The Essentials of Due Diligence
Sidney G. Saltz
Sidney G. Saltz is a Senior Counsel in the Chicago office of Holland & Knight and the group chair of the Section’s Leasing Group.
Due diligence is the procedure by which a purchaser seeks to determine whether a piece of real estate that it has contracted to buy is suitable for its purposes. For that reason, it really begins long before the contract is signed. It starts when the purchaser first decides to purchase real estate for use or for investment and then continues while the purchaser determines the geographic area where the property should be located and which properties it has viewed or examined might be suitable for its purposes. Once it locates a prospective property, the purchaser will have to make an analysis to determine a fair price to offer for that property and to determine the purchase price ultimately to be included in the contract.
Assume that the purchaser is purchasing a shopping center for investment. Before signing a contract, the purchaser will have viewed the center to examine its general condition; reviewed the “rent roll,” which is a summary of the leases; and performed other cursory examinations to generally determine the value of the property. In negotiating the contract, the purchaser will have sought, and may even have obtained, warranties from the seller as to the truth of the materials presented and as to other matters, possibly including the condition of the center. On the other hand, the seller may insist that any condition warranties be based solely on knowledge, or that no condition warranties be included at all—that the property is being sold “as is.”
Generally, the purchaser will not do a more intensive examination of the condition and economics of the property until the contract has been signed because, frankly, due diligence is expensive. Why would a purchaser want to spend the money for a complete investigation until it knows it has a deal with the seller? An exception can occur if the purchaser is in a great rush to buy the property (such as having to close within a short time to get the benefit of a tax-deferred exchange). In that situation, the seller may agree that the purchaser can start its due diligence before a contract is signed, provided that the purchaser agrees to indemnify the seller and to comply with certain specified requirements, such as carrying liability insurance, which are the same requirements as would be inserted in the contract. In this situation, the right to conduct due diligence should end if the contract is not signed within a specified period.
The contract will almost always contain a provision giving the purchaser a period of time—such as 45 or 60 days—to conduct (or conclude) its examinations and inspections and permit the purchaser to terminate before the expiration of that time if it is not satisfied with what it finds, usually at the purchaser’s discretion. The contract will, no doubt, contain the same indemnification and insurance requirements as would have been inserted into an agreement permitting early due diligence, as referred to above.
When the contract has been fully negotiated and signed, the purchaser will begin (or continue) its thorough examination of the property and the economics—its due diligence examination—which is another name for “what have we gotten ourselves into?” Where does the purchaser start?
Critical Dates List
The critical dates list is a schedule of the relevant dates in the contract. It includes the dates when payments of earnest money are due, the date when the due diligence period and other contingencies in the contract end, and the closing dates and other dates within which the parties must perform their various obligations under the contract. Generally, the critical dates list is generated by the purchaser’s lawyer (or his or her paralegal) after the contract has been signed. It may be preferable, however, for the list to be created just before the contract is signed for several reasons. First, creating the list is a great way to make certain that the contract has no inconsistencies among the various contingencies, and it gives the purchaser the opportunity to focus on its ability to actually accomplish the due diligence within the allotted time. Second, it permits the parties to take account of weekends, holidays, vacations, and the like. Finally, it creates the sense of urgency that is required to get the due diligence done on time.
The purchaser’s lawyer or his or her paralegal also should prepare a closing checklist itemizing all the documents required to close the transaction. The purchaser’s lawyer (or paralegal) will most likely not be in a position to prepare the portion of the closing checklist relative to the purchaser’s loan closing; the lender’s lawyer will be the person to prepare that. The purchaser’s lawyer, however, will be in a position to list all of the items that are required under the contract and that are customary in the jurisdiction, whether specified in the contract or not. Thus, the list will contain the title company’s customary requirements such as an ALTA statement, a “gap” indemnification or undertaking for the title insurer, tax disclosure forms, and similar documents that lawyers know will be needed.
Again, the closing checklist should preferably be prepared before the contract is signed. Such preparation may, for example, focus the purchaser on the need for municipal transfer stamps and that need may, in turn, require the payment of the water bill or even an inspection by the building or fire department before the stamps can be obtained. Without this advance preparation, the parties may not provide for those inspections in the contract or for the consequences of the failure of the property to pass those inspections.
