April 01, 2016 Feature

The Devil Is in the Details: Due Diligence in Commercial Real Estate Transactions

Brett T. Sullivan

The purchase of a commercial property by an individual (for investment purposes) or business (for either investment or business operation purposes) can be fraught with the potential for missing key information that can be very costly to the purchaser. Purchasers of commercial real estate are typically considered to be sophisticated parties, and whatever consumer protection laws may exist in a state for the protection of residential home purchasers seldom apply, if ever, to a commercial real estate purchaser. The old adage of “buyer beware” particularly applies to commercial real estate purchases and warrants careful application of due diligence procedures and checklists.

 

Why Engage in Due Diligence?

Most clients don’t like surprises and unexpected issues, and this is doubly true for clients who spend or borrow significant sums to purchase a commercial building or property. When the client commits to the purchase of the property, the goal of the purchase is generally to ensure that the characteristics of the property suit and satisfy the client’s needs and expectations, whether the client is purchasing it for an investment or for its own use. If all material aspects of the property and building are not carefully reviewed against a thorough checklist prior to completion of the due diligence period, the possibility exists for substantial loss.

 Different Goals of Due Diligence for Different Buyers

Buyers of commercial real estate can typically be divided into one of three types: (1) an investor: someone who wants to achieve an expected return on investment from the rents and other income generated by the property; (2) an end user: someone who expects to occupy the property; and (3) a developer: someone who will change the property in some manner and either lease it out or resell all or a portion of the property. These different groups will each approach the due diligence process a bit differently, as described below:

  • An investor will want to ensure the sufficiency and stability of future cash flows generated from the property and will want to pay particular attention to the quality of tenants as well as the existing leases.
  • An end user will be primarily concerned with ensuring that the property suits the user’s intended purpose and goals, both in the short term as well as the long term.
  • A developer will pay particular attention to the means by which the property can be permitted and planned for a different or higher and better use.

General Principles of Due Diligence and Questions to Ask

Property characteristics. Confirm the characteristics of the property that the purchaser intends to buy. This includes a careful study of the legal description, along with the improvements and fixtures located on the real property. Review all rights appurtenant to (or running with) the land and that benefit the property described by the legal description. Perhaps as important, verify and review each and every easement, encumbrance, covenant, and restriction that is evident from the preliminary title insurance policy. (Your client is buying title insurance, right?) Finally, if at all possible, counsel the buyer to walk the property and the buildings; this site visit can spur questions and discussion about issues that otherwise might not be raised. The review of the property features and title issues should be performed in light of the buyer’s intended use of the property.

Suitability of the property. Can the buyer use the property as intended? This question requires the advisor to determine the purpose for which the purchaser is purchasing the property. If the purchaser wants to use the property for commercial vehicle loading and unloading, is there adequate access to streets? Is there room for sufficient turnaround in the parking lot and adequate parking spaces? Are there any conditions or issues with the physical condition of the property that would prevent the intended use?

What about environmental concerns? Owing to the complexity of environmental laws, as well as the affirmative covenants and surveying that a lender may require, purchasers are well advised to retain the services of an experienced environmental consultant and a geotechnical engineer to advise as to environmental studies and reports that may be needed, including soil, radon, lead paint, and asbestos tests, as well as the potential for underground storage tanks. If the property is located in a seismically active area of the country, then a seismic risk assessment is warranted.

In order to determine the physical condition of the property and whether it will serve the intended uses, purchasers should request copies of “as built” plans and specifications for the building(s).

Legal restrictions on the use of the property. The purchaser should inquire and satisfy herself as to the zoning for the property and whether any special use or conditional use permits are in place. Are there any restrictive covenants that impose controls over the use of the property? Do the building and parking comply with the Americans with Disabilities Act? Is the property located near a special zone, such as a school, which may restrict the legal issuance of licenses, such as a liquor license?

The prudent advisor not only will carefully review the title insurance commitment but also will walk the property to determine if any encroachments or other restrictions are “in view.” Any easements, running covenants, and other consensual documents that may impose a contractual restriction on the use of the property should be reviewed.

Future cost impacts. Evaluate any and all future costs to be paid by the purchaser of the property in connection with its ownership. Examples of such costs include local improvements districts (LIDs), business improvement districts (BIDs), special assessments, drainage fees or charges, and any parking fees to be paid to third parties. Additionally, a review of the property tax records should be made to determine if the assessed value falls in line with fair value of the property; the sale of the property may trigger a reassessment by the taxing authority, resulting in higher future costs if the current assessment is low.

