Option or pre-emptive right: know the difference

Key takeaways

Pre-emptive rights have the potential to complicate the sale process of a property. In order to remove these complicating factors, it is not uncommon to see a property owner paying its tenant some consideration to waive its pre-emptive right at the time that the property owner wants to offer its property to the market.

In our experience, property owners are often too quick to agree to grant pre-emptive rights to their tenants and they can come to regret granting such rights.

Tenant queries

Prospective tenants often raise the following matters during lease negotiations:

• “We want to lease the property on the basis that if the landlord decides to sell the property we have the ‘first option’ to purchase the property.”
• “We want to lease one floor of an office building on the basis that we have the ‘first option’ to lease the floors immediately above and below us as expansion space if they become vacant during our tenancy.”

To address these matters requires clarification of what the prospective tenant means by “first option” – typically an option or a pre-emptive right.

Option 

An option is an irrevocable offer open for acceptance in a particular way until a particular time. By exercising its option at any time during the option exercise period the tenant has the right to compel the property owner to sell or lease the property to the tenant on the agreed terms and conditions contained in the option agreement. As the offer is irrevocable, it cannot be withdrawn by the grantor of the option before the option exercise period expires.

Pre-emptive right 

A pre-emptive right is a right to purchase or lease a property in preference to any other person. It can be a right of first refusal or a right of last refusal. Both of these impose a negative obligation on the property owner, requiring it to refrain from selling or leasing the property to any other person before giving the tenant the opportunity of purchasing or leasing the property in preference to that other person. Pre-emptive rights are commonly called rights of first or last refusal.

Right of first refusal 

A right of first refusal is a right to acquire an interest at a price nominated by the property owner. If the tenant does not accept the offer, the property owner is entitled to sell or lease the property to any other party within a defined time period following non-acceptance by the tenant of the offer to it on terms that are no more favourable to the other party than those offered to the tenant.

Right of last refusal

A right of last refusal is a right granted to a tenant to match an offer made by a third party to purchase or lease property from a property owner, which offer the property owner intends to accept if the right of last refusal is not exercised. A right of last refusal is often referred to as a “matching right”.

Despite these differences, the terms “first refusal” and “last refusal” are often used interchangeably, which can cause some confusion. In both circumstances the property owner cannot proceed to sell or lease its property to a third party if the tenant chooses to exercise its right. The particular clause in the contract granting the right of first or last refusal needs to be analysed in order to determine what the specific rights and obligations of the parties are.

Fundamental differences between an option and a pre-emptive right

Unlike a grant of an option, which confers a proprietary interest in the land (an equitable interest), a pre‑emptive right gives rise only to contractual rights and obligations between the parties.

In addition, a tenant can only exercise its pre-emptive right when the pre-emption event is triggered (i.e. only if and when the property owner wants to sell or lease the property) whereas the holder of an option can exercise its option at any time during the agreed option exercise period.

Tips and traps

If a property owner agrees to grant a pre-emptive right to another party, it should be mindful of how this may complicate its ability to sell or lease its property. For instance:

• If a property owner is granting a right of first refusal, it should consider reserving the right to accept an offer from a third party at a price of say 95% or more of the price at which the offer was made to the tenant. This flexibility will allow the property owner to proceed with a sale or lease when there is only a small margin of difference in price compared to the initial offer made to the tenant and this may avoid the problem of having to go back to the tenant if there is a last minute need to give a small discount in order to conclude the deal with the third party.
• A pre-emptive right should ideally be restricted in its application to a sale by private treaty. It should not apply where the property is put up for sale by public auction as long as the tenant is given advance notice of the auction so that it can bid competitively against the other interested parties.
• If a prospective purchaser is informed that another party has a pre-emptive right, it may decide not to proceed due to the risk that the time and cost it invests in assessing the opportunity and conducting due diligence could be wasted if its offer is trumped by the holder of the pre-emptive right exercising its right to buy. This issue can sometimes be addressed by a vendor providing prospective purchasers with a vendor due diligence report; and so cutting out much of the due diligence work that the prospective purchaser would otherwise do and by a vendor offering to pay an agreed amount to its unsuccessful shortlisted prospective purchasers as a contribution towards their due diligence costs.
• A property owner may be tempted to keep an existing pre-emptive right confidential in order to avoid deterring prospective third party purchasers from doing due diligence and making offers. In these circumstances, if the pre-emptive right is exercised by its holder, the property owner could find itself accountable for misleading or deceptive conduct for failing to disclose the existence of the pre-emptive right and could accordingly be liable for costs incurred by prospective third party purchasers in assessing the opportunity and conducting due diligence.

The above examples show that pre-emptive rights have the potential to complicate the sale process of a property.

We can advise you in more detail if you have any enquires in relation to the above.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).