Lease Option to Purchase Real Property in California

In a recent California appellate decision, the interaction between a lease and an option to purchase real property was clarified.  The tenant contented that it was entitled to an offset against the purchase price for the rents that it paid to landlord after it exercised its purchase option under the lease and during the pendency of the litigation over the purchase price. According to tenant, upon its valid exercise of the purchase option, the lease was transformed into a contract of sale, thereby extinguishing any landlord-tenant relationship, as well as any right the landlord had to receive further rent because no provision for payment of rent pending the close of the purchase was specified.

Landlord contended that tenant's notice to exercise the purchase option was not an unconditional acceptance of the terms of the purchase option, and therefore, did not constitute a valid exercise of the option. Landlord also argued that by continuing to pay rent, tenant was acting according to the understanding of the parties that rent would remain owing as long as tenant continued to possess the property during the pendency of any lawsuit between the parties.

An option may be viewed as a continuing, irrevocable offer to sell property to an optionee within the time constraints of the option contract, and at the price set forth therein. It is a unilateral contract under which the optionee, for consideration it has given, receives from the optionor the right and the power to create a contract of purchase during the life of the option.  An irrevocable option is a contract, made for consideration, to keep an offer open for a prescribed period.

An option is transformed into a contract of purchase and sale when there is an unconditional, unqualified acceptance by the optionee of the offer in harmony with the terms of the option and within the time span of the option contract. The "exercise" of an option is merely the election by the optionee to purchase the property.  Importantly, the exercise of an option results in a contract of purchase and sale.

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 lessee'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.  Where the relation of landlord and tenant exists under the terms of a written lease, containing an option to purchase which the lessee exercises, he is no longer in possession as a tenant, but his possession is that of a vendee (i.e., buyer).

The landlord ordinarily is not entitled to recover rent from the date when the tenant sought to exercise an option to purchase if landlord prevented effective exercise of the option.
In the recent decision, landlord did not argue that tenant never validly exercised the purchase option. Rather, landlord argued that tenant was required to continue paying rents until such time as tenant could "perform" (i.e., purchase the property), and that performance could not occur until the fair market value of the property was determined by the court due to the parties lack of agreement on the purchase price. However, tenant argued that it had a logical reason for continuing to pay rents, a reason that had nothing to do with believing that such rents continued to be due. Tenant stated that it continued to pay rents as a protective measure in order to ensure that it would not be found to be in default of the lease.

Landlord also contended that tenant's notice conditioned its "exercise" and willingness to enter into an agreement with landlord on the parties reaching an agreement on the "fair market value" of the Property, and the exercise of the option was not complete until the fair market value was determined.

Ultimately, the trial court determined that tenant 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 tenant possessed the property as a vendee, rather than a lessee.

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.
Also, the fact that the purchase option does not specify a price, but instead refers to the "fair market value" of the property, does not render the option unenforceable. Specifying "fair market value" as the price to be paid when exercising the option to purchase does not require future agreement of the buyer and seller, and it is a proper substitute for a specific purchase price and will support an action for specific performance.

It is fundamental that both the seller and the buyer are entitled to receive full performance of the contract where specific performance has been granted, and because execution of the judgment on a specific performance cause of action will occur at a date substantially after the date of performance provided by the contract, or the reasonable date of performance if no set date is provided, financial adjustments must be made to relate their performance back to the contract date.

First, when a buyer is deprived of possession of the property pending resolution of the dispute and the seller receives rents and profits, the buyer is entitled to a credit against the purchase price for the rents and profits from the time the property should have been conveyed. 

Second, a seller also must be treated as if it had performed in a timely fashion and it is entitled to receive the value of the lost use of the purchase money during the period performance was delayed.

Third, any award to the seller representing the value of the lost use of the purchase money cannot exceed the rents and profits awarded to the buyer, for otherwise the breaching seller would profit from its wrong.

This decision confirms that a purchase option in a lease is a viable method for a tenant to purchase real property, but the terms of the lease and purchase option provision are critical to determine the method by which the tenant can "exercise" the option, and such a lease should include terms for the payment of rent until the purchase is completed, and a mechanism to determine the price for the purchase and to resolve any disputes over the price.