Option to Buy Real Estate Does Not Confer “Interest” in Real Property

A California appeals court has held that an option to purchase real property is only a contract right and is not an interest in real estate.  The decision has ramifications for real estate developers that seek to use option agreements to create a “legal or equitable interest in real property” for purposes of California’s development agreement statute. 

An “option to purchase” is a contract in which the owner of land agrees not to revoke an offer to sell real property for a defined period of time.  The option is granted to a potential buyer, called an optionee, who pays a fixed amount for the option.  While option agreement terms vary, an option agreement must describe the subject property and the purchase price, among other things.

An option can be beneficial to both the potential buyer and the landowner.  For example, an option is used to give a potential buyer time to secure development approvals for the land.  If the development approvals cannot be obtained, the potential buyer lets the option lapse, because he is not bound to purchase the property.  Real estate investors also sometimes use an option to tie up property before equity and debt financing is secured.  

Usually, a memorandum of option is recorded in the real estate records of the county where the property is located.  By recording the memorandum of option, anyone searching the real estate records has notice of the potential buyer’s right to purchase the property under the option.  However, sometimes a memorandum of option is not recorded against title to the property, occasionally because the seller will not allow it, or other times because the parties simply elect not to do so for another reason.

People who record a memorandum of option sometimes mistakenly believe they have real property “interest” upon recordation of the memorandum.  It’s easy to make that assumption.  A recorded memorandum of option is a cloud on title even if it is not exercised.  Once recorded, all subsequent purchasers or encumbrancers are on notice of the optionee’s rights to buy the property.  Upon the completion of a sale pursuant to a recorded option, the title received by the purchaser “relates back” to the date the option was given and extinguishes the interests of the intervening party — including intervening easements, leases, deeds of trust, and other transfers.  

Cyr v. McGovran is one of a growing number of cases that find that an option does not vest or grant an “interest” or “estate” in real property.  Dwayne and April McGovran owned a ranch consisting of eight parcels of land in San Luis Obispo County.  The McGovrans listed the property for sale.  The McGovrans and Cyr agreed that Cyr would buy two parcels outright from the McGovrans and, apparently for tax reasons, could have options to buy the remaining six parcels over a period of two years.  If Cyr timely exercised his option to purchase the lots in an agreed-upon sequence, he would then have an option to purchase the next lot in sequence.

The McGovrans’ lender filed a notice of default as to some of the parcels subject to Cyr’s options.  As a condition to obtaining a new loan, the McGovrans gave the new lender an option to purchase the same six parcels that Cyr had options to purchase.  The lender’s option was exerciseable only if Cyr failed to timely close escrow on two of the lots.  The lender’s option conflicted with Cyr’s options in that the escrow closing dates shown in Cyr’s options were later than those shown in the lender’s option.  Pursuant to Cyr’s options, he had until December 30, 2003 to close escrow on two of the lots.  Pursuant to the lender’s option, Cyr had until September 15, 2003 to close escrow.

In August 2003, Cyr became aware of the potential problem with the lender’s option which could cloud title to the properties.  Cyr did not close escrow on the two lots by the September 15th date shown on the lender’s option.  On September 16, the lender recorded a Memorandum of Option Agreement clouding title to the two lots.  On November 4, 2003, Cyr’s attorney took issue with and denied the claim by the lender that it had some right in the properties which was superior to Cyr’s rights.

Cyr assigned his option rights on one of the lots to Mesa Vista, Ltd.  He assigned his option rights on the other lot to Mid-Coast Capital.  Both companies timely closed escrow pursuant to their options.  On November 26, the lender filed a complaint for specific performance of its option.  On the same date, the lender recorded a lis pendens.  The lawsuit was eventually dismissed and the lis pendens was expunged.

On December 23, 2005, Cyr filed an action against the McGovrans and their real estate agents.  One of the causes of action was for negligence, alleging that the McGovrans negligently failed to assure that the McGovrans did not grant to their lender an option inconsistent with Cyr’s options.  The McGovrans filed a motion for summary judgment.  The trial court agreed with the McGovrans on the basis that the complaint was not filed within the two year statute of limitations for an action based upon professional negligence.

