Part 1: Introduction to Due Diligence in Commercial Real Estate
Due Diligence – What is it?
Purchasing a property without conducting proper due diligence is like buying a used car without looking under the hood……what looks like the greatest deal can turn into your worst nightmare. Good due diligence consists of a thorough review of the physical, legal and financial risks of a potential investment property before committing to the deal.
The due diligence process serves to confirm all the material facts related to a property that could cause a buyer to hesitate from consummating the deal at the price and on the terms proposed by a seller. At a minimum, due diligence for a commercial real estate acquisition should consist of: (1) an environmental assessment; (2) title and municipal records review; (3) a survey; (4) an engineering and building inspection; (5) a zoning review; and (6) review and confirmation of financial data, each of which will be separately addressed in this Seven Part Series.
Due Diligence Contingencies in Contracts
A buyer can either conduct due diligence before entering into a contract with the seller or after the contract has been fully executed. If a buyer wants to conduct due diligence after a contract is fully executed, the buyer should have a due diligence contingency in the contract. A due diligence contingency is a length of time specified in the contract for the buyer to carry out and perform due diligence. If the buyer is not satisfied with its due diligence the contract contingency gives the buyer the right to back out of a deal without penalty (i.e. the buyer will get its contract deposit back). Contingencies are important for buyers who cannot predict with certainty the physical, legal and financial conditions of the property prior to entering into a contract. If a buyer enters into a contract that does not have a due diligence contingency and then uncovers a material issue the buyer will either have to proceed to the closing and accept the risk or terminate the contract and loose the deposit. Due diligence contingencies can vary greatly depending on the facts of each transaction, however there are two main categories: a general due diligence contingency and a specific due diligence contingency.
General Due Diligence Contingency or “Free Look”
For the buyer a general due diligence contingency in a contract is preferable to a specific due diligence contingency. For a general contingency the language in the contract is drafted to allow the buyer the ability to conduct all forms of due diligence (within reason) that the buyer needs in order to feel comfortable to proceed to the closing. This type of general contingency is known as a “free look” because it allows the buyer to terminate the contract for any reason or no reason and still receive a full refund of any earnest money deposit.
Specific Due Diligence Contingency
Specific due diligence contingencies are tied to narrow investigative procedures like environmental assessments, zoning studies, financing or building conditions. A specific due diligence contingency is most beneficial to the seller because it only allows the buyer to terminate the contract under limited conditions. For example, a specific due diligence contingency could contain an environmental provision that only allows the buyer to cancel the contract in the event that a Phase I Environmental Site Assessment recommends a Phase II Environmental Site Assessment (which involves testing) (Environmental Due Diligence will be covered in more detail in Part 2 of this Series); or a specific due diligence contingency could contain an engineering provision that only allows the buyer to cancel in the event that the building inspection reveals structural issues with the roof, walls or foundation (Engineering and Building Inspection Due Diligence will be covered in more detail in Part 5 of this Series). From the buyer’s prospective a specific due diligence contingency is a much riskier contingency than a “free look” because if due diligence reveals a material problem beyond the scope of the limited conditions, the buyer either loses its deposit or is forced to close and then is stuck with the problem.
- Use specific due diligence contingencies in the contract
- For each type of due diligence, clearly identify the reasons under which a buyer can terminate the contract and draft language as narrowly as possible
- Require the buyer to provide appropriate insurance for all of its consultants naming seller as additional insured
- Make sure that the buyer indemnifies the seller for any damages or liabilities that arise out of testing and that seller will repair all damage at its expense
- If buyer wants a right to extend the diligence period, require a non-refundable payment
- Get a “free look” general contingency which allows termination of the contract for any reason or no reason
- For all forms of due diligence contingencies make sure that the contract requires the seller to assist the buyer in conducting the due diligence by providing documents in the seller’s possession such as existing property files, reports and permits
- If the buyer is allowed to apply for permits or make any applications before closing the contract should grant the purchaser the authority to act on behalf of the seller when dealing with third parties such as municipalities
- Try to get a right to extend the due diligence period, without a non-refundable penalty
- For each type of specific due diligence, clearly identify the reasons under which a buyer can terminate the contract and draft language as broadly as possible
In the Concrete Jungle
In New York City buyers of real estate have been hoarding their cash reserves since the financial crisis in 2008. As a result, there is huge amount of cash chasing after very few deals which has placed a lot of the control in the hands of sellers. In New York City sellers therefore heavily favor entering into non-contingent contracts (often referred to as “all-cash” contracts) and have forced buyers to conduct as much due diligence as possible prior to entering into a contract. One reasonable solution is for the seller and buyer to enter into a non-binding letter of intent, which has an exclusive period during which the seller will only sell to that buyer. This allows the buyer a certain amount of time (usually very short) to conduct limited due diligence before entering into a binding contract. However, letters of intent should be used with extreme caution as courts may enforce them as binding contracts, especially with respect to any promise by the parties to “act in good faith”.
A helpful list of documents that a buyer should consider requesting from the seller prior to committing to any commercial real estate deal is here.
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