Pre-Closing Due Diligence with Commercial Real Estate Helps Avoid Post-Closing Remorse

Your business has taken off, and you've been searching for that perfect 7,500 square foot building on an acre of land close to town, with parking and a view, and you've finally found it. 

Mission accomplished, right?  Not so fast—before you become the proud new owner of that real estate, you are going to want to know many details about its past ownership, past uses, and any available information in the public records.  What you learn during your "due diligence period," sometimes called the "inspection period," will either solidify the fact that you've found your perfect piece of property, or tell you that you should terminate your contract before your due diligence period comes to an end.

Make Sure Your Contract Includes a Satisfactory Due Diligence Period


Any well-written contract for the purchase of commercial real estate will contain a provision allowing a due diligence period, during which time you, as the prospective buyer, have the opportunity to uncover key information about the real estate prior to purchasing it.  

The due diligence period in your contract should be long enough to allow you to conduct the inspections mentioned below, plus any additional ones that may be necessary to investigate whether requirements unique to your business, industry, or intended use of the property can be satisfied.  To make sure you have time to get the help you need, you should consult with prospective inspectors, such as title attorneys, surveyors, and engineers, to determine what their schedules will allow before you set a time period.

While the due diligence process can be somewhat costly, a thoroughly conducted one can help you avoid countless amounts of stress, costs, and legal liability if after you have become the new owner of the property it turns out the property has serious problems or is useless for your intended use of it.

Most often, you will place an earnest money deposit in escrow (i.e. in a trust account held by your attorney, the seller's attorney, or any real estate broker involved in your purchase).  The deposit is typically:

  • Held until the closing date, at which time it is applied towards your purchase price;
  • Returned to you if you or the seller terminates your contract prior to the end of your due diligence period or,
  • Released to the seller if you fail to terminate the contract by the end of the due diligence period and don’t close on the purchase of the real estate.  

Here is a list of key due diligence tools you and (and hopefully your attorney) should include in any purchase contract and use during this critical pre-closing period.

Title Examination


You should have an experienced real estate attorney search the legal chain of title to the property.  An effective "chain of title" search typically investigates at least the most recent 30 years of prior ownership of the property, and whether or not the prior owners placed any restrictions on the real property by way of an easement or other lien, or had a judgment or any other monetary lien imposed on them which might constitute an encumbrance on the title that you, as the new owner, may have to pay to get "good title" to the property.

An easement provides someone other than the legal owner of real estate with a right to utilize the real estate for some purpose.  For example, a prior owner may have given a neighboring business owner a right-of-way over a driveway in order for the neighboring owner and the owner's customers to access the neighbor's business.  Maybe that driveway now exists, or previously existed, right over the portion of the property on which you intend to build an expensive building!  Would you rather negotiate with that neighbor to release or move the easement before you purchase the property, or after you have bought it and, perhaps, built a multi-million dollar building over it?

Or, you're looking to purchase a busy existing bed and breakfast and find that a prior owner had once given the neighboring property owners the right to utilize the swimming pool and tennis courts located on the property back when those amenities weren't in high demand.  Once you open the bed and breakfast, and there is high demand, how will you explain the "neighbors" to your guests?

You definitely want to know if neighboring property owners or any other third parties will have the legal right to use the property you are looking to buy in any manner, especially before you actually own it. 

Alternatively, if you’re ever the one acquiring the right to utilize someone else's property, you'll want to understand the scope or limitations of that right, and whether or not you have any legal obligation to maintain the easement area.

Other easements, such as utility easements for power lines or sewer service, typically don't present any cause for concern, though your attorney will want to understand where they are located in relation to any buildings existing or to be built on the property.  

For example, if you plan to build a 20,000 square foot warehouse on a piece of property, you would want to know whether a 200 foot wide high-voltage powerline easement is located on the property, and, if so, where it might be located in relation to where you want to build.  Better to know before closing, rather than after, that there is a possibility, however small, that the out-of-state electric utility owner may one day demand that your building be moved, or that you pay the utility a lot of money to relocate its easement.

Other potential “encumbrances” on the chain of title, such as restrictive covenants, must be reviewed to ensure that your intended use of the property is not prohibited or limited in a way to make the property much less attractive to you.  Additionally, a restrictive covenant might limit where you can locate commercial signage on the property, or the type of construction that is acceptable within a commercial building or commercial business park.

Finally, any mortgages, judgment liens, or other liens that have encumbered title to the property will be documented and you can require they be paid off at closing out of the seller's proceeds, so that you acquire title to the property free of any prior owner-related liabilities.

Survey


There are many reasons why you need a survey of the property before purchasing it.  If you're lucky, the seller will have a survey that is less than 10 years old; your purchase contract should obligate the seller to share the survey and other title documents with you.  You may want to rely upon that survey if you are willing to take the risk that nothing has happened in the interim.  Otherwise, you should certainly hire a surveyor to prepare a new survey (and if you decide to “pass” on the purchase after seeing the survey, sometimes you can sell that survey to another potential buyer to recoup your expense).

A survey will allow you to see exactly where the property lines are located, if any buildings on adjacent land encroach on the property, or any building you want to use on the property you are purchasing encroaches on adjacent land.  The survey will also ensure that you have legal access to the property from public roads, either directly or with the use of an easement.  Nobody wants to purchase a parcel of real estate, only to discover that there is no vehicular access to public roads without crossing over a hostile neighbor's property.

