following lines:

"The Tenant has the right to purchase the freehold from the Landlord."

This was excruciating to read as a solicitor; documents which are unduly short usually an indicate that there was not enough consideration of the issues that may arise.

Let's go through some basic points.

1. What is an option agreement?

Option agreements are agreements for the future right of sale or purchase of an asset. A right to purchase is referred to as a "call" option (ie, the buyer has the right to "call" upon their right to sale), and the right to sale is referred to as a "put" option (ie, the seller has the right to "put" their asset up for sale).

This article focuses on "call" options on the freehold as incentives for commercial leases.

2. When should the right to the purchase start, and when should it end?

This is known as the "Option Period". Both parties will want certainty on this point; a landlord may not want to deal with the uncertainty of not knowing when the property will be purchased. A tenant is unlikely to have the funds immediately (hence the need to taken on the lease in the interim), but might want to begin the option period from the date of completion of the lease.

A balanced view should be taken considering the outcomes of the landlord and the tenant.

3. What will the sale price be?

This is known as the "Purchase Price" or "Strike Price".

Parties might want to agree the price straight away. This is more likely if the option lasts for a shorter period of time. Alternatively, the parties might leave it subject to later agreement at the market price (or the market price subject to a market value reduction).

Be warned however that disputes may arise concerning how the market price is to be determined. Proper drafting is required to ensure that the necessary dispute resolution backups are present to prevent a disproportionate loss of time and money in the case of such a dispute.

4. Will there be charge for granting the option?

This is known as the "Option Premium" or "Option Sum". This should not be confused with the Purchase Price, which relates to the amount payable in respect of the underlying freehold land; the Option Premium is merely the sum attributable to the right to purchase the freehold.

The landlord and tenant might agree that the tenant entering into the lease is sufficient and that no sum is due separately.

5. What are the terms of the sale?

This is a very important consideration. The parties should not be left to argue about relevant terms of the freehold sale at the last minute; the clock will be counting down on the exercise of the option and a deadlock is a needless impairment that will only serve to frustrate the agreement.

The parties might agree to use standard commercial terms. However, caution should be exercised as standard conditions might assume matters not known or determined by the parties at the time of entering into the Option Agreement; modifications should be made to accommodate the context of the transaction.

6. Don't get confused on similar agreements

An option agreement looks similar to other agreements used in similar, but different situations. Importantly, an option agreement is not a pre-emption agreement, which is also known as a "right of first refusal"; nor is it a conditional contract for the purchase of property, which will go into effect upon the performance of conditions, and not, as in the case of an option, at the election of the party with the right to enforce the transaction.

7. Caveat

Solicitors will have to consider a myriad more issues when preparing the final document. While the above issues play an important role, they are not the be-all-end-all, nor do they represent an exhaustive list of drafting considerations.

8. Summary

Although the conversation between landlord and tenant might start off as a friendly back-and-forth about the tenant's desires to one day own the freehold, the tenant will want to make sure that their right is not left as an unfilled "subject to contract" promise. That promise should be made cast iron.

Option agreements should be drafted by a legal profession who understands your needs, the nature of the underlying incentive, has a grasp of the framework of the option, and most importantly, is qualified to draft it. You should always ask your solicitor to explain the documents that you are entering into to you until you receive satisfactory answers.

We are specialists in commercial property, lease and business transactions. We offer bespoke services to clients so they get exactly what they need at a reasonable price. Call us on 020 88 666 333.

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