WHEN EXERCISING REAL ESTATE OPTIONS – Strict Compliance is Your Only Option

Options affecting real estate are commonly found in two circumstances: options to purchase real estate and options to extend the term of a lease. A recent decision by the Illinois Appellate Court filed February 28, 2018 in the case of  Michigan Wacker Associates, LLC v. Casdan, 2018 IL App (1st) 171222 concerns an option to extend the term of a lease, but its reasoning is instructive for real estate options generally. Strict compliance is required.

The Option to Extend Lease

In Casdan, the lease had an initial term ending December 31, 2011, but provided for two additional options to extend the lease, stating as follows:

“Tenant shall have the option to extend the term of this Lease for two additional five (5) year periods . . . the First Extension Option (expiring December 31, 2016) . . . and the Second Extension Option, (expiring December 31, 2021). The option to renew shall be exercised with respect to the entire Demised Premises only and shall be exerciseable by Tenant delivering the Extension Notice to Landlord, in the case of the First Extension Option, on or prior to January 1, 2011, and in the case of the Second Extension Option, on or prior to January 1, 2016, in all cases, time being of the essence.”

Required Notice

The lease also contained a provision governing notices that provided, in part, that “Except as otherwise expressly provided in this Lease, any . . . notices . . . or other communications given or required to be given under this Lease . . . shall be deemed sufficiently given or rendered only if in writing . . . sent by registered or certified mail (return receipt requested) addressed to the Landlord at Landlord’s address set forth in this Lease . . .; or to such other address as . . . Landlord . . . may designate as its new address for such purpose by notice given to the other in accordance with the provisions of this Article 27.”

The lease also provided that landlord could waive strict performance of a lease term only by executing a written instrument to that effect and, even then, the waiver of one breach would not result in the waiver of subsequent breaches.

Imprecise Exercise

On November 9, 2010, the tenant, through its attorney, sent a written extension notice to extend the lease term for the First Extension Option via Federal Express rather than via registered mail or certified mail as provided under the express terms of the lease. Landlord did not dispute the notice and treated the notice as having effectively extended the term of the lease to December 31, 2016.

Subsequently, the tenant claims to have effectively exercised the Second Extension Option to extend the term to December 31, 2021. On August 16, 2012, tenant, again through its attorney, emailed landlord raising matters tenant “would like to discuss”, and included the following statement: “We are now in the first of two (2) five (5) year options. Tenant would like to exercise the second option now, so we don’t have to do this again as soon. . .”

There were additional proposals and suggestions in the email that create issues concerning the definiteness of the purported exercise of the Second Extension Option, but for purposes of the court’s ruling in Casdan, it is unnecessary to address that concern.

Claim That Landlord Received Actual Notice

Tenant’s position was that through various conversations and emails occurring prior to January 1, 2016, landlord received actual notice of tenant’s exercise of the Second Extension Option. Before and after January 1, 2016, tenant made clear to landlord that tenant wanted to remain in the Demised Premises, make various leasehold improvements, and renew the lease. Further, because the landlord had accepted notice of exercise of the First Extension Option by means other than as strictly provided under the terms of the lease, landlord could not insist upon strict adherence to the terms of the lease for exercise of the Second Extension Option.

The Trial Court Ruled in Tenant’s Favor

Following a hearing, the trial court entered summary judgment in tenant’s favor, finding that the August 16, 2012 email was a clear and unambiguous exercise of the Second Extension Option.

The Appellate Court Reversed

On appeal, the trial court’s summary judgment ruling was reviewed de novo, with the appellate court noting that “we review the court’s judgment, not its reasoning,” and reversed the trial court’s judgment in favor of tenant.

The Appellate Court’s Reasoning

In explaining its decision, the Casdan court stated as follows (omissions from text are not noted):

Our supreme court’s seminal decision in Dikeman v. Sunday Creek Coal Co., 184 Ill. 546 (1900), remains the leading authority on option matters. The contractually mandated time for performance is generally an essential term of a contract. Unless that term is waived, an option is lost due to untimeliness. Discussing the nature of the option before it, Dikeman stated “[the] agreement was purely a privilege given to the lessee without any corresponding right or privilege of the lessor, and the only stipulation was that the right should be exercised at a certain time.” Id. at 551.

