Category : Language of Real Estate

Language of Real Estate

Option vs. Right of First Refusal

Option vs. Right of First Refusal

An option is a right to purchase property at a set price for a fixed period of time, whereas a right of first refusal is a right to purchase property only if it is offered for sale in the future.

Option — An agreement to keep open, for a set period, an offer to sell or lease real property. An option can be used, for example, to give the buyer time to resolve questions of financing, title, zoning, and feasibility before committing the buyer to purchase. Options are frequently used in the land assemblage process. The option must be supported by its actual consideration, separate and independent of the purchase price of the property. Mere recital of consideration alone is not sufficient except in a lease-option in which the provisions of the lease are themselves sufficient consideration to support the option.

An option merely creates a contractual right; it does not give the optionee any estate in the property. At the time the option is signed, the owner does not sell, nor does the buyer purchase, the property. Although the owner is obligated to sell if given notice by the buyer, the buyer is not obligated to purchase. An option to buy is also known as a call; an option to sell is known as a put.   An option must contain all of the essential terms of the underlying contract of sale. A binding contract is created immediately upon the optionee’s decision to exercise the option. Necessary information includes names and addresses of the parties, date of the option, consideration, words granting the option, date the option expires, a statement of purchase price, and principal terms. Often a copy of the purchase agreement is attached and incorporated by reference.

An option agreement often includes a statement as to the method of notice by which the option is to be exercised, provisions for forfeiture of option money if the option is not exercised, and acknowledged signatures of optionor and optionee (only the optionor must sign). Unless prohibited by its terms, the option is usually assignable.   If the option fails to cover all the material terms and leaves room for future agreement, then the option will not be enforceable. For example, if the option agreement detailed the parties, the property, the price, and the method of payment but omitted the interest rate on the purchase money mortgage, a court would not enforce the contract.

Thus, the parties should consult an experienced real estate attorney before entering into an option agreement.   Because a broker often does not earn a commission on an option until the option is exercised, the distinction between an option and a contract to buy and sell has a practical importance. If both parties are obligated to perform, i.e., there is mutuality of obligation, then the agreement is a contract for sale. If just one party is obligated to perform, then it is an option. An option is thus a unilateral contract in which the optionor/offeror promises to make the offer irrevocable for a certain time in return for the optionee/offeree’s performance of payments of the option money. When the optionee gives the appropriate notice of intent to exercise the option, he or she in effect accepts the offer, and there is then a bilateral contract for sale with both parties bound to perform.

The option money is usually applied toward the purchase price, but the parties must cover this point in the option contract itself.   If the optionee does not exercise the option, most options provide that the optionor keeps the option money and neither party is obligated to perform. Time is of the essence in an option agreement; thus the option automatically expires if not exercised before the termination date. Death of the optionor or optionee usually does not affect the option. The optionee or heirs can still exercise the right to purchase. The contract is also binding on the optionee’s heirs and assigns.  An option should be recorded, because the rights of the optionee will relate back to the date of the option and take priority over all intervening rights of third parties with notice of the option. Good title practice requires that a release of option be recorded in the event a recorded option is not exercised. Otherwise, the lapsed option constitutes a cloud on the title. Because of this risk, many options contain a defeasance clause stating that the recorded option will automatically cease to be a lien on the property upon expiration of the option exercise date.

Different types of options include the standard fixed option; the step-up option, where the purchase price increases during set stages of the option period; and the declining-credit option, where the percentage of the option price that may be credited toward the purchase price decreases as time passes (opposite of the full-credit option).  For more detail —

Right of First Refusal — The right of a person to have the first opportunity to either purchase or lease real property. Unlike an option, however, the holder of a right of first refusal has no right to purchase until the owner actually offers the property for sale or entertains an offer to purchase from some third party. At that point, the holder may match the offer. If the owner first offers the property to the party holding the right of first refusal, and this person refuses, then the owner is free to offer to any third party at that price or higher.   In a lease situation, a right of first refusal might give the tenant the right either to purchase the property, if offered for sale, or to renew the lease or lease adjoining space.

This right of first refusal is clearly more advantageous to the tenant than it is to the landlord as this property is less marketable than one without such a right. However, it may encourage the tenant to make improvements that the tenant might not otherwise have made.   Under an option to purchase, the tenant can decide whether or not to exercise the option at a fixed price during the option period. In a right of first refusal, however, the holder can exercise the right only if the owner has offered to sell or lease the property or has entertained a bona fide offer by a third person to purchase or lease the property.

