August 2, 2018
Like the purchase of all investments, purchasing commercial real estate requires substantial diligence. Unlike other investments, real estate has a specific process and unique diligence items. This article discusses that process and diligence.
Real estate purchases often begin with a term sheet, sometimes formatted as a letter of intent. The term sheet helps the buyer and seller complete negotiations on primary terms like the property description, purchase price, earnest money deposit, inspection period, and closing date. The process of negotiating a term sheet allows for early confirmation that the parties agree on primary terms and may speed the drafting and negotiation of the contract. The term sheet should be non-binding, except for a requirement that the seller negotiate exclusively with the buyer for a specified period. Making a term sheet non-binding preserves flexibility that the buyer may need when negotiating the purchase and sale agreement.
Purchase and Sale Agreement
The purchase and sale agreement includes the basic terms included in the term sheet – property description, purchase price, earnest money, inspection period and closing deadline – and other terms. Customary additional terms include:
- Covenants – A covenant is a promise to do, or to refrain from doing, something. For example, a seller might promise to deliver information regarding the property to the buyer, operate the property consistent with past practices, and avoid modifying any lease.
- Warranties – A warranty is a statement of fact. For example, a seller might warrant that the property is free from hazardous substances, complies with all laws, and that all leases are current.
- Conditions of Closing – A condition of closing is a fact, which if not true, allows the buyer to terminate the contract and, typically, receive a refund of the earnest money. Typical conditions include the absence of any change in the condition of the property, the continuing accuracy of the representations made by the seller, the seller’s performance of each of the seller covenants, and the continuing validity of each lease on the property. Unlike residential real estate contracts, financing contingencies are not often included (it being assumed that buyer will resolve financing during the inspection period).
- Closing Deliveries and Process – At the closing, the seller will need to deliver certain documents required to complete the sale, the buyer will need to deliver the purchase price and documents, and both parties will need to allocate taxes, utility charges, building service charges, rents, and other items of income and expense.
- Miscellaneous – Most contracts include a group of standard terms, sometimes referred to as boilerplate. Standard terms address things like: risk of loss, dispute resolution, default remedies, notice, assignment, calculation of time periods, choice of applicable law, etc.
Negotiating the Agreement
Having a signed term sheet or letter of intent does not make the contract execution a perfunctory event. Contracts for commercial real estate are not generally completed on fill in the blank forms. Instead commercial real estate contracts are generally documents prepared specifically for the transaction by the attorney for buyer or seller. Controlling the first draft of the contract is often a good idea, and many buyers prefer that their attorney create the first draft. Expect to spend time working with your attorney to confirm that the contract addresses details not included in the term sheet in the way that you want them addressed. Typically, after the first draft of the contract is complete, your attorney will send it to the attorney for the seller. The attorney to the seller typically discusses with their client, revises the contract to incorporate the seller’s requests, and sends a revised draft to your attorney. Your attorney will discuss the proposed changes with you, and the process repeats until buyer and seller have agreed to the text of the contract.
After the buyer and seller sign the purchase and sale agreement, the buyer generally begins due diligence. Typical due diligence includes:
- Survey – A survey will help you understand the property you are purchasing and the easements and encroachments that may impact the property. A survey should identify the boundaries of the property; encroachments, if any, by neighbors onto the property or encroachments, if any, from the property onto the property of neighbors or into setback areas; and the location of easements that affect the property. Unless there is a recent (generally dated less than a year prior to the anticipated closing date) survey, lenders often require a survey. Similarly, the title insurer is likely to require a survey as a condition of deleting a title exception for matters that would be shown by a survey. Even if a recent survey is available, buyers often prefer to have a new survey that is certified to the buyer or have the existing survey certified to the buyer. Absent such certification, the surveyor who performed the survey is not liable to the buyer for any error in the survey.
- Title search – A title search is a search of the public records to identify easements, covenants, liens and other matters that impact the use of property, and to confirm that title to the property is vested in the seller. Liens arising from a mortgage or deed of trust, a judgement against the seller, unpaid taxes, liens in favor of anyone who has provided services or materials to the property, or other items must be identified so the lien can be paid and removed at closing. Other encumbrances, like a sewer easement or restrictive covenant will likely remain on the property after closing. Encumbrances that will remain need to be evaluated to determine whether they adversely impact the current or planned use of the property.
A title examination is necessary for title insurance. After a title examination is complete, a title insurance company will issue a commitment to insure title, and after satisfaction of the conditions listed in the commitment, the insurance company will insure that the buyer has good title to the property, subject only to the encumbrances listed in the title policy. If the buyer plans to borrow money to purchase the property, the lender will require a title insurance policy that insures the lender’s mortgage or deed of trust is a first priority lien on the property, subject only to exceptions the lender concludes are acceptable.
