Imagine seeing a house or a piece of land that you love, but it isn't up for sale. You could heave a sigh and walk away, or you could speak to the owner about having first dibs on the property when he or she eventually comes to sell it. Negotiating a right of first refusal means that you, the potential buyer in this scenario, have the right to buy the property before the seller negotiates an offer from anyone else.
A right of first refusal is essentially having first dibs on a property or a piece of land. The owner must offer to sell the property to the interested buyer, on pre-agreed terms, before he negotiates offers from other potential buyers.
How Does a Right of First Refusal Work?
A right of first refusal (ROFR) is a future right in real estate. It gives a potentially interested buyer the right to buy – or rather, the right to refuse to buy – a specific piece of real estate before the seller negotiates other offers.
It's important to understand that a right of refusal does not guarantee a sale. The seller is under no obligation to sell the property. When he first lists the property for sale, or receives an offer that he's inclined to accept, at that point he must give the interested buyer the right to buy the property. The right of first refusal holder can choose to exercise this right and close the sale, but equally may choose to decline the purchase, in which case the seller can negotiate with other potential buyers.
When Might Someone Use a Right of First Refusal?
There are plenty of scenarios when you might want to draw up a right of first refusal:
Landlord and tenant transfers. A long-standing tenant may be interested in buying the rental home. Here, a right of refusal clause written into the lease would obligate the landlord to consider an offer from the tenant before listing the property on the open market.
Neighboring landowners. Landowners who own adjacent properties may wish to give each other first refusal rights over any future plot sales. If the neighbor does not wish to buy the property, or he cannot meet the terms of the agreement, then the seller is free to sell the land to someone else.
Developers. Developers often scout parcels of land that could be used for large-scale residential or commercial development in the future. They put this land "under option," meaning they have the right to buy the land as soon as it goes up for sale, before it's sold to any other buyer. The developer and the landowner may come to an agreement on price when the option is drawn up but more usually, the agreement will provide a formula for calculating the value of the land at the time of the sale.
What's the Impact on Buyers and Sellers?
For buyers, a right of first refusal gives the interested party first dibs on a property that isn't up for sale yet. This is extremely useful in hot markets, where homes tend to sell as soon as they are listed. There could be a financial incentive as well, as negotiating a right of first refusal allows the would-be buyer to suggest a sale price upfront and write this into the agreement. There's much less chance that the price will be pushed up by a bidding war in the future.
On the downside, the seller could receive an offer at any time and the interested buyer may have to move very quickly to close the sale.
Sellers benefit less from rights of first refusal because it hinders their ability to market the home and play numerous offers off against each other. Sellers cannot negotiate with other buyers until the right of first refusal holder has officially refused the property. Since it takes time to get a response, other interested buyers may lose patience and withdraw their offer before the right of first refusal plays out.
What Goes Into a Right of Refusal Agreement?
A right of refusal must be written into a legal contract called a "right of first refusal" or an "option" agreement, and the agreement itself can be as vague or as specific as you like. For example, a right of first refusal can bind only the current owner, or bind all future owners of the property. It can give the interested party a genuine "first dibs" on the land at a predetermined price, or it can allow the holder to match any legitimate offer the seller receives for the property.
Since a right of first refusal can mean different things to different people, it's important that the owner and prospective buyer are on the same page when drawing up the contract so there is no confusion about how the right of refusal will work and how it may be exercised. This is not a DIY legal project. You definitely will need lawyers involved in drafting the agreement.
The following sections contain some of the things to think about when briefing your attorney.
What Triggers the Right of Refusal?
Some agreements say that any sale or transfer – even a mortgage lien – will trigger the right of first refusal. In other words, the prospective buyer gets first dibs on the property whenever there's a transfer of ownership. Most owners do not like this provision because they want the ability to transfer the property to family members and trusts before the right of first refusal kicks in.
Option to Buy or Right to Match?
One type of right of first refusal gives the interested buyer the option to make an offer on the land at any time during the refusal period. Another type of right of first refusal gives the interested buyer the right to match any legitimate offer the seller receives for the property. This type of right of first refusal is contingent upon the property being put on the market and essentially is the ability to preempt another offer on the home.
What's the Price?
Where the right of first refusal is structured as an option, there needs to be a mechanism for agreeing to the sale price at the time the option is exercised. The seller and buyer can bind themselves to a specific price, for example, a fixed price of $200,000 or $3,000 per acre. If the right of first refusal is going to last for more than a year or two, there may be a provision for increasing the price at a fixed rate per year, for example, "$200,000 increasing by 3 percent each year" or "$200,000 increasing each year in line with the Consumer Prices Index."
More usually, the parties will agree to sell and buy at the property's fair market value at the time the right of first refusal is exercised. This figure will be determined by a professional appraiser or land valuer, and there may be extensive drafting to deal with the valuation process. If the buyer does not like the price, he is not obligated to follow through with the purchase.
How Long Does a Right of Refusal Last?
A right of refusal can last for as long as the parties agree, whether that's months, years or generations. However, since real estate markets and land values change so quickly, most rights of first refusal have a fixed end date just one or two years in the future. The longer the term, the greater the uncertainty, so it's better to keep the arrangement relatively short term.
How is the Right of Refusal Exercised?
The agreement must spell out:
- How the property owner will notify that right of first refusal holder that the property is about to be listed for sale, or that an offer has been received which the owner wishes to accept
- What the right of first refusal holder must do to accept the offer
- How these notices can be delivered (by mail, email, physical delivery and so on)
- Who instructs the appraiser, and when
- How much time each party has to respond to the various notices or price determination
Since the property owner will not wish to be held up by a hesitant right of first refusal holder, the timelines for exercising the right of first refusal are usually quite strict. Be prepared to make decisions in a matter of days rather than weeks.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.