Since Dikeman, courts have generally required strict compliance with options. See T.C.T. Building Partnership v. Tandy Corp. 323 Ill. App. 3d, 114, 115, 119-120 (2001) (treating the method for exercising an option as a condition precedent requiring strict compliance). Strict compliance is dictated not only by precedent, but by the needs of commercial transactions and fairness. Options to cancel or extend commercial leases are invaluable to a lessee, and a lessor generally does not receive consideration for the lessor’s agreement to be bound by an exercise of the option. Thus, a lessor may insist on a writing to further certainty as the lessor foregoes other opportunities to lease the space.

Consequently, actual or oral notice is insufficient to exercise an option where a party has failed to provide timely notice. Furthermore, cases finding actual notice to be sufficient outside the options context have no bearing on notice in option cases.

In addition, tenant does not dispute that it failed to strictly comply with the method of notice prescribed by the lease. Instead, tenant argues that actual notice is a sufficient substitute for the lease requirements and landlord waived strict compliance with the requisite method of notice.

Dikeman and its progeny clearly defeat tenant’s assertion that actual notice is sufficient.

See Casdan, 2018 IL App (1st) 171222, ¶¶ 33-37.

Key Lesson Learned . . .

One of the key lessons to be learned from Michigan Wacker Associates, LLC v. Casdan is that exercising an option – any option – is not a casual undertaking. Strict compliance with the method of exercise specified in the option instrument is essential. It must be specific, certain, and unconditional. It must also be timely, and the method of notice of exercise must strictly adhere to the notice requirements of the option instrument. Even actual notice of an attempted exercise of an option will not suffice if strict compliance with the method of exercise is not observed.

Thanks for listening . . .

Kymn

Lawyers are like most other business professionals. We want your business and we want your referrals – we just don’t always know the best way to ask for either.

Take me for example. I’ve been handling commercial real estate transactions and business deals for nearly 40 years. I’ve loved (almost) every day of it, and I look forward to many more (knock on wood). My clients appreciate my insights and value the guidance I provide. Other attorneys respect what I do, and brokers and CPAs like working with me because I strive for practical solutions to efficiently and effectively get the job done. I pay close attention to learn my clients’ business objectives, then work diligently and negotiate hard to get my clients what they expect – when they expect it. That’s what lawyers do. Or at least what all lawyers should do. For any client hiring a lawyer, what else is there?  Achieving client objectives and getting the deal closed on time is why lawyers exist. Deals fail, for sure, but we can never be the reason they fail. Deals that fail are a waste of everyone’s time and money. Getting the deal done, if it can be done, is our value proposition.

Deals are my lifeblood – my passion. They’re why I wake up every morning and get out of bed. I love this stuff. I can’t explain exactly why that is – it just is.  Why do musicians practice their instruments and play? Why do scratch golfers golf? Why do competitive skiers ski?  It’s our passion. We don’t know exactly why – it comes from within. And we always need more.

Commercial real estate deals always come first for me, but in every commercial real estate project is a business. They go hand in hand. My preference for a good real estate deal over a good business deal is a matter of only slight degree. There’s not really a number one and a number two. It’s more like #1 and #1A.

So what’s the problem?

The problem is, a lot of people don’t know I’m available to represent them. I write books and articles on commercial real estate. I give seminars on how to structure and close business and real estate transactions. I publish a commercial real estate and business blog.  People think I’m busy, or that I only handle huge deals. The truth is, I am busy – but never too busy to handle another deal, large or small. In the words of the late, great Lucille Ball: “If you want something done, ask a busy person to do it.” We all loved Lucy!

The most shocking question I get from prospective clients is: “Would you (I) be willing to handle my (their) next business or commercial real estate deal?”  Are they kidding? My answer is always an emphatic “yes”! It’s my passion. It’s my love.  It’s what I live for.

To be sure, I’m a business professional, and I charge for what I do, but if you have a commercial real estate deal or business deal, and need representation, I’m in. Never be shy about calling me. We’ll work out the economics. The range of deals I handle is extraordinarily diverse. For a taste, look at my blog Harp-OnThis.com, or check out my latest book, Illinois Commercial Real Estate on Amazon.com or in your local public library. I love this stuff. I need this stuff. Of course I want to represent you. When can we get started?

