General Practice, Solo & Small Firm DivisionMagazine
American Bar Association
General Practice, Solo, and Small Firm Division The Compleat Lawyer
Spring 1997 copyright American Bar Association. All rights reserved.
Commercial Real Estate Transactions
BY M. JAY YUROW
M. Jay Yurow practices commercial real estate law at the Virginia office of Venable, Baetjer and Howard, LLP. He wishes to acknowledge the assistance of his partner, Elizabeth Smedley, in preparing this article.
Whether a client is buying or selling, lawyers who handle commercial real estate transactions need much more than a firm handshake. They need a solid grasp of the issues - financing, taxes, titles, surveys - as well as an almost omniscient ability to assess the other side's intentions.
Representing the Seller
The range of the issues to be considered when representing a seller typically is more limited than those that must be addressed when representing a purchaser. Unlike the purchaser, the seller does not have the burden of determining whether the property is suitable. Nor does the seller have to worry about how to finance the acquisition of the property or what form of entity is most appropriate for holding title.
In many instances, the fundamental concerns of the seller are actually rather straightforward. Virtually all sellers would like the sale to be on an "as is" basis to minimize the risk that the purchaser might have claims for defects that are not discovered until after the closing. For much the same reason, sellers also prefer to limit the representations and warranties they make in the contract. Because retaining the deposit is often the seller's only remedy for a purchaser default, sellers want the deposit posted by the purchaser to be as large as possible and "at risk" at the earliest possible date. Finally, because most contracts provide that the seller bears the risk that the property will suffer no damage between the date the contract is signed and the closing, sellers generally want the closing to occur as quickly as possible.
Transaction costs. While the division of transaction and other costs is often based on local custom, there is usually no reason these costs cannot be shared in some other manner. Because the amounts involved can be substantial, you and your client should pay particular attention to the allocation of costs associated with roll-back taxes, special assessments, proffers, and broker commissions. It will be helpful if you can discuss the allocation of all costs with your client before contract negotiations begin. Otherwise, you run the risk of having to deal with an angry or disappointed client who receives a smaller check than anticipated.
Taxing matters. Before contract negotiations become too involved, you should discuss the tax implications of the transaction with your client. If your client does not understand the tax consequences of the sale and you are not able to advise your client on this topic, you and your client should meet with a tax lawyer or accountant to determine whether adverse tax consequences can be mitigated by structuring the transaction in a particular fashion.
Financing. One of the more difficult dynamics for an inexperienced client to comprehend is that the timing of a transaction is often dictated by a third party - the lender. If your client, as the seller, is willing to offer purchase money financing to the purchaser, it can retain greater control over the closing date, but must understand and be prepared to accept both the risk of being a lender and the added complexity of introducing the lender/borrower dimension into the negotiations.
A second advantage of seller-financing is that it removes one very significant variable from the contract negotiations - the financing contingency. This contingency is commonly required by purchasers who have not already secured a commitment for financing. If the purchaser cannot obtain financing, the contingency is not satisfied, the deposit is generally returned, and the purchaser is relieved of its obligation to complete the transaction. If a financing contingency is included in the contract, make sure that it contains specific guidelines about the financing terms that the purchaser must accept and the time period in which the purchaser must satisfy the contingency.
If seller-financing is an alternative for your client, consider how large a cash payment your client should receive at closing. The balance of the purchase price should be evidenced by a promissory note and secured by a deed of trust or mortgage. The degree to which additional documentation is required is governed by the size of the transaction and the characteristics of the property. Like all lenders, the seller should be named as an additional insured on insurance policies. The seller also should require that the purchaser obtain a mortgagee's title insurance policy from a reputable title company.
Be realistic. Perhaps the most difficult and overlooked task confronting a seller is the need to realistically assess the degree to which the purchaser desires to own the property. Before negotiating a contract, your client should have a clear indication that the purchaser is serious about acquiring the property, has the capacity to perform - that is, to complete the transaction - and has the ability to pay the purchase price at the appropriate time. Ultimately, if the purchaser cannot or will not perform, your client has wasted time and money and may have lost other opportunities that were available.
