iFunding Weekly Educational Newsletter

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.

Seller’s Tips

  • 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

Buyer’s Tips

  • 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”.

Good Resources

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.

Disclaimer

The information in this blog post (“post”) and website is provided for general informational purposes only, and may not reflect the current law in your jurisdiction. By using this website and post you understand that there is no attorney client relationship between you and Tomlin Law, PLLC. No information contained in this post should be construed as legal advice from Tomlin Law, PLLC or the individual author, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction. Although the information on this blog is intended to be current and accurate, it is not guaranteed or promised to be current, accurate, or complete. This blog contains links to other web sites. Tomlin Law, PLLC makes no guarantees or promises regarding these web sites and does not necessarily endorse or approve of their content.

Eight Habits of Highly Effective Commercial Real Estate Investors

Investing in commercial real estate can be a very lucrative business—but also a risky one that requires patience, fortitude, and industry knowledge to ultimately be successful. How do you separate yourself from the crowd? Here are eight ways highly effective investors stay on top of the game.

  1. Create a Solid Business Plan – It’s important to visualize both your short and long-term goals, which helps maintain focus and get back on track if you ever hit a stumbling block.
  2. Know Your Market Inside and Out – Acquire an in-depth understanding of each of your markets by keeping on top of current trends, transactions, and key economic figures that allow you to make informed decisions about purchases, dispositions, and other opportunities, both now and for the future.
  3. Read the News Every Day– Subscribe to publications that cater to both your market and industry, including daily newspapers, business journals, and trade publications. Set aside time each day—whether at breakfast, on your commute, or on a break—to catch up on the latest news. Blogs, Twitter, Facebook, and LinkedIn are four other sources to find and share stories related to your market.
  4. Never Stop Learning – Keep abreast of all industry regulations, laws, trends, terminology, and technology, which will allow you to adapt easily to market changes and conditions. Understand the ins and outs of your properties, your tenants, effective ways to save money, and how to keep your assets competitive.
  5. Understand Risk – There’s a reason there’s that old adage, “If it sounds too good to be true, it probably is.” Educate yourself on the risks that come with real estate investments—not only in terms of deals, but legal, financial, and market risk. Avoid investing in assets you don’t understand.
  6. Carve a Niche – While it may be enticing to be a jack of all trades, many successful real estate investors build their business on a specific niche; for instance, it might be only investing in certain asset classes, industries, or geographies. This allows investors to really develop a deep knowledge of the niche and everything that comes along with it.
  7. Build a Solid Team – From accountants, lenders, and lawyers to business partners, operational experts, and mentors, successful investors build a hard-working, knowledgeable team around them in order to share expertise and gain insight.
  8. Network – You never know from where your next deal or opportunity may come—perhaps from a colleague, client, business partner, friend, mentor, or fellow alumnus. There are many ways to drum up new business: Attend networking events, join boards, or become a member of industry or alumni organization, to name a few.

Understanding Capitalization Rate

Some common approaches to valuing a business as a going concern involve determining a good measure of earning power and capitalizing it. This determines the value of the business to an investor based on the future returns he or she can reasonably expect. A Capitalization Rate, commonly referred to as a Cap Rate, serves as the basic metric to value a Real Estate deal. It is the yearly rate of return expected on an all cash investment in a real estate property.

For example