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Commercial Real Estate Due Diligence

Added by Mike Baldner in Articles & Publications, Business Law on March 26, 2015

The returns on investments in commercial real estate come with risks. In order to mitigate some of these risks, buyers should conduct adequate due diligence prior to the acquisition. Most contracts of sale for real estate provide a time period where the buyer can conduct due diligence. If the buyer is not satisfied with the condition of the property, the buyer may terminate the contract, without liability and with the return of their earnest money. Very complex projects may have due diligence periods of over a year. Typically however, due diligence periods are at least sixty days long, with thirty days likely to be the minimum amount of time provided.

During the due diligence period, the buyer is essentially trying to verify a number of facts to ensure ownership will meet expectations. In general, the facts being verified fall into general categories: 1) Title; 2) Environmental; 3) Entitlements; 4) Physical Condition; and 5) Economic Feasibility.

Title, in relation to real estate, refers to the extent and nature of the owner’s rights in the property. Owners of property may take title subject to various preexisting liens, leases, and/or other agreements. To be enforceable against the owner these items typically either have to be of record, or observable by an inspection of the property. Given the complexity of reviewing the county records on their own behalf, most buyers rely on title companies to provide them with a title commitment which sets forth all recorded items the buyer will take subject to. Usually at closing the title company issues an insurance policy that insures there are no other recorded items in existence. The items which appear on the title report are reviewed by the buyer, usually with the assistance of an attorney, in order to assess what effect they might have on the buyer’s intended use. For unrecorded items, buyers can engage a surveyor to determine whether encroachments exist along boundaries, or evidence of adverse use is present. In addition, the buyer or its representative should meet with any occupants to assess the nature of their interest.

Environmental inquiry is always merited when acquiring commercial real estate for two important reasons. By law, an owner is responsible for clean-up costs for any contamination on or under its property, even if they did not cause the contamination. These costs can be significant, potentially millions of dollars. In addition, even if cleanup is not required if the property is undisturbed, construction may expose contaminated materials, soils and water that require expensive disposal. Buyers should hire qualified environmental consultants to conduct a study known as a Phase I, and for existing buildings asbestos and lead paint analysis. If done correctly, the buyer will not be liable for cleanup of undisturbed property, and it minimizes the risk construction activities will uncover contaminated materials, soils or water.

Entitlements are the governmental approvals that entitle the owner to use the property for the purpose they desire. These approvals can exist on various levels including federal, state, county, city, and various other political subdivisions. Most commonly this involves confirming the status of zoning, certificates of occupancy, impact fees, subdivision approvals, and other approvals required for the use of the property. Buyers often assume that the present use of a property is properly entitled, but in some cases the current use is not compliant and has merely escaped the attention of governing jurisdictions. In such cases, the outcome can be disastrous for a buyer. Given the complexity of such an inquiry, architects and other consultants are often involved. For property that is to be developed, the process of confirming entitlements for the new project can be fairly time consuming and may require investment in detailed plans and specifications which are presented to various agencies for approval, often through public hearings. In these cases, architects and/or attorneys are often consulted.

Investigating the physical condition of the property is advisable to avoid costly repairs of existing buildings and improvements, or to avoid extraordinary construction costs. On existing buildings and improvements, architects, contractors, and/or engineers are typically hired to assess the current state of the improvements. The consultant’s focus is usually on high cost items like roofs, parking lots, structural elements, HVAC systems, electrical components, and other utilities. Even bare ground should be investigated to ensure the soils are suitable for building and drainage, and to ensure the grades are suitable for development.

Economic feasibility ultimately depends on the buyer confirming the economic assumptions which existed at the time the contract was entered into were accurate and the acquisition is advisable. This can involve many factors, including unanticipated costs arising out of facts discovered in the other phases of due diligence, confirming income assumptions (by confirming lease terms with the tenants for example), securing investors, determining actual costs of development and/or finalizing financing.

Involving title companies, attorneys, environmental consultants, architects, engineers, contractors, brokers, lenders and other consultants requires a fair amount of coordination and expense and should be appropriately scaled depending on the level of the investment. While thorough due diligence cannot eliminate all risks of purchasing real estate, the risks can be reduced and quantified in order to ensure that the level of return is relative to the level of risk taken on by the buyer.

For more information, please contact our Real Estate Group or call 208.344.6000.