A key to the difference between an option and a right of first refusal is to determine which party has the right to initiate the sale or lease. In both an option and a right of first refusal, the holder has no interest in the land or equitable estate until the option or right is exercised.   In some condominiums, the association of unit owners retains the right of first refusal on any sale of a unit. Some state laws give a right of first refusal to a tenant whose apartment is to be converted into a condominium unit.

Rights of first refusal are common in agreements between partners, shareholders, joint owners (where the ultimate effect is to act as a waiver of the right of partition), landlords, and tenants. For more detail —

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Language of Real Estate Uncategorized

Security Deposit vs. Earnest Money Deposit

A case of Mistaken Identity — Security Deposit vs. Earnest Money Deposit

The security deposit is paid by a tenant up-front to cover any default in the lease, including damage, whereas a buyer puts up an earnest money deposit at the time of the offer to purchase, to be forfeited in the event the buyer does not perform.

Security Deposit — Money deposited by or for the tenant with the landlord, to be held by the landlord for the following purposes: (1) to remedy tenant defaults for damage to the premises (be it accidental or intentional), for failure to pay rent due or for failure to return keys at the end of the tenancy; (2) to clean the dwelling so as to place it in as fit a condition as when the tenant commenced possession, considering normal wear and tear; and (3) to compensate for damages caused by a tenant who wrongfully quits the dwelling unit. The security deposit is not regarded as liquidated damages, but rather is a fund held in trust for the tenant that the landlord can use to offset damages caused by the tenant. A security deposit is not taxable to the landlord until applied to remedy any tenant defaults. Neither can the tenant take the deposit as a tax deduction. Some states require security deposit monies to be placed in an interest bearing account in trust for the lessee.

The tenant’s claim to the security deposit monies is superior to all claims of the landlord’s creditors. An exception is claims of a trustee in bankruptcy.

Under the Uniform Residential Landlord and Tenant Act, the security deposit may not exceed one month’s rent. The landlord must return the security deposit, less any authorized retained portion, to the tenant no later than 14 days after the termination of the rental agreement. The landlord must give written notice to the tenant setting forth the grounds for and evidence supporting any claimed retention of any portion of the security deposit. Certain states require landlords to return security deposits to tenants within a specified time period and to account for all claims to any part of the deposits; disputes over security deposits may be handled expeditiously in small claims court, which provide for penalties in the event a landlord fails to comply with the regulations. Difficulties in the accounting and administration of security deposits have led some authorities to advocate their abolition. Although the Uniform Residential Landlord and Tenant Act preserves the security deposit, it limits the amount (one month’s rent) and prescribes penalties for its misuse. The act does not limit the prepayment of rent, as distinguished from security deposits; nor does it require the landlord to pay interest on the security deposits.

The lease should clearly specify whether a payment is a security deposit or an advance rental. If it is a security deposit, the tenant is not entitled to apply it as discharge of the final month’s rent. If it is an advance rental, the landlord will have to pay taxes on it when received. Many state laws specifically state that the security deposit is not to be construed as payment of the last month’s rent by the tenant. When the lessor sells the property, the sales contract should cover the appropriate accounting of security deposit monies (i.e., debit seller and credit buyer).

Earnest Money Deposit — The cash deposit (including initial and additional deposits) paid by the prospective buyer of real property as evidence of good-faith intention to complete the transaction; called bargain money, caution money, hand money, or a binder in some states. The amount of earnest money deposited rarely exceeds 10 percent of the purchase price, and its primary purpose is to serve as a source of payment of damages should the buyer default. Earnest money is not essential to make a purchase agreement binding if the buyer’s and seller’s exchange of mutual promises of performance (that is, the buyer’s promise to purchase and the seller’s promise to sell at a specified price and terms) constitutes the consideration for the contract. Thought should be given to placing the money in an interest-bearing account for the buyer’s benefit, which can be done by the parties agreeing in writing to place it with a neutral third party such as an escrow company.

The deposit, or earnest money, is usually given to the broker at the time the sales contract is signed. The broker’s authority to hold this money on behalf of the seller should be specifically set forth in the listing, because such authority is not implied in law. The broker has the responsibility under the license laws to deposit this money into a client trust account or neutral escrow; or with the knowledge and consent of both parties, the broker may hold the earnest money until the offer has been accepted. The broker may not, however, commingle this money with the broker’s own general funds. When the transaction is consummated, the earnest money is credited toward the down payment. If the seller defaults, the broker should check with the buyer before returning the earnest money. The buyer may not want the earnest money returned directly to the seller if he or she wishes to sue the seller for specific performance.