On appeal, Cyr argued that the three-year statute of limitations for an injury to real property applied, not the two-year statute of limitations for a professional negligence action.  The court rejected Cyr’s argument.  The court reasoned that Cyr did not have title to the real property and it was the lender, not Cyr, who recorded the Memorandum of Option Agreement and the lis pendens that clouded title to the properties.  The basis of the negligence action was not injury to the real property, but injury to the option rights to purchase the properties.  The latter injury was allegedly caused by respondents’ negligent performance of professional services.  Quoting Wachovia Bank v. Lifetime Industries, (2006) 145 Cal.App.4th 1039, 1050, the court reasoned:  “Although an option gives the optionee contractual rights to purchase the property, it is ‘merely an offer to sell and vests no estate in the property to be sold.'” The option holder does not have an “interest” in the land, the court found.

The court went on to say:  “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,” quoting Steiner v. Thexton (2010) 48 Cal.4th 411, 420.

Real estate developers and investors that purchase option rights should pursue recordation of a memorandum of option when feasible.  A recorded option offers more protection to a potential buyer because it offers constructive notice of the option and  “relation back” benefits. On the other hand, some sellers of real estate may prefer that the option not be recorded, because it acts as a cloud on title.  This is a matter of negotiation between the parties.

The Cyr case also calls into question a strategy used by cities, counties and developers in redevelopment transactions where the city or county owns the land.  When this strategy is followed, a city or county grants an option to a prospective developer/purchaser to create an interest in the property.  A “legal” or “equitable” interest is necessary to support the vested rights secured by a development agreement.  The Cyr case stands for the proposition that an “interest” in real property is not created by an option agreement, but the court’s decision does not expressly distinguish between “legal” and “equitable” interests.  There may be an argument that an “equitable” interest is created upon the signing of the option, but that argument looks less compelling in light of the Cyr court’s holding.  Depending on the facts, it may be more prudent for a city and developer to enter into a real estate purchase agreement, instead of an option, at the time the development agreement is entered.  The purchase agreement could be structured with pre-closing conditions that relieve the developer from the obligation to purchase the property in the event entitlements are not secured.  Legal counsel should be consulted to negotiate and draft such an agreement.

Breach of Commercial Lease Doesn’t Trigger Loan Guaranty, Resulting in $40 Million Loss for Lender

A tenant’s refusal to pay rent and the borrower’s resulting failure to make debt service payments did not trigger a “bad boy” loan guaranty because the lease was never terminated by operation of law, a California Court of Appeal has held. 

In GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC (referred to in this Post as the “Plummer decision”), the court’s holding resulted in a heavy loss of more than $40 million for the lender.  The court’s holding demonstrates the necessity of carefully evaluating lending risks and coordinating remedies in lease and loan documents, particularly when a real estate asset has a single tenant.

Facts of the Case

In the Plummer decision, the lender loaned $44 million to a borrower.  With the money, the borrower purchased two commercial projects in Chatsworth, California.  The borrower leased the properties to Washington Mutual Savings and Loan as the sole tenant.  The loan was non-recourse, secured by the properties but not any other assets of the Borrower, subject to exceptions for borrower misconduct.  An affiliate of the borrower, Northstar, executed a loan guaranty that contained triggers that corresponded to the borrower misconduct non-recourse carve outs.

Northstar’s guaranty to the lender provided that “[t]he Loan shall be fully recourse to Guarantor, and Guarantor hereby unconditionally and irrevocably guarantees payment of the entire Loan, if any of the following occurs after the date hereof:  . . . (iv) without the prior written consent of the [Lender, either lease] is terminated or canceled.”