The Purchaser's Position
A frequent misconception of both clients and lawyers who are not experienced in commercial real estate matters is the belief that the value of a property is ascertained by adding the worth of the land and the improvements. In fact, unless a client intends to use the property for his own purposes, the income generated by a commercial property is at least as important an ingredient in determining its value. If your client intends to finance the acquisition of an income-producing property, be assured that a lender will be as concerned with the quality of the tenants and the leases as it is with the value of the land and improvements.
What form to choose. One of the first issues lawyers for the purchaser must address is how the client should hold title to the property once acquired. Lengthy articles have been written about the advantages and shortcomings of the various entities (partnerships, corporations, and limited liability companies, to name a few) commonly used for holding title to real estate. Make sure you should understand both the tax consequences and the liability protections afforded by each in order to help your client select the entity that best suits its needs. Lawyers also should advise the client on whether to commingle the property with other assets or to acquire title to the real estate in the name of a separate, single-purpose entity.
Warrantees. A number of issues arise during the negotiation of a sales contract that are of particular concern and interest to the purchaser. While sellers loathe making representations and warranties, purchasers are comforted by the existence of such representations and warranties in the contract. Aside from the breadth and scope of the representations and warranties themselves, also consider the length of time that representations and warranties made by the seller should To Market, or Not to Market
That is the question posed by many sellers - should they continue to market the property once a sales contract has been executed? The seller must weigh the burden and expense associated with continued marketing efforts and the negotiation of a back-up contract against the fact that a back-up contract can enhance the leverage the seller has as issues arise (and they often do) during the study period and prior to closing.
As anyone experienced in commercial transactions can tell you, buyers frequently decide not to acquire a property. Sometimes the decision not to proceed is based on discoveries made during the study period. Often, the inability to satisfy development conditions described in the contract or to obtain acceptable financing is the terminal blow. In any event, serious consideration should be given by your client to continued marketing efforts even after a contract has been signed.
- M.J.Y. continue after the closing. Further, remember that the seller (or some person or entity with assets associated with the seller) must be available after closing to answer for any actionable misrepresentations or for the breach of any warranty. The best and most fiercely negotiated representations and warranties will do your client little good if the seller has already distributed all of the cash from the sale and dissolved.
The study period. Before deciding to acquire a property, most purchasers endeavor to collect as much information about the property as they can. While some of your client's due diligence can be done prior to executing a contract, most buyers are understandably reluctant to expend significant sums to investigate a property before it is under contract. Accordingly, much of the due diligence that the purchaser must perform to satisfy itself that the property is desirable or suitable for its purposes is done during that period of time commonly called the "feasibility period" or "study period." There is usually a tension between what the seller wants (a short study period) and what the purchaser desires (a lengthy study period). Counsel your client to be realistic when assessing the length of time that it will need in order to determine that the property satisfies its requirements.
Closing conditions. Understandably, many purchasers desire to instill as much certainty in the acquisition process as possible. While it is helpful that your client may have a study period to determine whether or not a rezoning of the property is likely to be approved, it will usually take far more time to actually complete the rezoning. A common solution is to make certain events that are fundamental to the purchaser conditions precedent to the purchaser's obligation to acquire the property. Depending upon the characteristics of the property, and the intended and current uses of the property, the purchaser may want to condition its obligation to acquire the property on the procurement or satisfaction of subdivision, site plan, and zoning approvals, or approval by architectural review boards. If the conditions precedent are not satisfied, your client may have incurred some out-of-pocket expenses, but can be assured that its her deposit will be returned and that it will have no further liability to the seller for failing to close.
