Due Diligence for Commercial Real Estate Acquisitions

Due diligence is the investigation of a person or business. In the context of a commercial real estate transaction, the buyer uses the due diligence process to gather information about property to be acquired. This Note explains, from a buyer’s perspective, why due diligence is necessary, what materials to review and what to look for.

Reasons for Due Diligence

Generally speaking, when acquiring commercial real estate, the buyer gathers information before making an offer on the property. Primarily, the buyer uses this information to decide whether property is a good investment and to determine what the property is worth. Often the contract of sale will allow the buyer a specified period of time to conduct more thorough due diligence before the contract becomes binding on the parties. If a contract does not contain a due diligence period, the buyer should complete the due diligence process before a binding contract is executed. In certain instances, a buyer may decide to terminate the contract or otherwise abandon the transaction after performing due diligence, but more commonly, a buyer uses the information to negotiate contractual protections (such as indemnification for enumerated liabilities) or to adjust the purchase price. A due diligence inquiry should establish the following key information about the property:

  • Confirm that the seller has good title to the property.
  • Ascertain the value of the property.
  • Understand the liabilities to be assumed and other potential risks of owning the property.
  • Learn more about the management and day-to-day operations of the property.
  • Identify any impediments to the transaction, such as required consents or any restrictions on transfer.

Due Diligence Materials: What to Review and What to Look For

Title Report. The title report or title commitment is a report compiled by a title insurance or abstract company. It provides essential documents and information about the property, including how title is currently held and what exceptions or encumbrances are of record (for example, an existing mortgage). The title report delineates the steps necessary to clear title issues to ensure that, to the extent possible, a buyer purchases the property free and clear of any liens or encumbrances. A full complete report may take more than a week to obtain. Accordingly, ordering title should be one of the first things a buyer’s attorney does when a client expresses serious interest in a property.

While the entire report should be reviewed, there certain components of significant importance:

  • Deed. How is currently title held by the seller? All persons or entities with an interest in the property need to consent to the conveyance of the property and sign the deed or otherwise authorize its execution.
  • Mortgage Chain. What mortgages encumber the property? Depending on the terms of the existing loan a buyer may consider assuming the seller’s mortgage. More commonly a buyer will want the mortgage paid off or assigned to the buyer’s lender.

In New York, mortgage recording tax is paid by the borrower to the State of New York when a mortgage is filed. The amount of the tax is based on a percentage of the mortgage (in the case of a mortgage of $500,000 or more, the tax is 2.8% of the loan amount). If the mortgage is assigned, mortgage recording tax is only paid on the difference between the old mortgage amount and the new mortgage amount (referred to as the “gap amount”) thereby saving the buyer from having to pay the tax based on the full amount of the new mortgage. It is not uncommon for sellers to require a portion of that savings as consideration for having the mortgage assigned.

  • Certificate of Occupancy – What are the legally permitted uses of the property? Is it being used in accordance with those permitted uses? Can it legally be used as intended by the buyer?
  • Violations, Liens and Judgments – What liens and judgments will the seller need to have removed or satisfied in order to deliver clear title? What violations are listed against the property and what fines associates with those violations? A buyer may agree to take a property subject to violations, but will often require a credit against the purchase price in the amount of the monetary fines. The buyer will then have to do the work which gave rise to the violation and have it removed of record.
  • Restrictive Covenants. Are there any restrictions on what a buyer can do with the property? A buyer will take the property subject to the restrictive covenants because the covenants are said to “run with the land.” Common covenants include utility easements (for example, allowing a telephone company to run wires above the property) or access easements (for example, allowing a neighboring property owner to use a portion of the property as a means of ingress and egress).
  • Real Property Survey – Does the seller own what the buyer thinks he or she is buying? A recent survey will depict the location of all improvements relative to a property’s boundaries and the location of any restrictive covenant encumbering the property>

Other Third Party Reports.

  • Environmental Site Assessment. Does the property have potential environmental issues? The report will enumerate potential or existing environmental contamination liabilities, such as underground fuel tanks, asbestos or lead paint. The report should address issues with the underlying land as well as physical improvements to the property. If a site is considered contaminated, a more detailed investigation involving chemical analysis for hazardous substances should be performed.
  • Engineer’s Report. Are the improvements on the property structurally sound? Are the building systems in compliance with local codes? Are they sufficient for the buyer’s intended use? All major building systems such as plumbing, heating, electrical as well as the structure itself should be inspected by an expert.
  • Zoning Report. Zoning laws, which are constantly changing, dictate how a property can be constructed, remodeled or used for business. A buyer will want to confirm that the property is currently in compliance with applicable zoning ordinances with respect to usage, parking, setbacks, height, density, coverage requirements and that the intended operation of the property and any construction that the buyer intends to perform will be permitted based on applicable zoning laws.

In New York City, the Landmarks Preservation Commission is authorized to designate a building as a “landmark” or to designate an area as a “historic district.” The owner of the designated landmark is legally required to maintain the building’s exterior in good repair and to secure approval before any exterior alterations are made.

Leases. Important provisions you should look for include:

  • Termination – as the new Landlord, what are your rights to terminate the lease? What are the tenant’s rights to terminate the leases?
  • Term – How much time is left on the term of the lease? Is there an option to renew the lease? If so, for how long and at what rent?
  • Rights of First Refusal – does the tenant have the right to buy the leased space or to rent or buy other space at the property?

A buyer should look to get an estoppel certificate (a certificate signed by the tenant confirming the terms of the lease and stating that the tenant has no right to terminate or other claims against the landlord that the buyer would inherit) from each tenant. A buyer will want estoppels from all of the tenants. Sellers may not want their tenants to know that they are selling the property. The parties may compromise by requiring a seller to deliver only a certain number of estoppels (based on square footage or number of tenants) in order to close under the contract.

  • Assignment and Assumption Provisions – as the buyer will you be required to assume these contracts?
  • Scope – what services are being provided? What is the expense?
  • Term – how long does the contract run? Are there any options to renew and for how long and at what rate?
  • Termination – what is each party’s right to terminate the contract?