There is some uncertainty as to exactly who owns the earnest money once it is put on deposit. Until the offer is accepted, the money is, in a sense, the buyer’s. Once the seller accepts the offer, however, the buyer may not get the money back, even though the seller will not be entitled to it until the transaction is completed. At this point, the money does not belong to the broker either, for it must be deposited in a special trust account maintained especially for such purposes. This uncertain nature of earnest money deposits makes it absolutely necessary that such funds be properly protected pending final decision on how they are to be disbursed.

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Language of Real Estate

Subordination vs. Subrogation

The language of real estate can sometimes be confusing to agents and consumers. In this series, we explore some of terms we’ll call Mistaken Identity. All references are to The Language of Real Estate now in its seventh edition.

Feel free to share any experiences you have had with these terms.

Subordination vs. Subrogation

Subordination means to give up priority to an anticipated future mortgage or lien, whereas subrogation means to substitute a creditor who succeeds to the rights of another.

Subrodination — An agreement whereby a holder of a prior superior mortgage agrees to subordinate or give up his or her priority position to an existing or anticipated future lien. Subordination agreements are frequently used in development projects where the seller of the land to be developed takes back a purchase-money mortgage and agrees to subordinate the mortgage or become subject to a construction loan, thereby enabling the developer/purchaser to obtain a first mortgage loan to improve the property. The subordination agreement thus alters the normal rule of giving priority to the first recorded mortgage. As a result, the construction mortgage, even though recorded after the existing purchase-money mortgage, becomes the first mortgage.   Many interim lenders refuse to lend any money in the absence of a subordination clause in all prior loans or other agreements. Thus, most presale purchase contracts for proposed condominium units have a clause subordinating the apartment purchaser’s right to buy the apartment (equitable lien) to any future interim construction mortgage given by the developer. Thus on default, the lender could wipe out the purchase contract if it wanted to do so.

Some states have statutes requiring specific forms and certain disclosures of subordination agreements. It might be considered the unauthorized practice of law for the broker to draft a subordination clause.

Subrogation — The substitution of a third person in place of a creditor to whose rights the third person succeeds in relation to the debt. For instance, a title company that pays a loss within the scope of its policy is subrogated to any claim that the buyer has against the seller for a loss. Insurance policies typically contain subrogation clauses. Whenever a payment is made from a state real estate education, research, and recovery fund to satisfy a judgment, the fund is subrogated to the rights of the injured party.   If the Department of Veterans Affairs makes advances to the mortgagee due to the default of the veteran-mortgagor, the VA is subrogated to the rights of the mortgagee against the mortgagor to the extent of these advances.

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Language of Real Estate

Easement vs. License

Mistaken Identity — Easement vs. License

An easement is a permanent right in property, whereas a license, which is not an interest in property, is a temporary right to use that property and may be revoked at any time.

Easement — A nonpossessory (incorporeal) property interest (short of an estate) that one person (the benefited party) has in land owned by another (the burdened party), entitling the holder of the interest to limited use or enjoyment of the other’s land. An easement fulfills the needs of one property at the expense of another.

Because an easement is an actual interest in land, the statute of frauds applies and an express grant of easement must be in writing, usually in the form of a separate deed or a reservation in a deed. Thus, an easement is an interest in land rather than a mere contractual agreement. Easements are also created by necessity (as in landlocked situations), by implication, or by prescription. Because the easement is both a benefit to the holder and a burden to the servient property owner, it significantly affects the value of the respective properties and the extent of the easement should be clearly understood. Most easements originate by express grant, so the drafter should clearly express the rights and duties associated with the easement. An easement can be an affirmative easement, such as a right-of-way to cross the property, or a negative easement, such as a restriction on fence height. It can also be created for different periods of time–for a term of months, years or for life.

Easements are classified as either appurtenant or in gross. An easement appurtenant is a right in another’s land (servient estate) that benefits and attaches to the owner’s land (dominant estate). An easement in gross is personal in nature and does not pass with the land because it does not benefit or attach to a dominant estate.

Litigation involving easements usually results from the initial failure to adequately define the easement area (the floating easement problem), the uses to which it may be put, or which party has responsibility for repair and upkeep. An easement for access purposes might not be appropriate for later use to lay utility lines to the property. When an easement or right-of-way is located by a grant that does not define its specific width, such width is assumed to be one that is suitable and convenient for ordinary, free passage.

