First Right of Refusal

First Right of Refusal; those magic words:

On occasion, during the negotiation process with a tenant in church owned property, the tenant may request that the agreement contain those four magic words, First Right of Refusal. On its face, the words appear harmless enough; if the property owner decides to sell the real property, the tenant will be the first in line to be the buyer. However, what those magic words don’t tell is the price the property is to be purchased at, or how it is to be calculated. Most people would simple tell you that the purchase price is the fair market value at the time of the sale.

Benefits to the Tenant:

Tenants like these rights because it will make them feel secure in the possibility of having a security in their future. The tenant will generally benefit more than the landlord because they can either negotiate with the owner at any time to buy the property, or they can also sit back and see what the market does. If a third party does present a good faith offer at a price below what the holder would have paid, they can exercise their right and buy the property.

In its most basic form, if the owner decides to sell, the owner may, but is not always obligated to either obtain an offer on the open market, or accept an unsolicited offer that sounds acceptable. I have seen some agreements that define the First Right of Refusal  as giving the tenant the right to purchase the property at basically the exact same terms (except those that are unique to the outside buyer) and conditions contained in an offer that the owner has received (and will accept) from that buyer.  Then, once a bona fide offer is received, the tenant, or holder of the First Right of Refusal may either agree to purchase the property under the same terms and conditions, or decline and allow the other buyer to move forward and sell the property.

Fair Market Value:

The general problem is usually in determining the fair market value. The fair market value of property is industry defined as the amount that a willing buyer would pay in cash, to a willing seller, at the properties highest and best use without taking into account the subjective value that the property may have to that buyer.

For simplicity, let’s assume that the highest and best use of the property is a church with an educational component, i.e. classroom building(s). Also assume that the property owner is also a willing seller and that the sale of the property does not constitute a distressed sale and the church can financially afford to remain at that location. This leaves us with determining the fair market value based on a willing buyer, which in this example is a school tenant with a rental agreement that contains only the magic words, a First Right of Refusal.

Since it would be reasonable to conclude that the highest and best use of the property is to remain a church with an education component, the likely buyer would presumably be either another church or school. In the eyes of the buyer, unless they would like to purchase the property to be used as a church and retain the tenant for income purposes, they may be willing to pay a premium for the property. Once this offer is taken to the tenant in order to give them the option to purchase the property for themselves, they may not want to pay that higher price. All well and good you say for the church… but, this has the making of a potential lawsuit.

The tenant will likely go out and get an appraisal of the property to determine their value based on the definition above. The appraiser will consider the tenant to be detriment to the property’s value under a long-term lease, and as a result, decrease the value of the property. This is because the highest and best use of the property is for the buyer to actually be able to use the property as a church and school upon taking possession.

On the inverse, another school would either not want the property since they will not be able to use it themselves as long as the tenant remains. Beginning to see the problem?

The effect of a First Right of Refusal may actually hinder the marketability of the property because acquiring an offer in good faith will require a third party buyer to invest time and effort negotiating a deal that may never happen, if the tenant exercised their right.

I witnessed a bank’s formal church/school appraisal with a three million dollar value be decreased by half a million dollars as a result of a long-term school lease. Based on the above paragraphs can you guess who the only buyer was, why, and at what price?

Alternatives:

The other option would be to go to the school tenant first with the understanding that the owner is willing to sell based on an appraisal of the property rather than locating a potential third party. Unfortunately, this may not be the best answer either, because markets change and appraisals for special use properties can be rather expensive. So even if the First Right of Refusal may state that each of the parties will obtain their own appraisal, once they realize that those appraisals will cost them each thousands of dollars, neither may want to acquire what would be an industry recognized appraisal from a professionally licensed appraiser.

What can be done is simple, really. If the tenant insists on a First Right of Refusal, don’t enter into a long-term rental agreement. If you do, make sure that there is language that states if the tenant does not elect to exercise their First Right of Refusal, they must vacate the property. Often easier said than done, but it’s a negotiating point.

If you elect to grant a First Right of Refusal, you will have to deal with the what-ifs that may come up at some point in the future. As an example, what would happen if the church wants to sell off only a portion of their property, or wants to do a property/land trade rather than a cash sale?

On the other hand, what happens if the church property, by the circumstances of the sale event, reverts back to its denomination would be that triggering event calling in the First Right of Refusal?

Or if the school tenant gets taken over or operated by another organization is the First Right of Refusal transferable?

If the property is sold to a third party, because the tenant elected to not exercise their First Right of Refusal, will the new owner have to honor the tenants First Right of Refusal if they then sell the property, or did the First Right of Refusal, terminate at the time of the sale without any future right? This is extremely important since the new owner will take title to the property legally subject to the rental agreement and the terms of that agreement, including the First Right of Refusal, and might this cause the outside buyer to back out of the deal?

As you can see by this brief summary of the pitfalls in granting a First Right of Refusal, there are many complex issues and unknowns that need to be carefully considered. After all, as the directors and officers of your church, you owe a duty to your church and its members to be good and careful stewards of the church property.

Please see our other related articles

Church Officer and Director Liability
Why Use Bushore Real Estate
Don’t Sign a Letter of Intent
Corporations in Suspension

 

Disclaimer: Every situation is different and particular facts may vary thereby changing or altering a possible course of action or conclusion. The information contained herein is intended to be general in nature as laws vary between federal, state, counties, and municipalities and therefore may not apply to any given matter. This information is not intended to be legal advice or relied upon as a legal opinion, course of action, accounting, tax or other professional service. You should consult the proper legal or professional advisor knowledgeable in the area that pertains to your particular situation.

 

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