In Petrolink v. Lantel Enterprises, 21 Cal. App.5th 275 (2018), the California Court of Appeal for the Fourth District analyzed whether a tenant that exercises an option to purchase contained in a lease agreement is entitled to a credit against the purchase price for rents the tenant paid and profits lost during the period of time after the tenant’s exercise of the option and before the tenant became the owner of the property.  The court held that the tenant in this case was entitled to a rent credit because, among other reasons, the tenant’s exercise of the option to purchase terminated the lease and thus ended the tenant’s obligation to pay rent.  The court further explained that had the parties consummated the sale as contemplated under their agreement, the tenant would not have paid such rents to the landlord.

The facts of the case are all too familiar.  The option provision in the lease stated that the purchase price would be “equal to the fair market value of the property based on an appraisal.”  Unsurprisingly, each party’s respective appraiser valued the property, which was undeveloped land, at polar opposites of the spectrum, with tenant’s appraisal at $320,000.00 and landlord’s at $1,650,000.00.  The parties were unable to reconcile their differences over the property’s actual fair market value; this eventually led them to court where they sought a judicial determination of the fair market value of the property.  The trial court’s independent appraiser determined the property to be worth $889,845.00, a relatively even split between the landlord’s and the tenant’s figures.  Consequently, the court demanded specific performance of the sale at the $889,845.00 figure, but did not grant the tenant an offset against the purchase price for the rents it paid after its exercise of the option.

On appeal, the appellate court ultimately found that the tenant/buyer was entitled to a credit against the purchase price for both profits lost and rents paid after the exercise of the option to purchase until the closing of the purchase transaction (which occurred more than four years later), minus the value of the landlord/seller’s lost use of the purchase price.

In reaching this decision, the court relied heavily on the findings in Peebler v. Seawall, 122 Cal. App.2d 503 (1954) and Sacks v. Hayes, 146 Cal. App.2d Supp 885 (1956) which together hold: “[w]here 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.”  Because the exercise of the option terminates the lease, there is no longer an obligation to pay rent thereunder, and therefore, the landlord/seller was no longer entitled to receive those rents from the tenant/buyer.  The landlord in this case contended that the tenant’s continued payment of rents after its exercise of the option evidenced an understanding between the parties that the tenant was supposed to continue paying rent until the parties had agreed on a purchase price; however, the tenant explained that the only reason it continued to pay the rent was to ensure that it would not be in default under the lease and have the exercise of the option rendered invalid as a result.  The court sided with the tenant and acknowledged that in this situation, where there is a degree of uncertainty after the exercise of an option to purchase, a tenant’s continued payment of rent is a wise decision as it precludes a potential finding that the tenant fell into default for failure to pay rent.

Interestingly, the court explained, “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 to him . . . Second, a seller also must be treated as if he had performed in a timely fashion and is entitled to receive the value of his lost use of the purchase money during the period performance was delayed” (emphasis added).  This remedy was originally designed by the court in Stratton v. Tejani, 139 Cal. App.3d 204 (1982) to relate the respective parties back to the position they would have otherwise been in, had the performance of the obligation to sell the property not been delayed by litigation and uncertainty, and the court applied it in the same fashion here.  The Petrolink decision, however, does not indicate that the buyer/tenant was deprived of possession of the property.  Perhaps the rule should be clarified to apply when the buyer is deprived of “ownership” of the property instead.  Regardless, the decision in this case presents a clear message to landlords and tenants: to avoid these uncertainties, option to purchase provisions in leases should set forth a clear method by which to calculate the fair market value of the property and should specify whether the lease will continue until the sale is consummated, whether the tenant/buyer is allowed to remain in possession, and whether the tenant/buyer is obligated to pay rents during such time.