No matter what type of commercial property you may be considering, whether office building, apartment, warehouse, or shopping center, the savvy prospective buyer needs to undertake a thorough investigation of a variety of elements that affect the value of that property. This is the due diligence process, and a buyer’s careful and comprehensive performance of this phase can mean the difference between a successful purchase and severe buyer’s remorse.
The Increasing Importance of Buyer’s Due Diligence.
In past years, a buyer’s due diligence was not as crucial as it is today because the purchase agreement contained seller representations and warranties regarding everything from title, the condition of the improvements and environmental conditions to the property’s compliance with zoning requirements. Buyers often limited their investigation of the property in reliance on the truth and accuracy of a seller’s representations and warranties, and a seller could be held liable for damages if the representations and warranties proved to be materially inaccurate or untrue. In fact, the buyer might even have been entitled to rescind (reverse the sale) the purchase agreement for such reasons.
These days, however—particularly in connection with the purchase of smaller commercial properties—the purchase is often on an “AS-IS”-“WHERE-IS”-“WITH ALL FAULTS” basis with the buyer undertaking the responsibility of thoroughly investigating the property and assuming the risk of almost everything about the property that the buyer does not uncover during its due diligence. Purchase agreements still include various seller representations and warranties that buyer can rely on, and similar remedies are available to buyer to pursue, but the representations and warranties are often limited to title, authority to sell and certain environmental conditions. Instead, the more likely scenario is that the purchase agreement will allow a limited period of time, typically 60 to 120 days, for the buyer and its representatives to conduct tests, inspections and examinations regarding the property and even discuss issues regarding the property with the seller’s agents and employees (the “Due Diligence Period”). Such examinations may include the environmental conditions of the property, the physical condition of any improvements and the state of any mechanical and electrical systems. It is also common for the purchase agreement to include a provision requiring buyer to hold seller harmless from any claims, losses or damages arising from such inspections, or any damage caused to the property in the course of such inspections.
The sole purpose of the Due Diligence Period is to give buyer the right to make its independent determination of whether it wants to purchase the property, or, in other words, to “kick the tires.” Typically, the buyer will have the right to terminate the purchase agreement at any time during the Due Diligence Period for any reason, or no reason at all, without incurring any liability to the seller. In the event of such termination, the buyer will receive a refund of any earnest money that may have been deposited. However, if the buyer does not terminate the purchase agreement within the Due Diligence Period, any earnest money paid becomes non-refundable.
The purchase agreement will also typically require the seller to provide the buyer with a variety of information (to the extent it has such information) that will assist the buyer in its investigation of the property. This information may include copies of tax and utility bills, tenant rent rolls, tenant leases, environmental reports and tests, licenses, permits, contracts relating to the property, and any surveys that seller has. The purchase agreement will often either allow buyer (or require seller) to obtain a current survey if the survey provided by seller is too old or not satisfactory to the title insurance company.
Things A Buyer Needs to Investigate During the Due Diligence Period.
So now that the purchase agreement has been executed, the Due Diligence Period has commenced and buyer has received seller’s due diligence disclosure documents, what are some of the matters the buyer should investigate?
First Things First: Title and Surveys. In the first instance, and before any other time is spent or expense incurred, buyer should engage a title insurance company or attorney to examine the title to the property for the purpose of obtaining satisfactory evidence, in the form of an attorney’s certificate, or better yet, a title insurance policy, that the property is indeed owned by the seller. This examination is very important even though title may be warranted by a solvent seller since liability for seller’s breach of its warranty of title is often difficult to enforce, does not cover the cost of litigation, and recovery is limited to the original purchase price (not covering subsequent improvements or increases in value). The goal of the title examination is to establish that the seller is the holder of good and marketable fee simple title (a 50 year unbroken chain of successive ownership into seller) to the property and to determine what liens, covenants, restrictions, and other matters the property may be subject to.
The survey should also be reviewed during the Due Diligence Period to determine if it discloses physical problems with the property such as improvements (e.g., a driveway) that encroaches an adjoining property or easements that would impair buyer’s intended use of the property.
The purchase agreement should provide that if the title examination or the survey review discloses matters that are not acceptable to the buyer (“defects”), the buyer will have the right to request that the seller cure such defects. Purchase agreements often provide that a seller is not obligated to cure any defects, other than those that can be cured by the payment of money at or before the closing. If the seller cannot, or will not, cure the defects, the buyer must then decide whether to terminate the purchase agreement or proceed with the transaction with the defects uncured.
