Due diligence in commercial real estate contracts – how much is enough or too much?

goldilocks 5Identities and Motivations

In purchase and sale contracts as well as some long-term leases, the scope and timing of due diligence is often a hotly negotiated topic.

From the seller/landlord’s perspective, the time for due diligence should be short and tie in neatly to closing. In addition, the scope of due diligence should be as narrow as possible.  Likewise, any representations and warranties related to items defined by the parties should be limited to the effective date of closing or as close to as possible to that time.

From the buyer/tenant’s standpoint, the timing should align with their financing goals for the property, coordination of operations, up fit as well as satisfaction as to what they are buying – i.e. clean title, no hazardous waste problems, proper zoning approval, building inspections, lease evaluation AND and that the seller/landlord stands behind its representations.

What to Look For

Let’s step back a bit and look at what items customarily fall within due diligence for commercial real estate contracts. Although there are differences depending on the type of property, the existing and intended use, age of buildings etc., generally most parties to these transactions should expect the following to be discussed and investigated:

  1. Title  (including  easements, encumbrances, restrictions and covenants, current title policy);
  2. Survey;
  3. Zoning and governmental restrictions, licenses and rules;
  4. Existing and Intended Use of the Property;
  5. Buyer Financing (if not a cash deal);
  6. Inspection of Improvements;
  7. Environmental Inspections and tests;
  8. Existing Leases or other Third Party Property Rights;
  9. Legal Status and Authority of the Parties; and
  10. Representations and Warranties.

goldilocks 2

Key Factors

One could post 1500 words on any of these topics (maybe later), but let’s focus on the issues that could develop when the contract is in play.  As an Owner or Buyer what should you watch out for, prepare for, and deal with in these transactions?

  1. Is this  a 1031 Exchange? – if so, expect the  buyer to want to move quickly and thoroughly to avoid the tax consequences that come from not hitting the closing deadline.
  2. Is this a cash deal? – if so, expect the buyer to want to accelerate the due diligence period to get the $$ into the asset as soon as practicable.
  3. If not, is the sale/purchase subject to conventional or non-conventional financing? – As a seller, you will want to have a back-up plan if the contract is terminated either way, but especially if buyer is pulling funds from sources that may have challenges on closing day.
  4. Is this transaction a stand alone deal or tied to bundling properties for a portfolio? – if the latter, be sure as a seller you are aware of the buyer’s plan and contingencies relating to the other properties.
  5. Is this a long term investment for the buyer or a flip? – this could significantly increase or decrease the scope of due diligence and the importance of those terms in the contract.

 

Takeaways

When the parties negotiate due diligence terms and go through the investigation process, all should be aware of the particulars of the asset, the factors lying within and outside the transaction, the motivations of the buyer/tenant AND seller/landlord, and any other relevant factors relating to the property, process and parties. Perhaps “a little dab will do ya”, but sometimes the situation may require multiple rounds of review and analysis.

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