So back to my initial point:  I do want your business and your business referrals. Like many other business professionals, I just don’t know the best way to go about asking for it. What do you suggest?

A mistake lawyers make is treating all clients the same. It’s a mistake shared by other professions as well. They’re not all the same. The issues clients face, and the solutions they deserve, are as varied as life itself.

With the rise of technology and the commoditization of legal services, nuance can be lost. Precise solutions to particular problems may be neglected while cookie-cutter boilerplate is offered as a cheap substitute. Not that all boilerplate and technology is bad – they can provide huge benefits when applied correctly. But just as a mass-produced size 9 leather dress shoe may be ideal for some, it is of little comfort or use to an athlete with a size 10 foot.

Automation is a cost-saver, no doubt. But is it a reasonable substitute for thoughtful analysis and tailor-made solutions to client specific problems?

There may be areas of life where commoditized legal services represent a reasonable tradeoff. Perhaps consumers engaged in everyday transactions are adequately-served by inexpensive one-size fits all solutions. Even a consumer buying a home – often touted as the largest single transaction most consumers will make in their lifetime – may be well-served by inexpensive boilerplate solutions on most occasions. In the world of consumer transactions and consumer finance, there is a protective overlay of consumer protection laws and oversight that will often fill in the gaps left by a one-size fits all approach.

But what about most commercial transactions? Buying or starting a business? Investing in commercial or industrial real estate? Raising capital from third parties? Entering into a partnership agreement or limited liability company operating agreement for a commercial venture where someone else is in control, and uses or controls your money – or where you use or control someone else’s money? Are these circumstances where one-size solutions and documentation make sense?

How do you protect yourself if something goes wrong? Experience shows something can always go wrong. And when things go wrong in a commercial transaction, expensive lawsuits often follow.

Business people consider themselves to be intelligent, reasonable beings. When they invest in a business or real estate project they expect it will succeed. If they thought otherwise, they would not make the investment. That would be foolish, and they know for certain that they’re not foolish. If it fails, they conclude it had be someone’s fault – but it certainly wasn’t theirs.  They must have been duped. Information must have been withheld. They must have been lied to or cheated.  The other party must at least be incompetent if not downright crooked.

You may laugh, but that’s often how it happens. You may be one hundred percent competent and above-board. You may have understood and discussed the risks to the point where you are certain that your partners or investors understand the risks as well – but if you’re the promoter of the failed business or investment, or you’re in charge of making management decisions – you should expect to find yourself staring down the business end of a double-barreled lawsuit claiming the loss is your fault – even if you lost money as well, and even if nothing you did or could have done resulted in the loss. Changing economic circumstances, business and lifestyle trends, and other factors far beyond your control may be the reason for the loss, but you will be blamed. How do to protect yourself?

Suppose you’re on the other side. What if you’re the investor or partner asked to invest? What do you look for? What do you require? How do you protect yourself?

Clients are not all the same. Commercial transactions are not all the same. The risks and benefits of each investment and business venture are not all the same. The solutions and documentation of each transaction cannot, therefore, be all the same.

If clients are engaged in serious business, serious attention is required. Both the attorney and the client need to understand this. Once a deal goes bad, it’s too late to go back and redo what should have been done at the outset.

Will doing it right up front cost more?

Probably.

Will it be worth it if things go poorly?

You bet.

Should clients buy a size 9 shoe for their size 10 foot?

Thanks for listening. . .

Kymn

COMMERCIAL LEASES AND THE LAW OF ELECTRONIC TRANSACTIONS

By Guest Authors: David P. Resnick and Seth Corthell

Most commercial leases are forged by a deliberate, organic process that includes face-to-face meetings, telephone calls and written correspondence between the landlord, the tenant and their respective agents, culminating in a written contract that historically was required to be signed by hand by both parties.  Over the past 20 years, the rise of email as a generally-accepted medium of business communication has prompted the law to allow certain contracts, including leases, to be entered into electronically, without a handwritten signature.  Progress has been made in this respect, both by statute and the common law; however, tweaking a centuries-old legal axiom takes time.  This article addresses recent developments and the present state of the law with respect to commercial leasing and electronic media.

The Historical Basics 

Under the law, all leases are contracts.  As such, leases require certain basic legal components to be enforceable.  Every contract must state definite terms and include a grant of consideration and mutuality of agreement and obligation between competent parties.  In order to be valid, contracts require offer and acceptance by the parties.