- Environmental analysis – Federal and state laws prohibit environmental contamination and obligate property owners to remediate environmental contamination of their property. The remediation obligation sometimes extends to owners who were not involved in the contamination, and in extreme circumstances can result in a buyer acquiring a property that has remediation obligations that cost substantially more than the value of the property. Determining whether the property is contaminated is critically important. The first step in evaluating whether a property is contaminated is a Phase I Environmental Site Assessment (Phase I). A Phase I should identify any potential or existing environmental contamination. Further, getting a Phase I can provide a buyer with certain affirmative defenses available under environmental laws. A lender usually requires a Phase I. If the Phase I reveals the presence or suspected presence of contaminants, a Phase II or other testing may be required.
- Building Inspection Report – Much like the home inspection you obtained before buying a house, a building inspection is prudent. Building inspections are typically performed by engineering firms and address all aspects of the building, with particular focus on items that have a known useful life, such as the HVAC system and the roof. Failing to understand the condition of the building on the property can lead to unwanted surprises after closing.
- Zoning diligence report – A planning and zoning report, sometimes called a PZR, should identify the current zoning of the property, including any special use permits, special use districts, or other similar zoning restrictions on the property. The PZR also identifies the uses allowed on the property, determines whether the current use meets current zoning standards, and if not, the extent to which the existing use is “grandfathered” (how long it can remain in its current condition and the circumstances under which it would be required to be updated to comply with the current zoning code). If renovations or a change in use is contemplated, the planned renovation and new use should be evaluated also.
- Appraisal – An appraisal will be required for any loan by a bank or similar traditional lender. Applicable law requires the bank to control the appraisal process.
- Operating Expense and Rental Analysis – You should obtain the history of operating income and expenses related to the property, including costs projected in a maintenance plan (or a maintenance plan you develop based on the building inspection report), and consult with your accountant or other financial advisor to assess the financial strength of the property, the likely return on investment, and the purchase price.
- Lease Review/Tenant Estoppel Certificates – If income from the property is based on rent from existing leases, inspecting each lease to evaluate the term of the lease, the rent due under the lease, and the obligations the lease imposes on the landlord is prudent. In addition, obtaining certifications, generally called a tenant estoppel certificate, from the tenants is wise. In an estoppel certificate a tenant typically affirms that their lease is valid, that rent has not been paid more than 30 days in advance, that there are no current obligations due from the landlord, and that neither the landlord nor the tenant is in default. A tenant estoppel certificate is a good way to confirm that there are no outstanding issues or lease disputes between the tenants and the current owner.
- Property Manager – If the property is being managed, interviewing the property manager can reveal information about the condition and operation of the property, and about existing tenants. Additionally, if you plan to engage a property manager to manage the property after you acquire title, the existing property manager may be a good candidate. If you do not plan to retain the existing property manager, evaluating the termination provisions, if any, of the property management agreement is prudent. These same considerations apply for service contracts related to the property.
- LLC Creation and Operating Agreement – Most real estate investors prefer to create a limited liability company to own real estate. In some circumstances, the lender will require a new entity that is a single purpose entity, also called a special purpose entity or SPE for short. If a new limited liability company needs to be formed, it is a good idea to allow time for the formation of the entity during or immediately after the inspection period.
- Tax Planning – Owning, operating, refinancing, and selling real estate have significant tax consequences. Discussing a purchase and the contemplated operation and disposition of real estate with your tax advisor is strongly recommended. A good tax advisor will help you understand the tax ramifications and offer guidance on the most tax advantageous way to structure the transaction.
Most buyers obtain a loan to finance the purchase. Work to obtain a loan should begin during the inspection period. Obtaining a loan for commercial real estate often includes delivery to the potential lender information about the property and about the buyer and working to reach an agreement on a term sheet or commitment letter. Negotiating loan documents, often follows a process much like the process for negotiating the contract described above.
While the general process of purchasing real estate can be described easily, every property is unique, most transactions are distinct, and creating the process and documents for a transaction requires the support of a thoughtful and experienced group of advisors. Purchasing commercial real estate is generally not a do-it-yourself activity and generally not one that lends itself well to internet or other forms.
If the buyer is satisfied with the results of its due diligence examination, and is able to obtain the necessary financing, the parties move to closing. Closing typically involves seller delivering closing documents (usually a deed, owner’s affidavit, company resolution authorizing the sale, affidavit regarding the Foreign Investment in Real Property Tax Act, a document related to IRS Form 1099, notices to tenants, and a closing statement that describes the flow of funds at closing), to the closing attorney or title company that is acting as the settlement agent. The buyer generally signs loan documents and delivers only the purchase price and a signed copy of the closing statement. When the settlement agent has received all documents and funds, it will submit the deed for filing the land records and disburse the funds in accordance with the closing statement.
Nexsen Pruet has a number of real estate, environmental and tax attorneys who have substantial experience with the acquisition of real estate and has strong ties to the consultants who perform the work described above. You can learn more about Nexsen Pruet's Real Estate team here.
Keith Burns practices real estate law with the belief that the difference between good and great outcomes lies at the intersection of details and business goals. His legal strategies reflect that philosophy of meticulousness combined with pursuit of practical solutions. He strives on mitigating risks and capturing return. To learn more about the real estate purchase process, contact Keith at 919.653.7835 or firstname.lastname@example.org.