Title review. Among the studies that your client should undertake during the study period is a review of title. Title reviews are done either by a title abstractor or title company. In either case, an abstractor searches the land records to determine what matters burden or benefit the property and prepares a report of title or a title commitment that lists encumbrances, exceptions, and other matters of record.
Your client can often shift some of the risks of ownership to the title company by obtaining specific endorsements to address particular concerns. For instance, a title company can provide assurance that the property has access to and from a dedicated roadway, or if the property is comprised of two or more parcels, the company can issue an endorsement insuring that the parcels are contiguous. The cost of the endorsements will vary depending upon the jurisdiction and the type of coverage requested. You also should require that beneficial easements (such as an easement over an adjoining parcel that permits access to the property) be included in the description of the insured property, and that all existing mortgage liens, judgments, and similar encumbrances be satisfied and released prior to closing.
The survey. To fully understand the title report or commitment, it may be necessary to have a survey of the property prepared. Without a survey, you and your client cannot be certain that the size of the property is as stated in the contract, nor will you be able to determine the exact location of the property or identify the location of any easements or other exceptions affecting the property. If the seller has had a title report or survey prepared by a reputable contractor, consider contacting the abstractor/title company or surveyor to update the title report or survey. Updating existing title reports and surveys is usually faster and somewhat less expensive than engaging new professionals to perform the work again.
Environmental assessments. Unless your client is going to finance the acquisition of the property itself, it will almost certainly need to obtain an environmental site assessment to assure the lender that there is no environmental contamination present. Environmental engineers or consultants can be hired to prepare an environmental audit for the property. If the audit reveals the presence of any hazardous material, you also will need to counsel your client about the risks of owning a property that has environmental defects. If the property is already developed, your client also may want to obtain an architectural or structural engineering report to ensure that the improvements are sound.
Many lenders have a list of approved title companies, surveyors, environmental consultants, and structural engineers. Before you or your client engage a contractor to perform any of these services, make certain that the contractor is on your prospective lender's approved list or is acceptable to the lender. Otherwise, your client runs the risk of having to pay to duplicate the study.
Review of leases. If the property is occupied by tenants, obtain a current rent roll, together with copies of all leases from the seller. Your client will need to review the leases to determine whether the rents being paid by the tenants will cover the costs of owning and operating the property. A review of the leases also is essential in determining what rights the tenants have to renew their leases, expand, or purchase the property. Finally, your client should take a hard look at the identity of the tenants to ascertain whether the tenants are creditworthy and otherwise able to honor the obligations described in their leases. It also is imperative that the purchaser discover whether any of the tenants are in default under their leases and the extent to which the seller has, in the past, alleged the existence of defaults or initiated litigation to deal with the tenants.
Frequently, these questions are answered by representations made by the seller in the contract. Development. If the property is not yet developed, a number of development issues must be considered, including:
- Is the property subdivided?
- Has the property received site plan approval from local officials?
- Is the current zoning appropriate for the purchaser's intended use or does the property need to be rezoned?
- Is the density adequate?
- Does the property have access to and from dedicated roadways?
- Are utilities available to the site and are they in adequate quantities?
Unless each of these questions can be answered affirmatively, your client should understand that it may prove more costly and time consuming to complete the project than was anticipated. Financing. One concern that all purchasers share is how they will finance the acquisition of the property and, if the site is not developed, the subsequent development and construction. A client that has not secured a commitment for financing should begin discussions with lenders at the earliest possible date. Because the financing terms offered by lenders can vary significantly, the client should meet with at least several lenders to discuss the project and the essential terms on which each lender would agree to make financing available.
To the extent that the purchaser can identify a source of financing early and ascertain the requirements of a particular lender, the purchaser should enlist the assistance of the seller in satisfying some of the lender's requirements. Because the seller has a vested interest in whether the loan closes, it should, within limits, be willing to help the purchaser by providing information and permitting the lender's representatives to have access to the property. You would also do your client a great service by including in the contract a covenant that the seller will cooperate with the lender and the purchaser in satisfying the lender's requirements.