A new survey will also reflect whether any adjacent property owner’s signage, fence, or buildings, or parking areas are encroaching on a part of the property you're about to purchase, though it may also reveal that the seller's parking lot, which you intend to use, encroaches upon your neighbor’s property! 

In such instances, you may require your seller to obtain an easement or right-of-way from the adjacent property owner prior to the closing, so that you're not required to stop using the existing parking area after closing only to find that there isn't enough room on your property to replace it, however much you're willing to spend to do so.

Sometimes, a seller will have to pay the adjacent property owner for that easement.  If the seller or the adjacent owner refuses to resolve the issue to your satisfaction, you can withdraw your offer before the expiration of your due diligence period and recover your earnest money deposit.

Either way, by getting it resolved (or having the seller resolve it) before you become obligated to purchase the property or finding it can't be resolved, you're avoiding any unexpected demands from a neighboring property owner post-closing.  You might even find a problem like this to be a negotiation point you can use to get a better price for the property, even if it wouldn't prohibit you from using the property as you intend.

If you're buying an undeveloped piece of property and intend to construct any buildings on it, you'll want a survey to show you the "lay of the land" before you begin construction.  If you're acquiring construction financing, your lender will require a survey of the unimproved property before construction, as well as an as-built survey that reflects the status of the property and the building(s) located on it once the improvements have been constructed.

Finally, your attorney might find that the legal description within the property's chain of title is quite old and unclear, or even fatally in error.  For example, if the property’s "metes and bounds" description (a legal description that uses compass points and distances to certain points of reference) makes reference to trees, creeks (or even berries and acorns resting on rocks—true story…) as the points of reference between distances, it's quite possible that those points of reference no longer exist, in which case, your description should make reference to the survey you have commissioned and recorded in the official land records prior to closing.

Environmental Inspection


Even though you may have had nothing to do with causing contamination,  unless you conducted "all appropriate inquiries" to discover whether contamination exists prior to closing, once you own the property, you're going to be legally responsible for any clean-up of contamination of the soil or water that's discovered to be existing upon, or underneath, the property.

Where the historical use of a piece of property is unknown or unconfirmed, a prudent purchaser will obtain a Phase I Environmental Site Assessment (referred to as a “Phase I”) which explores the past use of the property.  When a Phase I comes back “clean” it typically means that the research revealed no past uses of the property that could have led to contamination, and your environmental due diligence is complete.  You have then conducted "all appropriate inquiries."

However, if a Phase I reveals that the property was once used as a gas station, dry cleaners, waste dump, etc., the "all appropriate inquiries" regulation requires that you must at least obtain a Phase II Environmental Site Assessment, in which samples of soil, air, and water (as applicable) are tested for any actual contamination.  If the Phase II shows there is no evidence of contamination, you may then be insulated against liability if any contamination, in fact, exists.  In instances in which a Phase II does reveal certain contamination, you and the seller can work together to negotiate how the contamination will be addressed or remedied (and paid for) before you close.

Zoning Compliance


Your attorney will research the zoning ordinances applicable to the property, to make sure that it's current use, or your intended use (if different) is automatically allowed, or if you must apply to the zoning authority for a variance for your intended use.  This search will also reveal if you have the worst case—that your intended use is never allowed. 

This is also important if you're looking to construct a building on undeveloped land.  Knowledge of the applicable zoning ordinances will help you understand how large your improvements can or must be, the setback requirements, any use prohibitions, and any ancillary requirements for items such as parking lots and landscaping, etc.

Stormwater Facility


In certain industrial parks and commercial settings, land will be subject to a shared stormwater facility, which is designed to handle stormwater runoff and to control water flow rates.  These facilities include pipes, ditches, underground tanks, and stormwater ponds. 

You should work with an engineer to determine the existing or necessary stormwater facilities required for the property you're purchasing.  Your lawyer can also help you understand the maintenance obligations that you would owe to your fellow landowners (if any) in connection with maintaining a stormwater facility, and the necessary easements that you should obtain to have the legal right to utilize an existing stormwater facility infrastructure for the benefit of your property.

Existing Tenants


A well-written purchase contract will require the seller to inform you of any existing tenants and give you copies of all written leases that affect the property.  You will work with your attorney to determine which leases will continue to be in existence after closing (and therefore assigned to you as the successor landlord at closing), and which tenants could be given proper legal notice of their need to relocate before or after closing if you need the space they occupy for your purposes.

Financing


Before your due diligence period expires, you’ll want to have a loan commitment letter from your lender.  The letter will outline the terms of the loan the lender is willing to give you to purchase or improve the property and will provide reasonable assurance that your loan financing will be approved as long as the requirements of the commitment letter are satisfied by the closing date.  If, however, you're unable to get a necessary loan and are short of cash to close, this will not relieve you of liability to the seller for breaching your contract.  Your attorney may be able to negotiate terms in the purchase contract to limit your liability in such event.

Conclusion


While most of these tools and evaluations are easily addressed prior to the closing, it's important to work with someone you trust and to begin your investigation as soon as you have a fully signed purchase contract in hand (if not beforehand!). 

Surveys, environmental examinations, and zoning proceedings can require many weeks or months to conduct and conclude, and the clock starts ticking when the parties have a fully executed contract.  While it may seem daunting, with careful and diligent examination before you're the new owner, you'll avoid any post-closing remorse.

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© 2019 Ward and Smith, P.A. For further information regarding the issues described above, please contact Joanne Badr Morgan.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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