Washington Mutual went out of business and it and its successors stopped paying rent and abandoned the properties.  The borrower ceased making loan payments to the lender.  The lender took title to the properties through a non-judicial foreclosure sale in which it bid approximately $11 million.  The lender then brought suit against Northstar, the guarantor, for the balance due on the loan — approximately $42 million plus attorney fees and costs.

Court’s Decision

The principal legal issue was whether the tenant’s ceasing to pay rent and abandoning the property terminated the leases, triggering the guarantor’s duty to pay the amount owning on the loan if the leases were “terminated” “without the prior consent of Lender.”  The trial court concluded that the leases were terminated without the lender’s consent and the guarantor was liable. 

The Court of Appeal disagreed, holding that the guarantor was not liable under the guaranty.  When the tenant stopped paying rent and abandoned the premises, the leases were not terminated as a matter of law.  Both leases contained provisions, pursuant to California Civil Code section 1951.4, that the leases continued in effect for so long as the landlord did not terminate the tenant’s right of possession, notwithstanding the tenant’s breach of the lease.  The leases expressly provided:  “No act by Lessor other than giving notice of termination to Lessee shall terminate Lessee’s right of possession.”  The borrower never gave notice of termination of the leases.  (Why would the borrower do so under these facts?)

As a result of the lease provisions and operation of California Civil Code section 1951.4, the leases did not terminate and the guaranty was not triggered.  The court reasoned that its interpretation of the guaranty was consistent with the parties’ intent, expressed in the deed of trust and other loan documents, to  carve out exceptions to the loan’s non-recourse provision only in the event that borrower committed certain “bad boy acts” that pose particular risks to the lender’s interests and collateral.  Those same acts could trigger the liability of the guarantor.  But in this case, because none of the express “bad boy” acts occurred, so the lender’s sole recourse was to the collateral. 

The lender tried to argue that although the lease termination provision in the guaranty resembled a “bad boy” guaranty it should operate like an absolute guaranty because full recourse is triggered regardless of whether the lease is terminated by the tenant or the landlord (i.e., the borrower).   However, the court did not accept that argument, stating that the leases were never terminated and only the borrower held the right to terminate the leases, which the borrower did not do.  For the same reasons, the tenant’s repudiation of the leases did not trigger the guaranty.   The leases expressly provided they could not be terminated by an act of the tenant. 

Analysis

Do you think the lender believed, at the time the loan was made, that the guarantor had no obligation if the borrower stopped making debt payments on the grounds that its sole tenant decided to walk from the lease?  The answer to this question is almost certainly no, but the court’s decision doesn’t provide any facts to help us understand the thinking of the loan officer or loan committee.  Did the lender underwrite this loan believing that Washington Mutual was essentially at no risk of default?

Going forward, lenders and their counsel will want to pay close attention to remedies in leases and loan documents.  Lenders may be tempted to require their borrowers to include lease continuation provisions in order to continue collecting rents from a defaulting, creditworthy tenant.  However, as this case instructs, if a tenant suffers a financial calamity and goes out of business, those lease continuation provisions have little utility and can actually be harmful if a “bad boy” guaranty is not properly structured.

The language of a loan guaranty should also be carefully reviewed so that it reflects the expectations of the parties.  Does the lender expect that the single tenant will provide the sole source of funding for the loan?  Or does the borrower need to back up the loan and have incentive to find a replacement tenant?  If the latter is so, the guaranty could have provided that any abandonment of the premises by its single tenant combined with a failure of the borrower to make debt service payments triggered the guaranty.   The trigger would not be “termination” of the lease, but abandonment of the premises regardless of whether the lease was “terminated.”  If the original tenant goes out of business and abandons the property, the borrower should find a replacement tenant and continue to make debt service payments during the search.  Then, the incentives are properly aligned between the borrower and the lender:  both want a stable rental stream.  Of course, there are circumstances where a lender may be willing to take on the additional risk after extensive underwriting of the single tenant, but the pricing model for the loan would likely have to be adjusted to account for the additional risk.  The Plummer case offers a unique view into decisions that were made during the real estate finance bubble prior to 2008 and their heavy financial consequences.