Two recent California cases highlight some of the unexpected consequences of entering a lease that includes an option to purchase by the tenant. In Petrolink, Inc. v. Lantel Enterprises, 21 Cal.App.5th 375 (2018), the landlord leased undeveloped property to the tenant and included the following purchase right in the lease: “As long as the Tenant is not in default of this Agreement, Tenant will have an option to purchase at any time after the first ten (10) years of the lease term at a price equal to the fair market value of the property based on an appraisal.”

The tenant exercised its option, and each party obtained an appraisal — the landlord’s being five times the amount of the tenant’s. The parties sued each other. The trial court found that the tenant had a valid option to buy the property, even though the purchase price was not fixed in the agreement, and that the tenant had validly exercised that option. The court then hired its own appraiser, who reported a fair market value between the two parties’ appraisals, and gave the tenant the right to buy the property at the court’s determined value. The court also held, however, that the tenant should not receive a credit against the purchase price for the rent that the tenant continued to pay while the lawsuit was pending. The tenant appealed.

The appellate court cited settled law as follows: “Where an option to purchase exists within a lease agreement, the exercise of the option to purchase causes the lease and its incorporated option agreement to cease to exist, and, instead, a binding contract of purchase and sale comes into existence between the parties. . . . Further, a consequence of the termination of the lease agreement is that the former [tenant’s] obligation to pay rent under the lease also terminates, unless there is an express stipulation that requires continued rent payments after the exercise of the purchase option.” In effect, the court held that when the tenant exercised its purchase option, it ceased to be a tenant under a lease and instead became a buyer under a purchase agreement. And, according to the court, “[u]nless there was an express agreement in the lease that required the [tenant] to continue to make rent payments after the exercise of the purchase option, no further rents were due.” Ultimately, the appellate court held that the tenant could buy the property at the fair market value determined by the trial court, and should receive a credit against the purchase price for the rents that the tenant continued to pay after it exercised the option.

In Smyth v. Berman, 31 Cal.App.5th 183 (2019), the landlord leased a building to the tenant for a fixed term that would then convert into a month-to-month tenancy. The parties also hand-wrote onto the lease, and initialed, “Right of 1st refusal to purchase.” The landlord received a third-party offer to purchase the property after the fixed term of the lease had expired, but while the tenant still occupied the building as a month-to-month tenant. The tenant asserted its right of first refusal to buy the building, but the parties could not agree upon terms, and the landlord sold the property to the third-party buyer. The tenant sued.

Citing settled law, the court noted as follows: “When a lease expires but the tenant remains in possession, the ‘relationship’ of the landlord and tenant ‘changes’. . . . [The] only terms from the expired lease that are presumed to carry forward into a holdover tenancy are the ‘essential’ terms of that lease [such as the terms of occupancy and the amount of rent].” The court also acknowledged that courts are split around the country as to whether a purchase option is an “essential” term of a holdover tenancy. Per the court, a majority of states (including New Jersey, Illinois, Michigan, and North Carolina) hold that a purchase option is not an essential term of a lease, while a minority of states (including New York, Maryland, Wisconsin, and Hawaii) permit a purchase option to carry forward into a holdover tenancy. California follows the majority, which views a purchase option as a “separate and distinct right” that is not an “essential covenant” of a lease (unless the parties expressly agree otherwise). In this instance, the court held that the tenant’s right of first refusal was akin to a purchase option and that the tenant could not exercise that right after the stated term of the lease expired, even though it was a permitted month-to-month “holdover” tenant.

In New York, a similar question was settled in Kaygreen Realty Co., LLC v. IG Second Generation Partners, L.P., 78 A.D.3d 1010 (N.Y. App. Div. 2010). In that case, the tenant exercised a purchase option under its lease. The landlord, however, claimed that the option was not properly exercised, since the tenant was in default of various terms of the lease, even though the defaults had occurred after the tenant had exercised the purchase option and satisfied various conditions (including a deposit of $100,000). Ultimately, the court decided in favor of the tenant, holding that the tenant’s exercise of the purchase option had effectively terminated the lease, rendering any default moot: “Generally, a tenant’s exercise of an option to purchase contained in a lease merges the landlord/tenant relationship into the vendor/vendee relationship serving to terminate the landlord/tenant relationship unless the parties intend otherwise.”

These cases highlight some of the particular complexities of including an option to purchase in a lease. How and when may the purchase option be exercised? Will the lease remain in effect, and must the tenant continue to pay rent, between the exercise of the option and the close of the purchase? Will a default by the tenant under the lease (either before or after exercising the purchase option) impact the tenant’s right to purchase? And what should the landlord’s lease remedies be, especially if the tenant preserves its right to purchase? Similarly, will a default by the tenant under the purchase agreement trigger a default under the lease? Or should the tenant just forfeit the purchase right but retain its right to occupy the premises under the lease? Parties to leases should carefully consider and document these issues to avoid unintended consequences and potential disputes.