This list reflects commonly asked questions but it is not exhaustive and should not be relied upon as legal advice for any particular set of circumstances. If you have questions about your commercial real estate matter, please contact one of our attorneys.
WHAT IS DUE DILIGENCE?
Generally speaking, when acquiring commercial real estate, the purchaser gathers information to decide whether property is a good investment before making an offer on the property. Sometimes, a purchaser is able to include in the contract of sale a specified period of time to conduct more thorough due diligence before the contract becomes fully binding upon the parties (a “due diligence period”). If a contract does not contain a due diligence period, the purchaser should complete its due diligence process prior to contract execution. A due diligence inquiry should help a purchaser:
- Confirm that the status of title and existence of restrictions, liens, etc.
- Ascertain the market value of the property and the availability of any required financing.
- Understand the liabilities to be assumed and other potential risks of owning the property.
- Learn more about the economics of the transaction (e.g. the revenues and expenses of the property).
- Identify any impediments to the transaction, such as required consents or any restrictions on transfer.
What types of due diligence materials should I review and what should I look for?
Title Report. The title report 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). A complete report may take more than a week to obtain. Accordingly, one of the first things a purchaser’s attorney should do is to order a title report. 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? Is the existing loan assumable? More commonly a purchaser will want the mortgage paid off or assigned to the purchaser’s lender.
- Certificate of Occupancy. What are the legally permitted uses of the property? Is the use of the property in accordance with those permitted uses?
- 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 are associated with those violations? A purchaser 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 associated with existing violations.
- Restrictive Covenants. Are there any restrictions of record on what a purchaser can do with the property? Are there any easements of record?
- Real Property Survey. An accurate 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. A 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.
- Property Condition Report. Are the improvements on the property structurally sound? Are the building systems in compliance with local codes and sufficient for the purchaser’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. A purchaser 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 purchaser intends to perform will be permitted based on applicable zoning laws.
Existing Tenancies. When buying an occupied building it’s imperative that a purchaser review the existing leases. Unless the leases specifically state that they can be terminated, they will be assigned to the purchaser at closing and the purchaser will become the landlord subject to the terms and conditions of the 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?
- Scope – what services is the landlord currently? What is the expense?
A purchaser 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 purchaser would inherit) from each tenant.
The contract of sale will include essential terms including the purchase price, the deposit amount, representations of the seller (and the purchaser), the closing date, etc.
What is a time of the essence closing date? A “time of the essence” (“TOE”) closing date means that a failure to close on the stated closing date will result in a default under the contract and entitle the non-defaulting party to applicable remedies. Generally, the failure of a purchaser to close on a TOE date will result in a seller’s claim to the contract deposit. The failure of a seller to close on a TOE date generally entitles a purchaser to commence a legal proceeding for specific performance to secure a court order to compel the seller to convey title in accordance with the contract terms,
Right to Assign. Oftentimes, a purchaser may want to set up a new entity to take title to the property following contract execution. In such an event, a purchaser will need to have the right to assign its rights under the contract to the new entity. Seller’s often push back on a request for the right to assign out of concern that a purchaser may “flip” the contract to an unrelated party unfamiliar to the seller.
Assignment of Seller’s Mortgage. In New York, as well as some other states, the filing of a mortgage requires the payment of mortgage recording tax (“MRT”). In NYC, the tax can be quite significant. If the seller already has a mortgage filed against the property, a purchaser may require that such mortgage lien be assigned to the purchaser’s lender as the principal balance of the assigned mortgage will be exempt from MRT.
Apportionments. As well as adjusting for real estate taxes, water charges, etc., the parties to a commercial contract will look to apportion the collected (and sometimes uncollected) rents paid and/or owing from the existing tenants. All tenant security deposits are to be assigned and delivered to the purchaser at closing.
Representations. A purchaser will seek to have the seller makes various representations including the accuracy of the rent roll to be annexed to the contract, lack of notice of any litigation affecting the property or the seller, lack of notice of any casualty or condemnation proceeding, lack of tenant disputes including claims of rent overpayments or tenant defaults, due authority of the signing party, etc.
Continued Operations. A purchaser will want to ensure that the seller continues to maintain the condition of the property and pay all expenses of the property during the contract period, including all insurance premiums.
1031 Tax Deferred Exchange. A 1031 exchange is a process where a seller has the ability to exchange the property subject to the contract with another property(ies) without having to pay capital gains tax until (potentially) a later date. A “qualified intermediary” will need to be engaged as part of the process. If a seller is interested in engaging in a 1031 Exchange, the contract should include a provision outlining the terms of the procedure.
The terms of a lease take on significant importance, as unlike a contract of sale where its terms generally become moot following the closing, such lease terms continue to control for years to come. There are many potential eventualities during a lease term and the parties try to anticipate as best possible to address them in the lease.
Term. How long do the parties intend to be committed to the lease? A tenant must assess how long it is prepared to be obligated to pay rent. Parties typically negotiate for optional renewal terms that provide flexibility. Oftentimes landlords will seek longer terms to bolster the finance-ability of the property.
Permitted Use. Landlords will seek to limit the permitted uses of the space to only a tenant’s then existing business. Tenants seek to make the permitted use as broad as possible, perhaps for “any legally permitted use”. There are different reasons for a landlord wanting to limit uses by any tenant including a desire to achieve a positive tenant mix and honor exclusive use provisions. A tenant may want to expand its product lines/services. Additionally, without the ability to expand the permitted uses beyond what may not have worked out, the right of assignment and sublet are materially restricted.
Security Deposit and Guaranties. A landlord will assess the financial strength of a tenant and may require a sizable security deposit (either cash or letter of credit) and/or a personal guaranty from a creditworthy principal of the tenant. There are different types of guaranties including a full guaranty, limited guaranty and a “good guy” guaranty. The terms of any guaranty requires careful review and negotiation as it will have significant potential impact upon the economics
Right of Assignment/Sublet. It can be very important to a tenant to have the right to assign its interest in the lease and/or have the right to sublet the space to a third party. These rights afford a tenant an ability to get out from under the lease obligations should the business fail or there is a need for larger space, etc. Landlords typically seek to limit these rights for various reasons, including the desire to control the occupancy of the space.
Go Dark. Larger tenants often negotiate the ability to close the business prior to the end of the lease term without it creating a default under the lease. Landlords do not like “dark” spaces as it can create blight or other unwelcome effects upon the balance of the tenancies. Co-tenancy clauses take the go-dark clause one step further. They allow a tenant to not just cease operations but also to reduce or completely abate rent when specified vacancies occur in a shopping center. Frequently used in anchored shopping centers to allow other tenants to vacate if an anchor goes dark. A co-tenancy clause can protect a tenant against being in a shopping center that doesn’t have the promised level of traffic.
Contingencies. Oftentimes, leases will contain contingency clauses that enable a tenant to terminate the lease if it does not secure necessary approvals. One example would be the need for a tenant to secure a liquor license. A liquor license is essential for a restaurant to be financially viable. It is not uncommon for a new lease to contain some period of free rent period. As a tenant you will want to tie that time frame to the period of time it is likely to take to obtain a liquor license. You may also want to negotiate a contingency permitting termination of the lease if it is unable to obtain a license. A landlord is unlikely to agree to have the deal be contingent for any significant period of time so knowing the hurdles you face in obtaining the license is important.