A Right Of First Refusal may be in use in many circumstances, but what does it mean when it is used in Real Estate?
In real estate, the right of first refusal is a clause, or provision in a lease or other agreement. It gives one party in the agreement the right to buy a specified property before the owner negotiates a sale with any other potential buyers. Basically speaking it’s like saying the person with the right of first refusal has “first dibs” on the property.
Having said that, as with many other things in real estate, the right of first refusal can be found in many shapes and forms. Here I will take a look at the different ways in which right of first refusal can be structured, how, where, and when it might be used, and what can happen if there is a breach of the agreement.
When Is The Right Of First Refusal Used?
There are a variety of situations in which the right of first refusal may be used:
A Right Of First Refusal Between Family Members
On some occasions, a relative of a homeowner or landowner may have an interest in purchasing their family members’ property. However, they may find that the family member has no interest in selling at the time, or the would-be buyer may not want to have the owner move from the property before they are ready.
In these circumstances, the family members may sign a “freestanding” right of first refusal agreement. The “freestanding” is not a legal or technical term, but I use it here to distinguish it from a right of first refusal agreement which is part of a lease or other agreement.
This agreement would usually state something along the lines of :
“When Grandpa Whittle decides to move from his home – the property of XYZ details from the land registry – Sam Whittle, the owner’s paternal grandson, will be allowed to purchase the property before grandpa negotiates with or sells to anyone else.”
Obviously, an actual right of first refusal will be written more formally if a legal professional prepares it but even such an informal agreement, if it is written down and signed by both parties, would be legally binding. It is assuming, of course, that grandpa was still in possession of all his faculties.
A Right Of First Refusal Between Landlord And Tenant
A tenant who has an interest in buying the property they are renting may ask for a Right Of First Refusal clause to be written into the tenancy agreement. If the landlord agrees to this clause, they must allow the tenant to buy the property before accepting an offer from anyone else.
Depending on the exact terms of the clause, this may not prevent the landlord from placing the property on the open market. However, it would prevent the landlord from selling to anyone other than the tenant before the tenant had the opportunity to purchase.
Again, depending on how the clause was written, it would also prevent the landlord from accepting any unsolicited offers for the property without first giving the tenant the chance to counter or improve upon that offer.
A Right Of First Refusal Between Business Partners
People who start a business together may enter into a Right Of First Refusal agreement. This can then be invoked when one of the partners in the company chooses to leave. The right of first refusal on an exiting partners’ portion of real estate assets owned by the business ensures the remaining partner or partners can consolidate their own position in the business, control who was able to buy into the business or both.
This type of agreement can also be used when an entrepreneur utilizes the resources of an angel investor. The investor may require a Right of First Refusal agreement so that, should the venture fail of the entrepreneur chooses to sell-up, the investor has the option to purchase any real estate before anyone else.
A Right Of First Refusal Between A Homeowner And A Homeowners Association
There are an increasing number of homeowners associations that are including a right of first refusal clause in their CC&R’s or by-laws.
In this case, the homeowners association may not wish to actually purchase a specific property. Instead, the right of first refusal clause is used so the HOA can stop the discount sale of a property from lowering the value of other homes in the development.
However, on some occasions, these clauses may be used to prevent the sale of a property to someone the HOA feel is unsuitable for the community.
The Legality Of Right Of First Refusal Clauses In HOA CC&R’s And By-laws
These clauses are coming under increasing scrutiny as they could be used by HOAs who wish to socially engineer the population of their community. Unless there are clear, unambiguous criteria against which potential owners are vetted, it’s possible that HOA boards can be in breach of the Civil Rights Act of 1968.
This Act includes legislation commonly known as the Fair Housing Act. The Fair Housing Act made it unlawful for a landlord or homeowner to discriminate against a potential tenant or buyer based on their race, color, gender, religion, or national origin.
Since then, this legislation has been extended to cover potential tenants and buyers of other protected classes. This means that a landlord or seller cannot discriminate against, or choose a tenant or buyer because of, family status, disability, or pregnancy.