The Due Diligence Checklist
It is always a good idea for the purchaser to have a due diligence checklist. That checklist is usually prepared by the purchaser itself, especially if the purchaser is an experienced buyer and seller of real estate. On the other hand, if the purchaser is a one-time purchaser, purchasing a piece of property to occupy for its own business, it may not have the knowledge or experience to know what due diligence is required. In this situation, a checklist prepared by its lawyer, broker, or contractor will be invaluable.
Such a checklist appears on page 34. As can be seen, the checklist is very inclusive and thus may not be appropriate for all transactions. It covers physical due diligence as well as legal and economic due diligence. It can be used for vacant property as well as improved property, for income property, and for the purchaser’s use property. The items that are not applicable should, of course, be disregarded.
Due Diligence in Practice Physical Due Diligence
The purchaser should immediately hire the proper people to conduct the physical due diligence. It will want to make certain that the condition of the property is good, that no environmental problems will require remediation or adversely affect its ability to obtain a mortgage, that it will not encounter any unforeseen costs, and, in general, that the value of the property, from a physical condition point of view, is consistent with the purchase price being paid. If the property contains undeveloped land on which an expansion or outbuildings can be built, the purchaser may wish to have a soils engineer do soil borings to determine if additional improvements can be made without compaction of the soils to support the building.
If the heating, ventilating, and air-conditioning (HVAC) equipment is working but will need to be replaced shortly, or if the roof will need replacing, or if other conditions are not as expected, that can mean that the center is not worth the price negotiated in the contract. On the other hand, if those costs are to be paid by tenants, those issues may not be as critical. This ties in to the lease review and analysis, discussed below.
Also to be considered during physical due diligence are the warranties relating to physical condition, if any, contained in the contract. Although many contracts are written on an “as-is, where-is” basis, some contracts do have warranties as to the physical condition of the property. For example, they may recite that the HVAC equipment is in “working order,” or in “good working order,” or that the roof is free from leaks. Whether those warranties have any value will depend on the financial capability of the seller to perform (the proceeds of the sale may go to pay off debt or may be distributed to the owners of the selling entity) and its willingness to pay without being sued. Other warranties may be based solely on the seller’s knowledge, so that in order to collect on them the purchaser must not only prove that the condition of the item was bad but also that the seller knew it was bad. Still, the existence of a warranty is helpful if the adverse condition is discovered before the closing because it may improve the purchaser’s leverage in negotiations. It all depends on how the contract is drafted.
Although all of the physical inspection matters are important to consider because they could involve costs, the ones that are of the most concern are environmental, HVAC, roof, and code compliance. Problems in these areas could involve substantial expense that is capital in nature and that may not be covered in the pass-through provisions of the leases.
Take environmental due diligence, for example. Purchasers start by ordering a Phase I environmental assessment from an environmental engineer. It is important that the engineer is known to be competent and thorough and qualified to perform the type of assessment that will be required by the lender in connection with its mortgage. Sometimes purchasers hire the engineer who previously assessed the property. That may be a mistake. If that engineer missed a condition on its last inspection, he or she may have an incentive not to disclose that condition because disclosure may expose the engineer to liability. An issue will also arise if the Phase I assessment discloses possible conditions indicating that further study—a Phase II assessment—is appropriate. Sellers frequently prohibit purchasers’ having Phase II assessments performed without their consent because if the Phase II assessment confirms that remediation is required and the sale does not close, the seller may be required to report the condition and have it remediated.
Review of the Phase I assessment (and Phase II assessment, if performed) requires knowledge of environmental law. It is always wise for the purchaser to have those reports reviewed by an environmental lawyer, preferably at a preliminary stage, before going to the lender. Although it is certainly inappropriate for the environmental lawyer to seek to hide problems that may be disclosed, it is possible that the engineer, not having a sense of the transaction, may speculate unnecessarily or become irrationally passionate about problems encountered. The way the report is drafted can kill a deal all parties want to close. The experienced environmental lawyer can rationally discuss the report with the engineer and request that the report state only facts, accurately and dispassionately.
The roof condition is also a major concern because roof replacements are expensive and the costs often cannot be passed through to tenants. Also, the condition of the roof cannot be determined from the ground and even a cursory inspection by the purchaser or its broker will not truly reveal its condition (unless it is really very bad). The purchaser should be aware that any roofer worth its salt will find problems with the roof. The roofer is looking for work. That is why some purchasers hire roofing consultants—who do no roofing work themselves—to inspect the roof. Here again, one must review the consultant’s report with care. The report may say, for example, that the roof will need replacement but be unclear on the time frame. All roofs will need replacement—someday. The report should state the anticipated remaining life of the existing roof so that the purchaser can make a more rational decision regarding its condition.
