Seller Beware: Important Due Diligence Issues for Commercial Properties

Vacant Retail Building with For Sale Real Estate Sign

Most people involved in real estate have heard the phrase "caveat emptor" or "buyer beware." 

There are risks inherent in purchasing property: unseen structural flaws, hidden environmental contamination, and other unsuitable conditions that won't be advertised on a broker's website.  Buyers are not expected to purchase blindly—even the least sophisticated purchaser will engage in some degree of "due diligence" to learn about the asset they are hoping to acquire.  On-site inspections, appraisals, environmental testing, and other site-specific analyses are often conducted to minimize, and hopefully, eliminate those risks—to turn "buyer beware" into "buyer aware."  Less discussed are the challenges and issues that face sellers during the due diligence process.  Consideration of the risks posed by due diligence investigations can help sellers position themselves to minimize liability during a potential deal or offer them the flexibility to move on quickly with minimal cost in the event that the sale fails to close.

Landowners looking to convey their property often approach due diligence as a "you problem," something left to the potential buyer and its agents during the due diligence period of the purchase agreement.  This approach is understandable, the buyer is incurring the risk of purchasing an unknown quantity and stands to lose the most in the event that it purchases property with defects or that is unsuitable for their intended use.  Nonetheless, there are risks for a seller as well.  On-site inspections may result in damage to the property or harm to the parties conducting those investigations.  Lengthy due-diligence terms necessary to prepare architectural plans or obtain zoning approvals desired by the buyer may tie the property up without a guarantee that the transaction will close.  There is also a possibility that site preparation may result in materialmen liens, more often referred to as "construction liens" that can encumber the seller's title to the property.  Understanding these concerns, and taking appropriate steps to identify and protect against them in the purchase agreement, is essential to minimizing a seller's risk.

Premise Liability and Property Damage

Most landowners understand that they may be liable for injuries to others that occur on their property.  That same principle of premise liability applies to a potential buyer and its agents who may need to access a seller's property to perform due diligence inspections.  Often, these agents will be third-party contractors (e.g. environmental inspectors, engineers, or architects) who are engaged by a buyer.  If these parties are injured on-site, the seller may incur costs.  Even if the seller if ultimately found blameless for the injury, there may be legal costs required to defend against a claim.  There is also the possibility that on-site inspections result in damage to the property.  There are two primary ways to mitigate these risks: requiring the buyer to obtain insurance protecting against premise liability, and requiring the buyer to indemnify the seller against any claims or property damage related to due-diligence inspections.  Both of these options can, and should, be addressed in the purchase agreement executed prior to any on-site due diligence inspections.

Entitlement Problems

Most sellers have encountered entitled buyers, but in this case "entitlements" refers to zoning or other governmental permits or approvals sought by a buyer prior to closing.  Sometimes the seller will pursue these entitlements themselves to make the property more marketable or increase its value.  More commonly, the purchase agreement will allow a pre-closing period of time for the buyer to seek whatever entitlements it needs, often allowing the buyer to terminate the contract prior to closing in the event that those approvals are withheld.  There are two challenges posed to a seller in these situations: the property will be unavailable for sale to another party while the buyer pursues entitlements with no guarantee that the transaction will close and without the flexibility to sell the property for a higher price if the market changes; and if the buyer obtains the entitlements, the property may be unfit for other uses (e.g. if a buyer obtains a rezoning to pursue a particular use, the property may be unsuitable for previously permitted uses). 

If a buyer wants to tie a property up while it pursues entitlements, it should compensate the seller for that off-market time and for the risk that the market price of the property changes during the contract term.  The former can be achieved by including deposit requirements in the purchase agreement and making those deposits non-refundable after certain dates or certain milestones in the entitlement process.  For example, a buyer pursuing a rezoning on property it has under contract may be required to put funds into escrow at the execution of the contract and may lose the right to the return of those funds after six months.  Additional deposits can be contemplated in the agreement to compensate the seller for the time the property remains off-market, or to allow the buyer to extend the purchase period so that it can continue to pursue entitlements that may not be achieved during the initial entitlements period. 

The risk that the market price for the property trends upward during the term of the purchase agreement can also be addressed in the purchase agreement.  The contract may simply account for some variation in price by setting the purchase price higher for a longer term deal than a shorter one, or by building in escalation terms that reflect a set increase over time (e.g. a percentage increase in price if the closing is delayed by more than 180 days) or allowing the seller to obtain a new appraisal during the term of the contract that may modify the purchase price.  Whatever option a seller pursues, it should be conscious of the value provided by allowing a buyer time to pursue entitlements and include provisions in the purchase agreement that compensate it for the loss of opportunities that may present themselves during the term of the agreement.

Sellers should also be aware of the dangers of binding entitlements. Buyers may seek out and obtain government approvals that restrict the permitted uses for the property—which is not a problem if the buyer closes on the transaction following approval, but can be a significant burden on a seller if the transaction fails to close and they are left with an asset that has lost value.  For example, a buyer may agree to a "downzoning" from a more intense to less intense zoning use in order to garner approval for a proposed project.  If that approval is granted and the buyer fails to close on the property, the seller now has a downzoned parcel of land and may not have recourse under the purchase agreement other than the right to retain any deposit provided by the buyer.  Sellers should consider this possibility when they determine the amount of a deposit, and should also consider additional contract terms that compensate them in the event a buyer fails to perform under the purchase agreement post-entitlement.  Liquidated damages, conditional escrow funds that become non-refundable post-entitlement, or contract terms allowing the seller to seek specific performance of the purchase agreement are all options that may protect a seller in these types of situations.

Construction Liens

Most due diligence is limited to investigations of the property in its current condition, or feasibility analysis to determine whether a proposed use is compatible with the property.  Less commonly, buyers may seek to improve the property prior to closing or engage third-parties to plan future improvements.  Perhaps an existing tenant enters an agreement to purchase the property and obtains approval from the seller to construct improvements on the property prior to closing.  Or perhaps a buyer engages an architect to design improvements for the property.  Both of those situations may entitle third-party contractors to "construction liens" in the event they are not fully paid for their work.  More detail on construction liens can be found here, but the risk to a seller is that the construction lien attaches to the for-sale property, even though the seller never contracted with the lien claimant and has no obligation to pay them. 

This issue can be solved fairly easily by including two important terms of the purchase agreement.  First, require the buyer to indemnify the seller against any potential lien claimants engaged by the buyer.  Second, require the buyer to resolve any liens filed against the property or default under the contract.  Together, these provisions should protect the seller against the costs and risks associated with a lien claimant filing a lien directly against the property.

Conclusion

Due diligence is often perceived as an issue for buyers to navigate, but there are important issues for sellers to address in any purchase agreement.  Working with an experienced commercial real estate lawyer to understand and navigate those issues is an important step to avoid these potential pitfalls and ensure that a transaction goes from signature to closing without unexpected problems.

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© 2021 Ward and Smith, P.A. For further information regarding the issues described above, please contact James R. Todd.

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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