Summary and implications
An option to purchase (that is, a call option) is an incredibly useful tool for a developer who is seeking to assemble ownership of a site for a development scheme. The land which comprises the intended development site may be owned by a number of different parties, and the use of options to acquire these interests is capable of providing the developer with the required combination of certainty coupled with flexibility.
The developer acquires the ability to call for the transfer of the land at a time that suits him (for example, once options are in place covering the whole of the site), but without being committed to do so. The landowner will usually be paid an option fee, and if the option is never exercised, will have generated this income from their land without giving anything away (other than a commitment to sell during the option period).
There are a number of commercial and legal issues to be considered in connection with option agreements, which are relevant to both the landowner and the developer. These include:
- The terms of the option itself;
- How the sale price is calculated;
- Asset management of the land between entering into the option and completing the sale; and
- Possible alternatives to an option agreement.
The terms of the option agreement
Options are inherently flexible arrangements, and the parties can (subject to certain specific statutory restrictions) generally agree such terms as they see fit.
Main issues when agreeing heads of terms:
- How long will the option last? Although an option agreement lasting many years is legally possible, the landowner will not want to sterilise their land and their ability to asset manage/sell for any period longer than that which reflects the benefit they receive from entering into the option agreement (i.e. the option fee).
- Option fee. How much is being paid by the developer, and when? A fee will almost certainly be payable on exchange. Are periodic payments also to be made during the life of the option? Is the option fee deducted from the eventual sale price?
- Will the developer have the right to extend the option (for example, by serving notice before expiry of the initial option period, extending the option for a further fixed period)? Again, is a fee payable for this, and do any of the other terms of the option/eventual sale need to be amended if an extension is allowed?
- Price. If the option is exercised and the land is sold, how is the price calculated? Is the developer paying a fixed price, or are there any variables? If the option period is of sufficient length that the value of the land may change, both parties will need to consider how to deal with this. Possibilities include RPI (or other index) increases; stepped increases; or an open market valuation at the point of sale. Conversely, if the market drops, would the developer be entitled to a price reduction? This is less common than mechanisms for price increases.
- If the option is exercised and planning permission is granted/the development proceeds, does the landowner receive any form of overage to reflect the increased value of the land?
- Asset management. What can the landowner do (and what must they not do) with their property during the option period? The developer will want as much control as possible, and will not want the landowner to grant any leases, or rights over the land, or do anything else without its consent (the developer will have a vacant possession strategy for the entire development site at the forefront of its mind). The landowner needs to be aware that this therefore reduces its ability to maximise income from the property. This is explored further below.
Asset management of the property
A long-term option which prevents any asset management such as new leases is unlikely to be attractive to a landowner unless a significant option fee is paid. Therefore, where there are asset management opportunities, a compromise may need to be reached.
The developer may in this scenario be prepared to permit the landowner to grant contracted out tenancies which do not extend beyond, or which have landlord break options prior to, the developer’s required vacant possession date. However, the developer will almost certainly require a level of oversight to ensure it is satisfied that the leases are validly excluded from the security of tenure provisions of the Landlord and Tenant Act 1954, and that the break options are valid and will allow vacant possession to be delivered in accordance with the development timetable.
Inevitably this type of arrangement requires monitoring by the developer, and may require the developer to consent to the form of leases being used. The parties therefore need to be aware that this will involve increased legal, surveying and internal costs for both parties, which need to be factored into the overall commercial deal for the grant of the option.
Alternatives to option agreements
Options are not the only method of securing the ability to acquire land in the future, but they do, in many ways, offer the greatest flexibility for the developer. The main alternative in this context is probably a conditional contract, although pre-emption agreements could also be used. However, these provide much less certainty for the developer and will rarely be sufficient in a site assembly scenario.
Key differences: options, conditional contracts and pre-emption agreements
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The flexibility which options provide, and the freedom to agree terms as the parties see fit, together with the inherent complexity of transactions involving major developments, present the developer and the landowner with a number of commercial issues to consider and agree at heads of terms stage, so that each potential scenario is addressed within the option. A well drafted option agreement will provide the developer with confidence that ownership of the development site can be achieved, and called for at the appropriate time.