Tenant and Lease Analyses—Economic Due Diligence
Given that the property under discussion is a shopping center, in all probability there will be tenants. In that situation, the tenant analysis referred to in category B of the Due Diligence Checklist should be addressed. If there are no tenants, or very few, an entirely different type of market analysis will be required, involving traffic patterns, demographics, and other similar conditions.
In any event, the historical economics of the property must be examined. What have the income and expenses been? Are the tenants current in their rent? What is their payment history? What are the taxes and can they be reduced? What is the current market rent for vacant spaces? Generally, the purchaser addresses all these matters, possibly with the aid of its broker or other advisors, but with little input from its lawyers.
On the other hand, lawyers can be useful in performing the due diligence referred to in category D of the Due Diligence Checklist. Although it does not necessarily require someone trained and experienced in the law to abstract the leases and compare the business terms with the rent roll attached to the contract, legal training and experience are useful in spotting provisions in leases that are unusual, problematic, in conflict with the provisions of other leases in the center, or inconsistent with provisions generally included in leases drafted or negotiated by the lawyer in other centers owned by the purchaser. The lawyer will pay particular attention to use clauses and exclusives in the leases and advise the purchaser on tenant remedies for violations of exclusives. If there are expansion rights, the lawyer will, if he or she is provided with a site plan, be able to determine if there are conflicting rights to the same space.
Title and Survey
The lawyer’s input on the lease review may be useful, but it is not indispensable. The lawyer’s input is, however, vital in connection with the review of title and survey. The title commitment and survey may not be prepared for some weeks after the contract has been signed, so it is not unusual for the contract to have a contingency period relating to the review of those materials that is not coterminous with the remaining due diligence period. Usually the purchaser will have some time after receipt of the title commitment, exception documents, and the survey to object to matters shown in them; then the seller has a period of time to cure or insure over the matters. If the matters are not fully resolved, the purchaser has time to determine if it will purchase the property despite the problems. Finally, even if the time provided to cure title has elapsed with issues still outstanding, but with the purchaser’s not having terminated the contract, the purchaser may still have the opportunity to terminate if the due diligence period has not ended and the contract provides that the purchaser may terminate during that period.
To evaluate the status of title and the effect of a survey, it is valuable for lawyers to have some familiarity with what the policies protect against, and what they do not. To oversimplify, an owner’s title insurance policy insures the owner of a piece of property that it owns marketable title to the particular parcel of property, free and clear of all encumbrances except those listed in a schedule, and that there is access to the property, unless that access is limited as provided in the schedule. In the case of leasehold property, the owner’s title policy with the leasehold endorsement insures that the lessor owns the property leased and that the lessee owns a valid leasehold estate in the property, subject to the qualifications in a schedule. A loan title policy insures that the mortgagor owns the property mortgaged and that the mortgagee has a valid lien on the property, subject, again, to the matters listed in the schedule. All policies cover the cost of defense of the title.
One of the parties will order a title commitment, which is a commitment by the title company to issue its policy when the premium is paid. The matters listed in the schedule to the commitment are usually matters of record, and it is possible to obtain copies of the documents creating the encumbrance, so they may be examined to determine whether they have an adverse effect on the client. For example, a very common encumbrance is an easement. If there is a five-foot-wide easement for utilities along the boundary of the property, the chances are that it will not create a problem, provided that paving a driveway over the easement area is not prohibited. On the other hand, if the property was recently a farm and the prior owner granted an easement to a pipeline company to run the pipeline diagonally across the property, or did not even specify at all where the pipeline was to run, those are problems. Of course, there may be monetary liens, litigation, or a host of other types of encumbrances revealed in the schedule, which may or may not prevent the client from achieving the benefit of its bargain.
Surveys come in all shapes and sizes. Boundary surveys simply show the outline of the property. So-called spot surveys show the boundaries and the buildings. ALTA surveys, and topographical surveys, show the contours of the land and are needed if the property is to be graded before construction (the topographical data are usually paid for by the purchaser).
An ALTA survey is one prepared in accordance with the Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys, as adopted by the American Land Title Association and The National Society of Professional Surveyors. The current standards were published in 2005. The standards also include a table (Table A) of optional matters to be shown on the survey, one of which is the contours. A survey prepared and certified in accordance with those standards is an excellent survey, and because the surveyor is required to examine a title commitment, it will locate and identify the various locatable encumbrances, such as easements. In general, lenders will require ALTA surveys.
