If you’re looking to buy a home, you may find that you come across different clauses defining what you can and can’t do in buying a home or selling the property. It can really be acronym soup! Today, we’re going to go over another acronym used in negotiating real estate offers, ROFR or right of first refusal.
In the following, we’ll go over a right of first refusal and compare them with other common negotiation clauses in real estate so you can feel confident in moving forward with your home purchase.
What Is A Right Of First Refusal (ROFR)?
When discussing real estate, the term “right of first refusal” refers to a clause in a lease or other contract that gives an interested buyer the contractual right to be the first party to put an offer on a property when a seller lists it on the market. If another party expresses interest in the property, the rights holder has the option to either purchase the property over the other potential buyer or decline the opportunity and permit the seller to freely consider other offers.
If someone knows they like a property, but it’s not currently for sale, an ROFR clause can allow them to have the first right to purchase a property if the seller does decide to put it on the market. Under this agreement, the seller has to contact the potential buyer and give them a chance to purchase it before they can accept another offer on the property.
How Does Right Of First Refusal Work?
Right of first refusal is negotiated before homeowners bring a property to the market. Before a seller accepts an offer from a member of the public for their property, they have to make it available to the person who has the right of first refusal. That person usually has a time limit on how long they have to negotiate before the seller can negotiate with other potential buyers. There’s a date window on the notification and once that time passes or the buyer declines, the seller is free to negotiate with others.
There are a couple of ways that right of first refusal often come to pass. A real estate agent might see you have the property that’s highly desired by a particular client and ask if you would be open to a ROFR agreement if the property went up for sale. A landlord might also try to entice renters by agreeing to a right of first refusal clause for tenants, should they ever decide to sell.
Should the time for the right of first refusal pass, other potential buyers can make an offer for the home. This doesn’t mean the option holder doesn’t still have the right to try to buy the property, but it will mean they have to compete with others. If someone declines their first option to buy the property, they may be taking a calculated risk that they can get the property for cheaper once it’s on the open market rather than paying the agreed-upon price that may have been stipulated in the contract.
How Do You Enter A Right Of First Refusal Agreement?
If you’re going to execute an agreement for a right of first refusal, it’s best for both sides to have lawyers involved. This is because there should be a time limit window where the agreement to ROFR applies. Typically included in these contracts are an agreed-upon way to calculate what the future sale price of the property might be. In the absence of a specific purchase price agreement, the potential buyer may have the right to match an offer that the seller was going to accept from a member of the general public. If the buyer no longer wants the property, the seller simply accepts the other offer.
For example, the price might be a flat amount or a certain percentage above the current market value. The terms and rules of the agreement should be clear to all participants prior to anyone signing on the dotted line.
Pros & Cons Of Right Of First Refusal
ROFR agreements have benefits and drawbacks for each party to the transaction. Let’s run through both sides of it for both the buyer and seller.
Here are the considerations a potential future buyer might have to think about before entering into a ROFR agreement.
The benefits for potential buyers are as follows:
- No competition: Even if the seller puts the property on the market, they can’t accept any offers before allowing you to have a shot at the property based on the terms in your original contract. This could enable you to get a home you really value without having any anxiety about a bidding war.
- Prices are often pre-negotiated: Because pricing terms are often included in the contract, you could be getting a property for less than it would earn if it hit the open market. It's worth noting that this only works out if you’re in a market where prices are rising steadily.
- Time to work toward goals: For renters, entering into an ROFR agreement allows them the time to work on their credit and save up for a down payment while potentially locking in a purchase price, so they’ll be ready to buy when the landlord is ready to sell.
There are some drawbacks for the buyer as well.
- Limited decision window: There’s a time limit built into the typical ROFR agreement, so when the seller does decide to put the property up for sale, the potential buyer needs to be ready to make a quick decision and know whether they can line up the financing. They should be ready to enter into a purchase agreement within a matter of days.
- Prices are often pre-negotiated: This is both a pro and a con for both the buyer and seller. Essentially, if prices have gone down in your area, you could be overpaying by making a deal based on the terms of the original agreement. But if you let the property go to the open market, you take the risk that you won’t be able to get it.
The seller has their own incentives and downsides to weigh. Let’s do a quick rundown.
There are a few potential benefits to the seller.
- No listing required: If you enter into a ROFR, there’s a chance you could sell your property without ever having to list it - which can keep your costs down considerably.
- You could make a windfall: If the buyer really wants it without the possibility of competition, you may be able to make out like a bandit and sell the property above market value.
- Give preference to certain buyers: Right of first refusal may be given to family members or current tenants in the property first and the seller may wish to have an opportunity at the property before it hits the market.
Just as there are drawbacks for buyers, there are drawbacks for sellers as well.
- You end up limiting your market: Typically, the more buyers that have a chance to participate the better chance a seller has to gain a higher price. By giving someone the first option, you could unintentionally be lowering your price.
- A fixed contract price could hurt: If you have a specific price point laid out in the contract that ends up being lower than the current market value for the property, you could be leaving money on the table.
- It could cause lending issues: Even if you’re not currently looking to sell your property, the existence of a right of first refusal could create issues if you’re looking to refinance an existing mortgage. Lenders and major mortgage investors generally prohibit you from getting a loan when these types of clauses exist because the property serves as collateral for the loan. If you default for any reason and the lender has to sell the property to recoup the investment, they won’t want any clause that prohibits them from making it available to the most possible competition in order to get the most money.
Right Of First Offer (ROFO) Vs. Right Of First Refusal (ROFR)
So far we’ve talked about rights of first refusal, but there are also clauses dealing with right of first offer (ROFO). Right of first offer allow someone the opportunity to make the first move when someone is looking to sell. Unlike a right of first refusal where a seller may be obligated to sell to the potential buyer under the terms of the original contract, the seller is still free to market the property for sale to others. The potential buyer has a time limit to put together an offer, which the seller can accept or reject. The seller is also free to go back after having initially rejected the offer if they can’t get a more favorable deal from someone else.
A right of first refusal agreement allows a buyer and seller to enter into an arrangement by which the potential buyer is given the first crack at a property when it goes up for sale. The terms may stipulate a certain price, or they may be given the opportunity to match the offer of a third party who isn’t part of the ROFR. A right of first offer (ROFO) gives a potential buyer the right to make the initial bid on a property, but nothing limits the right of the seller to explore other offers. Whether you’re looking to buy or sell a home, you should consider all of your options in the real estate transaction before entering into a right of first refusal agreement.