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.