As noted above, when the lawyer for the purchaser receives the survey, the title commitment, and the exception documents, he or she should examine them, as a package, to determine if any matters adversely affect the value of the property for the purchaser. There may be easements encumbering the property or easements benefiting the property. There may be a water or sewer line that runs across the adjoining owner’s property for which an easement has not been obtained. There may be encroachments. There may be liens. There may be covenants and restrictions.
An important thing to watch for on the survey is whether any buildings encroach over the setback line or yard dimension specified in the zoning ordinance. Many surveyors will not review the zoning or raise that issue on the plat. Certainly, if a building goes to a lot line, it raises a question about whether a side, front, or rear yard is encroached. If it is, the building may be legally nonconforming or even illegally nonconforming. A legal nonconformity (which will not be shown in a zoning endorsement to the title policy unless the title company is requested to insure that the improvements are legal and conforming) can usually be maintained, but the particulars of the zoning ordinance will have to be examined to determine if there is an expiration date for that nonconformity and the events under which the property must be brought into conformity (such as a fire or a major renovation). Nonconformity can have a material adverse effect on the value or mortgageability of the property.
The purchaser’s lawyer also will have to bear in mind, when reviewing the title and survey, that the lender (who may not have seen the documents yet) will have to approve them as well, and will have additional requirements relative to the mortgage, particularly the policy endorsements.
As noted above, it may be appropriate for the purchaser’s lawyer to review the zoning ordinance, depending on whether a zoning endorsement is to be obtained. The purchaser or its lawyer should review any service contracts, particularly if they are not terminable. Certificates of occupancy may have to be examined, as well as any of a whole host of agreements to which the purchaser may be subject after the acquisition of the property. If litigation is pending, a review of the cases may indicate whether any liability will fall on the purchaser. If eviction actions are pending, the purchaser may be the proper party to pursue them if they are not resolved before the closing (because the seller will no longer have the cause of action), and the purchaser and its lawyer should be aware of pending or possible counterclaims.
Mortgage lender requirements are beyond the scope of this article. But, before the parties get to the documentation and closing of the financing of the purchase, a loan commitment will have to be negotiated between the purchaser and its lender. The careful review and negotiation of that commitment are important because the commitment is an enforceable contract between the lender and the borrower and, although the commitment does not deal with all the matters that will be covered in the loan documents, what it does deal with will be incorporated.
What the commitment does not say is as important—perhaps more important—than what it does say. A prime example deals with the issue of the availability of insurance proceeds for restoration in the event of a fire or other insured casualty. Loan documents typically provide that the lender may, at its election, apply insurance proceeds to restoration or to pay down the loan. If the proceeds are not made available to restore, very serious adverse consequences could flow to the borrower. For a further discussion of this problem, please see this author’s article in the July/August 1999 issue of Probate & Property entitled Tug of War—Who Gets the Casualty Insurance Proceeds? Unless the issue is covered in the commitment, the borrower will have very little leverage to negotiate the matter when it receives the loan documents.
Possible Re-trading of the Deal
Fortunately, although some purchasers sign contracts intending to re-trade the price after concluding their due diligence inspection, irrespective of the matters discovered during the due diligence period, that is the exception and not the rule. Still, it is not unusual for circumstances to dictate that the price be renegotiated.
For example, if the purchaser discovers that the HVAC equipment is not in good working order or the roof requires replacement, and the leases do not require the tenants to pay the cost, the purchaser will seek a price reduction equal to the cost of correcting the condition. Similarly, if the center looks fully occupied, and in fact is fully occupied, but the tenants are delinquent in their payments, then the center does not have the economic value on which the purchase price in the contract was predicated. The purchaser may decide not to terminate, which it would have the right to do, but instead may seek a price reduction. Of course, the purchaser will have to act to preserve its right to terminate by commencing its negotiation before the right expires or, if it is not prepared to do so, it may have to terminate the contract (unless the seller agrees to an extension of the due diligence period) and attempt to negotiate a reinstatement on more favorable terms. If the problem giving rise to the desire to terminate appears early in the due diligence period, the purchaser may wish to seek a price reduction as well as an extension of that period because it will not want to keep spending its money on inspections when it already realizes that the deal does not make sense at the price in the contract.
