Right of First Refusal (ROFR) Definition

What Is a Right of First Refusal (ROFR)?

The right of first refusal (ROFR), also referred to as the “first right of refusal,” is a right that entitles its holder to transact business with a seller before any other party can. If the holder declines to transact business over the other buyers, the seller can entertain other offers.

How Does the ROFR Work?

ROFR

An ROFR is an agreement between two parties: the owner of the asset and the holder of the right. In real estate, it usually appears as a clause within a lease or another contract that allows its holder to buy the property (or decline the right) before its owner can list it for sale to the public or entertain other offers[1].

An ROFR serves as insurance for the entitled party against any loss of opportunity to buy an asset ahead of everybody.

A party may request for an ROFR to get entitlement on a property when its owner decides to sell it in the future. This right can have its own contract or be added to another agreement.

Similar to an option contract, an ROFR does not obligate its holder to buy an asset when it becomes available for sale. Rather, it exclusively grants the entitled party the option to make an offer before other parties can. An ROFR, however, obligates the property owner to properly notify its holder about the intent to sell the asset so the ROFR holder can exercise the right. The asset owner may begin talks with other buyers only after an ROFR holder declines the right.

No two ROFRs are exactly the same. These agreements have basic elements and may include extraordinary terms needed for protecting the best interests of both parties.

ROFR Terminology

The parties that agree to put an ROFR in writing deal with different circumstances. The specifics of an ROFR reflect the unique situations of the buyer and seller. They may also benefit from legal advice to properly negotiate the details and ensure the agreement addresses possible issues and is suitable for both parties.

These are some of the terms discussed during ROFR negotiations.

Triggers

A trigger is an event that signals when the ROFR should come into effect. The agreement should spell out the ones that trigger (and those that do not) the enforcement of the contract. For instance, listing the asset may cause the ROFR to take effect while borrowing against it may not.

Duration

The contract may define its expiration. For example, the agreement may stipulate that the ROFR may become invalid when the lease ends or after a specified period, even when the lease is still good.

Response Window

The contract may stipulate that the ROFR holder must decide to buy the asset within a certain period. Otherwise, the asset owner can move forward and accept offers from third parties. This provision can prevent the ROFR holder from abusing the right by unreasonably deferring a decision.

Exclusions

The contract may specify the events where the ROFR should not apply. A common exclusion is when the asset changes hands between family members. Exclusions help reduce the situations that can force the rights holder to make a decision. Being compelled to buy an asset unnecessarily defeats the purpose of negotiating for an ROFR.

Transferability

The contract may or may not allow the ROFR holder to transfer the right to another party.

What Happens When the Seller Violates the ROFR?

The ROFR is a contractual right, so all parties involved are subject to a state’s contract law. Therefore, the rules and penalties may vary from jurisdiction to jurisdiction.

In Texas, for instance[2], if a property owner sells the asset in violation of the ROFR, the entitled party may still exercise the right to buy it as if the agreement was validly executed. If the ROFR holder allows the unlawful sale of the asset by doing nothing, the entitled party’s acquiescence may lead to the termination of the right. In this case, the ROFR holder may no longer sue at a later date.

If the seller ignores the rights holder’s attempts to enforce the agreement, the harmed party may take legal action against the violator. The ROFR holder may pursue money damages as a means for compensation for the loss of opportunity to purchase the asset.

Is a ROFR Necessary?

In some instances, a ROFR clause or contract is necessary (especially in real estate). These circumstances are described below.

For Rental Properties

A tenant may want to enter into a ROFR agreement with a landlord to mitigate the possibility of eviction when the rental property gets sold. The landlord may grant the tenant this right as a courtesy and help allay any fear the tenant may have before signing a lease.

Acquisition of a Family Member’s Property

A property owner may create a ROFR contract with one or multiple family members to give them the exclusive opportunity to make an offer on the piece of real estate first. In estate planning, ROFR agreements exclude property transfers to family members[3].

Accepting a Contingent Offer

Specifically, this is a contingent offer based on the successful sale and settlement of a buyer’s property[4].
Since homeowners normally cannot afford to purchase new properties without selling their current residence first, contingent offers are common, especially in buyer’s markets.

When the seller accepts the contingent offer, the buyer receives a sales contract with a limited-time ROFR clause[5]. The sales contract does not prevent the seller from keeping the property for sale listed and entertaining other offers.