Easements should not be confused with profits or licenses. A profit is the right to take the soil, minerals, or products of the land. A license is not an interest in land, merely permission to use the land of another for some limited purpose; it can be revoked at any time.

License — Permission or authority to do a particular act on the land or property of another, usually on a nonexclusive basis. A license is a personal, revocable, and nonassignable right, but unlike an easement, it is not considered an interest in the land itself. If a right to use another person’s land is given orally, it is generally considered a license rather than an easement. The landowner may revoke such a right at any time, unless it has become irrevocable by estoppel. A license ceases upon the death of either party and is revoked by the sale of the land by the licensor. For example, a landowner who grants a friend permission to enter his or her property for hunting purposes thus grants the friend a license to use the land. If an owner mistakenly builds a rock wall across the boundary line so that it encroaches onto the neighbor’s property, the owner sometimes pays the neighbor for a license to keep the rock wall in place. This arrangement should be reduced to a formal encroachment agreement that is signed and recorded so that it runs with the land.

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Language of Real Estate

Assumption vs. Subject To Mortgage

A case of Mistaken Identity: Assumption vs. Subject To Mortgage

Both involve the sale of a property without paying off the underlying mortgage. With an assumption, the buyer agrees to become personally liable for any deficiency judgment upon default; subject to means the seller remains primarily liable for the note and the mortgage.

Assumption of mortgage — The acts of acquiring title to property that has an existing mortgage and agreeing to be personally liable for the terms and conditions of the mortgage, including payments. In effect, the buyer (grantee) becomes the principal guarantor on the mortgage note and is primarily liable for the amount of any deficiency judgment resulting from a default and foreclosure on the property. The original mortgagor (grantor) is still liable as surety on the note if the grantee defaults. The personal liability of the purchaser to pay the mortgage debt is usually created by an assumption clause in the deed (or assignment of lease if a leasehold mortgage is involved). Normally a deed need be signed only by the grantor, but where there is an assumption clause both buyer and seller sign the deed so that the buyer becomes personally bound to the assumption. Because of the seller’s continued liability, he or she usually asks a higher price for the property if the buyer is to assume a mortgage-the seller is, in effect, trading on the low interest rate of the existing mortgage. The lender is, in effect, a third-party beneficiary of the assumption agreement.

Subject to mortgage — A grantee taking title to a real property “subject to” a mortgage is not personally liable to the mortgagee for payment of the mortgage note. In the event that the grantor/mortgagor defaults in paying the note, the grantee could lose the property, however, and thus his or her equity, in a foreclosure sale.



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Language of Real Estate

Chain of Title vs. Cloud on Title

The language of real estate can sometimes be confusing to agents and consumers, especially with terms and concepts that appear the same. In this series, we will explore some of the terms we’ll call Mistaken Identity. All references are to The Language of Real Estate now in its seventh edition.

Feel free to share any experiences you have had with these terms.

Chain of Title vs. Cloud on Title

The chain of title reveals the succession of owners in the history of a
property, whereas a cloud on title is a defect or impairment in the title.

Chain of Title —  The recorded history of matters that affect the title to a specific parcel of real property, such as ownership, encumbrances and liens, usually beginning with the original recorded source of the title. The chain of title shows the successive changes of ownership, each one linked to the next so that a “chain” is formed.

Ownership of a particular property frequently passes through many hands subsequent to the original grant. If any link is broken in a property’s chain of title, then the current “owner” does not have valid title to the property. For example, if a forged deed was somewhere in the chain, then no subsequent grantee would have acquired legal title to the property.

Cloud on Title — Any document, claim, unreleased lien or encumbrance that may superficially
impair or injure the title to a property or cast doubt on the title’s validity.
Clouds on title are usually revealed by a title search and may be removed from
the record by a quitclaim deed or a quiet title proceeding initiated by the
property owner. Usually, the owner is prevented from conveying a marketable
title while the “cloud” remains, unless it is only for a minor
nuisance item.

Typical clouds on title are (1) a recorded contract for deed that has not been
removed from the record, but under which the buyer has defaulted; (2) a
recorded option that was not exercised, but that still appears on the record;
(3) a recorded mortgage paid in full, but with no satisfaction of mortgage
recorded; (4) property sold without the wife’s release of her dower interest;
(5) an heir of a prior owner with a questionable claim to the property; (6) the
situation in which one of many heirs has not signed a deed; (7) a lis pendens
(pending litigation) having been dropped but not removed from the record; (8) a
lessee in default having an option to purchase, which probably will not be
enforceable if he or she breaches the lease; or (9) a prior conveyance with an
incomplete legal description.


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