Of course, not all renegotiations result from conditions of the property. Some of them result from matters outside the property itself. For example, if there is a severe economic downturn, or interest rates increase unexpectedly, or the amount the purchaser expected to borrow is not available, or some adjoining development is not built as planned, and if the language in the contract permits the purchaser to terminate in its discretion, then the purchaser may seek to take advantage of the existence of the due diligence contingency to either re-trade the price (or other terms, such as requiring seller financing) or walk away from the deal.
A purchaser’s ultimate remedy for being dissatisfied with the inspections, investigations, or conditions external to the property if the transaction cannot be renegotiated is to terminate the contract. Termination is not something purchasers do lightly. Consider that, by the time a 45- or 60-day due diligence period expires, the purchaser will have spent a lot of money on legal fees to negotiate the contract, and for legal and other costs in connection with its due diligence. It may even have paid a commitment fee to a lender, which it may forfeit if the loan does not close. Nor should one discount the emotional commitment that the purchaser has in buying the property. That will give the purchaser the incentive to accept a lesser reduction in the price than it would have accepted if it had perfect knowledge of all the conditions at the inception of the original negotiations. Unless the seller has another prospective purchaser waiting in the wings (or even a backup contract), it may also have an interest in compromising on the price or other terms. Otherwise it may find itself back in the market, knowing about adverse conditions pertaining to the property or the economy and seeking to sell the property for more than it may be worth. Thus compromise is often, but certainly not always, possible.
A due diligence contingency is almost inevitably a part of a contract for the purchase of real estate, whether it is a shopping center, an office building, an industrial parcel, or a residential building. Even (or perhaps especially) in the case of the purchase of unimproved property, due diligence is appropriate for the purchaser to determine if the property is suitable, physically and economically, for the purchaser’s intended use. Due diligence affords the purchaser the opportunity to find out not only the negatives of a piece of real estate but also the positives. It affords the parties the opportunity to make adjustments to the terms of the purchase to fit the circumstances found and to make the deal, if not better for each party, at least fairer to both. That is why the thorough investigation described in this article is not only essential but beneficial.
Due Diligence Checklist
1. Property description including detailed description of mechanical systems.
2. Plans and specifications, if available.
3. Roof report.
4. Engineering reports to cover the following items:
a. structure, including the condition of the slab, columns, bumpers, structural walls, exterior doors, and dock doors;
c. exterior caulking;
d. exterior painting;
e. washrooms and locker rooms;
f. interior ventilation;
g. unit heaters;
h. mechanical systems including sprinkler systems, electrical, plumbing, and HVAC;
i. lighting, ceiling tiles and light lenses, dry wall, and entrance steps;
j. compliance with laws and ordinances including ADA;
k. building size;
l. parking lot; and
5. Phase I Environmental Assessment (including asbestos).
6. Phase II Environmental Assessment, if recommended by engineer.
7. Floor or space plans.
8. Meters in multi-tenant spaces.
10. Soil analysis for load-bearing capacity, if required.
11. Access and other appurtenant rights, such as easements, that benefit the property.
12. Availability and adequacy of utilities.
13. Code violation search from the local municipality, if required.
14. ADA compliance.
B. Tenant Analysis (If There Are Tenants)
1. Financial statements and credit reports.
2. Tenant interviews covering the tenant’s plans regarding the building, comments regarding the building and its management, and a discussion of the business outlook of the tenant.
C. Economics of Property
1. Analysis of historical income and expense statements.
2. Comparison of historical income and expense statements to purchaser’s pro forma/budgets.
3. Cash flow analysis.
4. Review of tenant files including billing statements, tenant collections, and comparison to lease.
5. Review and analysis of reimbursable and nonreimbursable expenses.
D. Lease Analysis (If There Are Tenants)
1. Review all leases and abstract the same.
2. Analyze lease problems, if any.
3. Analyze expansion rights and option space in multiple-tenant buildings for conflicts.
4. Analyze potential conflicts between use clauses and restrictions on retail multi-tenant properties.
5. Review for options to purchase, options to terminate, and rights of extension or renewal.
6. Review “Go Dark” clauses and assignability clauses on multiple-tenant retail properties.
E. Market Analysis
1. Rent comparable and sale comparable.
2. Market descriptions/supply and demand.
1. Review title commitment and exception documents.
2. Review survey.
3. Review zoning.
G. Ancillary Contracts
2. Certificates of occupancy or equivalent.
3. Warranties (including roof) and assignability thereof.
4. Management company in place to manage the property.
5. Service contracts—cancellation clauses.
6. Any common area management agreements.
7. Other agreements.
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