When a better offer comes along, the seller may force the buyer to purchase the property within that time limit. Otherwise, the former can demand the contract’s cancellation.

Regulation by Homeowners Association (HOA) or a Condo Board

The ROFR can be enshrined in the governing documents of many HOAs[6] and condo boards[7], empowering them to screen property sales within their communities. Usually, these bodies use this right to prevent home value depreciation.

Pros and Cons of an ROFR

ROFRs have advantages and disadvantages for both sellers and buyers.

For Buyers

This right can buy its holder adequate time to save money to put down a higher amount on the property and become more creditworthy. A low loan-to-value ratio (LTV) [8] and high credit scores [9] help borrowers qualify for mortgage loans with favorable terms.

Moreover, a ROFR may give its holder the chance to suggest a sale price and avoid entering into any bidding war with other parties that can inflate the property’s value.

That said, the entitled party has to be financially ready to buy the property on short notice.
In addition, for rental properties, a tenant who negotiates for a ROFR in the lease gets the edge over other parties if the landlord decides to sell the rental property.

For Sellers

On paper, the ROFR can be disadvantageous for sellers. It can take away their flexibility to entertain offers from third parties and lose out to competitors.

However, since its holder has expressed interest in the asset, the seller may negotiate for a higher asking price. It is an opportunity for the seller to pocket more money than the property’s current value.

ROFR vs. Right of First Offer (ROFO)

The right of first offer is a similar concept. Like the ROFR, the ROFO is an agreement between two parties. Both give the holder the chance to make the first offer on an asset before the owner puts it on the market. The difference is that the seller does not have to accept the offer and may choose to entertain others in the hope of finding better deals.

If searching for more favorable offers is fruitless, the seller and the ROFO holder can return to the negotiating table. This time around, the buyer is in a stronger position to make a lower offer on the property since there are no competing bids on the market.

Discerning sellers realize the risk of declining the initial offer of ROFO holders. As a result, many of them are less inclined to gamble and strongly consider the offer right away due to its financial incentives.

Doing business with the ROFO holder allows the seller to make a fast sale, reduce legal expenses, and contend with lower brokerage fees.

Takeaways

The ROFR gives its holder the opportunity to buy a specified asset before anyone else. In the real estate realm, it is usually a clause in the sales contract between a property’s buyer and seller or in a lease between a tenant and a landlord. The ROFR obligates the seller to inform its holder about any intent to sell the specified property or if there is interest in the purchase of the property. If the seller violates the terms of the ROFR, its holder may sue.

The ROFR is similar to the ROFO, except that the latter allows the seller to turn down a rights holder’s offer despite the buyer’s interest in making the purchase.

Sources

  1. Corporate Finance Institute. (2020.) What is a Lease? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/other/lease/
  2. Sheehan Law, PLLC. (2018.) Right of First Refusal in Texas Real Estate. Retrieved from https://www.farrensheehanlaw.com/real-estate/right-of-first-refusal/
  3. Routson, C. (2017.) Issues to Consider in Rights of First Refusal. Ward and Smith, P.A. Retrieved from https://www.wardandsmith.com/articles/issues-to-consider-in-rights-of-first-refusal
  4. The Goodhart Group. (2017.) The Home Sale Contingency Explained. Retrieved from https://www.thegoodhartgroup.com/home-sale-contingency-explained/
  5. Century 21®. (n.d.) The 72-Hour Clause. Retrieved from https://www.century21.com/glossary/definition/the-72-hour-clause
  6. Williams, T. (2019.) A Homeowner’s Guide to HOAs: Homeowners Associations, Explained. realtor.com®. Retrieved from https://www.realtor.com/advice/buy/homeowners-guide-to-hoas-homeowners-associations/
  7. Meggitt, J. (2018.) Responsibilities of a Board of Directors for a Condo Association. SFGATE. Retrieved from https://homeguides.sfgate.com/responsibilities-board-directors-condo-association-3355.html
  8. Zillow. (2020.) What is a Loan-to-Value Ratio? Retrieved from https://www.zillow.com/mortgage-learning/loan-to-value-ratio/
  9. Experian. (2021.) How to Improve Your Credit Score. Retrieved from https://www.experian.com/blogs/ask-experian/credit-education/improving-credit/improve-credit-score/

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