Don’t Let Exercise of Purchase Option End Tenant’s Duty to Pay Rent
Do you grant your tenants the option to purchase the leased premises? If you’re using a standard lease form to provide such an option, you might also be inadvertently giving the tenant an unexpected windfall: one or more months of free rent in the months after it exercises the option. Here’s a look at the loophole and how to plug it.
What’s the Loophole?
The key question: What are the tenant’s rent obligations after it exercises a lease purchase option and before the sale actually closes? There’s a lot at stake. Exercise of the purchase option is just the beginning of a lengthy process. By the time the purchase price is set and all the closing conditions are fulfilled, months may pass. The danger for landlords is that the tenant may claim that the exercise of the purchase option ends its duty to pay rent, even though there’s still time left in the lease term. And if the lease doesn’t expressly address the issue, the tenant might have a solid legal case. Potential result: Free rent or an equivalent reduction in the purchase price for the months between exercise and closing.
Tenant Uses Loophole to Get $75,000 in Free Rent
If you think we’re just making it up, ask the Illinois landlord that granted its tenant a lease option to purchase the building at a price to be determined by appraisers selected by both parties. The tenant exercised the purchase option in July 1989; the last closing condition, final appraisal, took place in April 1991. All the while, the tenant continued to pay rent. But the closing still didn’t occur as the parties continued to haggle over the purchase price. Finally, the tenant went to court to force the landlord to sell the building. It also demanded a reduction in the purchase price equal to the amount of rent it had paid since it exercised the purchase option.
The tenant didn’t get all of what it wanted, but it did get a lot. The court ended up shaving $75,000 in the rent the tenant paid starting in April 1991 when all of the conditions of the purchase option were finally met. At that point, the sides were no longer in a landlord-tenant relationship, the court explained. It was as if the tenant became the real owner of the building—the “equitable owner” in legal terms. As a result, it was no longer liable to pay rent unless the lease expressly stated otherwise—the lease in this case didn’t state otherwise. Adding insult to injury, the court concluded that as equitable owner, the tenant was actually entitled to receive rents from other tenants in the building [Industrial Steel Construction v. Mooncotch, Nos. 1-92-4221, 1994 Ill. App. LEXIS 1052].
The Solution: Make Purchasing Tenant Liable for Post-Exercise Rent
The way to plug this loophole is to ensure that the purchase option clause gives you the right to collect rent after the tenant exercises the option through the date of closing. It’s also advisable to stipulate that the tenant isn’t entitled to receive rent payments from any of the other tenants in the building to cut off a potential “equitable owner” argument.
Model Lease Language
Tenant covenants that it shall pay all Rent, Additional Rent, and other charges that accrue under this Lease up to and including the date of the Closing. Tenant also acknowledges that it has no claim to any rent, additional rent, or other charges which shall be payable to Landlord by any other tenants or other occupants of the Building, and which shall accrue up to and including the date of the Closing.