Additional Things to Investigate During the Due Diligence Period.
Once the buyer is satisfied with the title examination and survey review, the buyer should consider investigating some or all of the following matters.
- Adverse Claims, Liens and Encumbrances: Whether: (i) any person (other than seller and tenants disclosed in seller’s due diligence documents) claims or is entitled to possession of all or any portion of the property; (ii) there are any unpaid or unsatisfied security deeds, mortgages, claims of lien, special assessments, or bills for sewerage, water, street improvements, taxes or similar charges that constitute a lien against the property.
- Flood Plain: Whether: any portion of the property is in a flood plain.
- Access to the Property: Whether: (i) access to the streets and roads adjoining the property is limited or restricted, except by applicable zoning laws; (ii) the streets are complete, dedicated, and accepted for maintenance and public use by appropriate governmental authorities; and (iii) any and all curb cuts and similar permits or licenses necessary or appropriate to provide or facilitate such access to the property have been properly issued and remain in full force and effect.
- Utilities: Whether: (i) all utilities for the property, including but not limited to, water, sanitary sewer, storm sewer, electricity, telephone, high-speed data service, trash removal, and garbage removal, are in good working order and good repair; and (ii) all utility services serving the property are publicly or privately owned and operated and are available and operating for the benefit of the property in such a manner and capacity as are necessary and appropriate for the operation of the property for their present use at standard rates, without any requirement for the payment of any tap-on fees or other extraordinary charges.
- Access for Utilities: Whether the property has: (i) all appurtenant easements that are necessary and appropriate for the installation, maintenance and use of all necessary and appropriate facilities for water, sanitary sewer, storm sewer, drainage, electricity, gas, telephone and high-speed data services, disposal and garbage disposal; and (ii) the right to connect and use all of said facilities from the property to the sources of said services.
- Improvements: Whether: (i) the improvements on the property and all portions thereof, including without limitation, all roofs, walls, windows, elevators, foundations, footings, columns, supports, joists, heating, ventilating and cooling systems, electrical systems, plumbing systems, paving, and parking facilities and landscaping are in good order, repair and operating condition; (ii) there is any termite or other pest infestation, dry rot, or similar damage with respect the improvements; (iii) all of the improvements are water tight; (iv) there is any soil subsistence or other soil condition that presently does or may in the future adversely affect the property; and (v) the storm water detention facilities have been properly installed on the property, are in compliance with applicable laws, and are of sufficient capacity for buyer’s intended use of the property.
- Environmental Issues: Whether the property: (i) has been used for the generation, discharge, release, storage, or disposal of hazardous materials; (ii) is free of any hazardous materials; (iii) has been excavated, has landfill deposited on, or taken from, the property; (iv) contains any underground storage tanks; (v) has or had any underground storage tanks on it and that any underground storage tanks that were on the property have been removed or decommissioned in accordance with applicable law; and (vi) has any construction debris or other debris, rocks, stumps, or concrete that have been buried on the property.
- Property Boundaries: Whether, based on the survey and a physical examination of the property, there are any disputes concerning the location of the property lines and corners of the property.
- Violation of Laws—Tax or Insurance Increases and Condemnation: Whether seller has received any written notice of: (i) any alleged violation of any covenant or legal requirement affecting the property, including applicable zoning laws, building codes, anti-pollution laws, health, safety and fire laws, sewerage laws, environmental laws or regulations, or any covenant, condition, or restriction affecting the property; (ii) any possible widening of any streets adjoining the property; (iii) any possible condemnation of all or any portion of the property; (iv) any possible imposition of any special tax or assessment against all or any portion of the property, or any proposed increase in the tax assessment of the property; (v) the need or advisability of special flood or water damage insurance; or (vi) any possible increases in tax rates or insurance rates for all or any portion of the property.
- Suits or Proceedings: Whether seller has received notice of (whether actual or threatened) any actions, suits or proceedings related to the property.
- Zoning: Whether the property is presently properly zoned for buyer’s intended use.
Whether a buyer is purchasing commercial property for investment or as a location for its business, such a purchase is a large commitment of time and money. Thoughtful and thorough due diligence by the buyer may be the most important part of the process, and, regardless, can help alleviate headaches down the road.
If you have any questions regarding commercial real estate matters, contact Chip Gerry at CGerry@fh2.com or (770) 399-9500 for more guidance.