The only exception to this is in the case of properties which are built specifically for people over a particular age, i.e. 55 years or over and homes that have been constructed for people with disabilities.
To protect against allegations of discrimination, Homeowners Associations which choose to use a Right Of First Refusal clause should clearly document the criteria by which they assess a potential buyer or tenants’ suitability. In addition, paperwork documenting how these criteria were applied should be maintained for a number of years after each transfer of tenancy or ownership.
How An HOA Might Use A Right Of First Refusal
As I previously stated, a homeowners association does not usually include a right of first refusal clause in its governing documents so they can buy a property. Instead, the right of first refusal clause is more often used to veto a sale. This gives an HOA the option to reject an offer to purchase that the seller might otherwise be happy to accept.
A rare exception to this can occur when an HOA has chosen to include a right of first refusal clause that they can use to buy a property in the community. This could be used to cover a situation where a homeowner has run into financial difficulties which could result in bankruptcy or foreclosure. In this case, select HOA’s may choose to buy the homeowner’s property at market value in order to prevent the home from being sold at a discount or left empty. Discount sales and vacant homes can affect the other properties in a homeowner’s association-governed community by:
- Lowering the market value of other properties in the development by reducing the comparable properties data by which homes are partially valued.
- Giving homeowners with a perceived lesser financial and /or social status the opportunity to afford a home that would otherwise be prohibitively expensive. This, in turn, may lower the perception of exclusivity for which residents are willing to pay a premium.
- Affecting the ability of other residents to sell their properties. This could happen if several homes sell at a discount, and lenders become reluctant to offer new buyers a mortgage for a property in the community.
- Vacant homes can affect the “feel” of a community. In addition, depending on the level of security in a development, homes without residents can attract squatters or criminal acts which subsequently have further negative impacts on image and price.
- If no rules are prohibiting renting homes in the development large numbers of rentals may become a potential issue. Discounted homes or properties held by lenders are more likely to be rented out to off-set long-term holding costs. Renters and landlords who do not have any personal connection to a home can take less care of a property, consequently impacting other properties in the development.
A Right Of First Refusal Between Neighbors
A homeowner might ask a neighbor if they are willing to enter into a right of first refusal agreement. This is seen more frequently in rural areas where a homeowner may be interested in buying adjoining land to:
- Expand the property they have for agricultural production.
- Give themselves and their families more space.
- Extend their own homes.
- Develop the land by building residential properties to sell.
- Prevent developers from purchasing the land for the purposes of development.
This form of Right Of First Refusal is a freestanding agreement and does not necessarily form part of another contract or lease.
How Do The Parties To A Right Of First Refusal Agreement Agree On A Price?
There are no set criteria over how to agree on a property price when the Right of First Refusal is evoked. Often the procedure by which the sales price will be agreed is written into the clause or agreement. The most frequently used methods are:
- The property is valued via an independent assessment at the time the agreement is signed. This is agreed to be the base price for the property, and this value will increase each year. The amount of the increase is usually either a set percentage rate or the rate of inflation. Care must be taken by both parties to ensure they are clear about whether this arrangement uses compound interest or an annual increase based on a percentage of the initial assessed value.
- There is no valuation of the property at the time of the agreement. Instead, when the right of first refusal is invoked, both parties may pay for one or more independent assessments. The number of evaluations can be defined in the agreement. Upon receipt of the assessments, the parties will calculate the average assessment amount, and that will be the sale price. Again, care should be taken that all parties are clear about how this will be carried out. There will be differences in the final sales price depending on whether a mean, mode, or median average is calculated. Which is used should be set out in the agreement.
- If the owner places the property on the market or receives an unsolicited offer to purchase, they must contact the person with whom they have the Right Of First Refusal Agreement. That person then has the right to purchase the property for the amount which has been offered to the owner by the other potential buyer. In this case, if written correctly, the right of first refusal clause negates the possibility of the prospective buyer being drawn into a bidding war.
How Does A Right Of First Refusal Affect A Buyer?
A right of first refusal is usually used to prevent an undesirable situation. As such, it provides the potential buyer a certain degree of security.