Legal right of the seller to convey. Finally, the purchaser should ensure that the seller actually has the legal right to sell and convey the property in accordance with the terms of the purchase and sale agreement. Purchaser’s counsel should ensure that the agreement contains specific representations and warranties that the seller has taken all steps necessary to obtain the right to sell the property, which may include specific resolutions authorizing the seller’s agent to execute the deed and closing documents.

Financing. If the seller is providing financing for all or a portion of the purchase price, a number of questions need to be asked by purchaser’s counsel. Basic loan questions such as the amount of the loan, interest rate, collateral (real property or a combination of real and personal property), repayment terms (and balloon provisions), as well as reserve requirements (for example, interest expense reserves, insurance reserves, and real estate tax reserves) need to be thoroughly answered and analyzed.

Additional financing issues that purchaser’s counsel will need to review include the requirements for a minimum interest yield. Many borrowers fail to take into account a yield maintenance requirement that mandates a substantial yield payment (i.e., prepayment penalty upon early payoff of a loan).

If the loan is to provide funds for construction, additional factors to be reviewed include the number and types of advances on the construction loan. For example, does the construction loan provide for “soft expenses” such as architecture or engineering fees? Also, are there requirements for the construction loan to be drawn down over a maximum or minimum number of months? What are the requirements for the borrower/purchaser to provide lien releases as well as approval by a licensed architect (or other construction professional) in order to obtain draws on the construction loan?

Finally, borrower’s counsel needs to get familiar with the client’s bookkeeping to help ensure the borrower is able to meet lender reporting requirements.

Investor Due Diligence

Because investors are very concerned with future cash flows from the property, counsel for an investor should pay particular attention to the leases in effect on the property as well as past financial performance for the property. A list of due diligence items to review concerning leases and the property’s financial information include the following:

Tenant questions to be answered:

  • What are the lease terms and options (if any) to extend the term?
  • Does the tenant have an option to purchase or a right of first refusal?
  • What are the tenant’s and landlord’s respective maintenance obligations under the lease?
  • Has the seller acted in a manner consistent with the lease terms?
  • What are the duties of the landlord to provide utilities to the leased premises?
  • Who has the obligation to pay the real estate taxes?
  • What is the status of any common area maintenance (CAM) escrow accounts?
  • Are there controls on the mixture of tenants and the use of the property by tenants?
  • Are the leases automatically subordinated to future mortgages or deeds of trust?
  • Are tenant insurance policies confirmed to be in force and meet or exceed insurance coverage requirements described in the leases?

Financial performance documents to acquire:

  • financial statements prepared for the property for the last three years and a year-to-date financial statement;
  • a description of capital expenditures made for the property over the last five years;
  • current operating budgets for the property, which should include a variance report (the purchaser should follow up with the seller as to significant variances);
  • schedules for CAM escrow accounts showing deposits and payments for the past three years;
  • copies of all maintenance, management, service, and other contracts regarding the use, management, and operation of the property, including warranties and guarantees that are in effect; and
  • copies of prior utility bills for the last three years as well as year-to-date.

End User Due Diligence

The end user wants to ensure that the property will work for present as well as future needs. Will the end user’s anticipated operations require special permits for the zoning applicable to the property? Also, if the end user wishes to expand operations and increase the size of a building or buildings located on the property, or construct new ones, how difficult will the expansion be and how much will it cost? Are there any unique circumstances applicable to the property that would otherwise limit expansion? Has the seller received any notices of building fire, environmental, or safety codes indicating that the end user may not be able to use the property for the anticipated use?

Adequately answering these questions may require the advice of an experienced local land use consultant as well as a construction professional who can be asked to project the risks associated with expansion through the end user’s anticipated time frame.

Developer Due Diligence

A developer looking to construct or develop the property for a higher and better use will be very concerned about development restrictions. Therefore, the due diligence questions for the end user (as well as the applicable general due diligence questions concerning permitting and development considerations) will specifically apply to developer due diligence.

Developers should seek input from all sources concerning the marketability and absorption of the future use. Although not in the realm of the typical real estate attorney, many real estate attorneys have a network of real estate professionals (including brokers and consultants) who may be able to provide guidance to the developer.

Conclusion

Buying commercial real estate involves the analysis of dozens or sometimes hundreds of individual details. The careful real estate attorney advising a purchaser recognizes that the “devil is in the details” and will use the questions in this article, and others, to develop checklists in order to help guide real estate clients through a successful closing.

Brett T. Sullivan

Brett T. Sullivan is a partner with Lucent Law, PLLC, in Spokane, Washington. He focuses his practice on representing individuals and businesses in real estate, business, and estate planning transactions.