It also gives a buyer time to improve their credit score, save for a down payment, or get together enough cash deposit for the entire property price.
How Does A Right Of First Refusal Affect A Seller?
A tenant who has a right of first refusal clause or agreement is likely to take better care of a property, knowing that it may become theirs in the future.
However, property owners can find a right of first refusal restrictive, especially if they wish to sell quickly and they have to wait for the party with the right of first refusal to formally terminate their option to buy.
What Happens If One Party Breaks The Right Of First Refusal Agreement?
What happens if one of the parties to a Right Of First Refusal fails to adhere to the agreement is highly dependant or the details included in the agreement and how robustly the contract is written.
At one end of the spectrum, if an agreement has no tangible criteria against which compliance can be used, then it may be more or less unenforceable.
At the other end of the spectrum, there could be significant and specific penalties for non-compliance with the terms of the agreement
However, generally speaking, if the seller fails to adhere to the Right Of First Refusal, there is little the other party can do to stop the sale of the property involved. Instead, the usual legal remedy is to sue the seller of the property for damages.
If a buyer fails to keep to the agreement, there is generally not an issue. This is because all they have to do is give up their right to purchase the property, and the seller can move onto another buyer. The exception to this would be a situation where the buyer does not give up their right to buy, shows no sign of moving forward with the sale, and there are no time limits in the agreement. In this situation, a seller is advised to seek legal counsel over how long they should wait for the buyer to decide moving forward with another buyer.
Depending on the wording of the agreement there may be scope for a seller to sue the other party to the agreement for damages if the other party behaves unreasonably, taking excessive amounts of time and then withdraws from the sale causing the seller to lose the chance to sell to another buyer.
Should You Sign A Right Of First Refusal Agreement?
The only consistent element in a right of first refusal agreement or clause is that one party has the opportunity to purchase a property before anyone else. After that, they are as variable as the properties and signatories involved.
The agreement may be so loosely written that it is almost unenforceable or it may have multiple rules covering:
- How the sales price will be set
- Whether a buyer must provide proof of their ability to move forward with the property purchase, what that proof must be, and the time scales involved for providing the evidence.
- How long the right of first refusal is valid. For example, whether it will expire after a set period or will be in place indefinitely.
- Whether the Right of First Refusal agreement is transferable, this could be either by inheritance or through the sale or other transfer of the agreement.
- Any exceptions to the right of first refusal.
- The consequences of non-compliance with the agreement.
If you are considering becoming a party to a Right Of First Refusal agreement, the first thing you should do is read a draft copy first to ensure you are happy with and understanding of, all of the details. If there is anything with which you are not satisfied, you can always try to negotiate with the other party. However, do not sign an agreement you are not entirely happy with, just because the other party will not negotiate. Listen to any niggling doubts you may have.
Then, it is always advisable to consult with a legal professional before taking the final step and signing on the dotted line.
Final Thoughts
In real estate, the right of first refusal is an agreement between a property owner and a potential buyer. It gives the potential buyer the right to buy the property before anyone else, if and when the owner chooses to sell.
The Right Of First Refusal may be created as a standalone agreement, or it may be a clause or set of terms within a wider contract or lease.
These agreements benefit buyers by reducing uncertainty over who may end up owning the property in which they have an interest and what that new owner may do with their purchase. In the meantime, sellers benefit when a potential buyer is a tenant or neighbor of the property in question. In this case, the would-be buyer is likely to take better care of a property that they may eventually own.
A Right Of First Refusal agreement can take many forms. As such, it is imperative that before entering into one, both signatories obtain legal advice about the suitability, fairness, and enforceability of the agreement and ensure it is right for them.
About The Author
Geoff Southworth is the creator of RealEstateInfoGuide.com, the site that helps new homeowners, investors, and homeowners-to-be successfully navigate the complex world of property ownership. Geoff is a real estate investor of 8 years has had experience as a manager of a debt-free, private real estate equity fund, as well as a Registered Nurse in Emergency Trauma and Cardiac Cath Lab Care. As a result, he has developed a unique “people first, business second” approach to real estate.
Check out the Full Author Biography here.
This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policy.