In addition, almost all leases are subject to the statute of frauds.  Patterned after an English statute enacted in 1677, the statute of frauds is the legal doctrine that certain contracts – including leases and other contracts affecting any interest in land – be contained in a written, signed instrument.  Certain exceptions commonly apply, notably to short term (i.e. less than one year) leases.  But prior to recent developments, the law was relatively straightforward:  Real estate contracts must be in writing to be enforceable.

The Culture Evolves

In light of this precedential legal backdrop, many questions arise from our increasing reliance on email in commercial leasing.  For instance, can an email or series of emails constitute a written lease?  Can an electronic signature on a lease bind a party in the same way as a handwritten signature?  Short of an ink-signed paper document, what might constitute a binding lease?

In 1999, in response to questions like these and calls for clarity on the use of electronic media for business transactions, the Uniform Law Commissioners promulgated the Uniform Electronic Transactions Act (UETA).  The UETA was the first effort to create a uniform set of laws with respect to electronic commerce, and 47 states have adopted it since its release.

Section 7 of the UETA contains the fundamental rules of the act:

• A record or signature may not be denied legal effect or enforceability solely because it is in electronic form.
• A contract may not be denied legal effect or enforceability solely because an electronic record was used in its formation.
• If a law requires a record to be in writing, an electronic record satisfies the law.
• If a law requires a signature, an electronic signature satisfies the law.
•  

In short, the objective of the UETA is to establish that in the context of applicable transactions, electronic signatures are the equivalent of manual signatures and electronic records are the equivalent of hard copies.  A stated “paradigm” of the UETA is that it applies only to parties to transactions who have each acquiesced by some means to be bound electronically.  Moreover, under the UETA a party may always refuse to be bound by electronic correspondence.

Application

While case law is plentiful with respect to electronic communications and application of the UETA, the common law is still evolving as to the application of these topics in the context of  commercial leases and other real estate contracts.  A few notable cases highlight the complexities and pitfalls inherent in adjudging the enforceability of contracts without historically reliable handwritten signatures.

Though not ultimately related to a lease, St. Johns Holdings, LLC v. Two Electronics, No. 16 MISC 000090, 2016 WL 1460477 at *3 (Mass. L.C. April 14, 2016) is an example of a court’s willingness to expand its interpretation of the statute of frauds in the context of electronic communications.  In that case, the plaintiff, St. John’s Holdings (SJH) contacted the broker of defendant Two Electronics (T-E), first seeking to lease T-E’s property and later seeking to purchase the property instead.

Following a period in which the parties exchanged and negotiated draft purchase agreements through their respective agents, T-E’s broker sent a text message to SJH’s real estate agent stating that T-E wanted SJH to sign the purchase agreement first and provide the deposit check before T-E would finalize it.  At the end of the message, T-E’s broker (bearing authority for T-E) wrote his name.  The same day, SJH’s agent went to the office of T-E’s broker and delivered the check and the signed agreement.  Unbeknownst to SJH or its agent, T-E had a competing offer from a third party, and had accepted the other offer the same day it received the signed agreement from SJH.  T-E then refused to execute the agreement with SJH.

SJH subsequently brought an action for a declaratory judgment that the contract was executed, and for specific performance of the contract.  T-E moved to dismiss, arguing that SJH could not allege that T-E ever provided a signed writing compliant with the statute of frauds grounds.  SJH argued that the broker’s name at the bottom of the text message from T-E’s agent was sufficient to satisfy the statute of frauds.

The court ultimately agreed with SJH, finding that the text message in question, read in conjunction with the previous negotiation communications between the parties satisfied the requirements of the statute of frauds.  In coming to this conclusion, the court noted the evolution of business practices and the prevalence of electronic communications in business transactions.  The court analogized the broker’s name at the bottom of the text message to an electronic signature at the bottom of an email and deemed it sufficient to satisfy the statute of frauds’ signature requirement.

Similarly, Crestwood Shops, LLC v. Hikene, 197 S.W.3d 641, 644 (Mo. Ct. App. 2006), demonstrates the significance courts will apply to email correspondence under the UETA in adjudicating the validity of contractual offer and acceptance.  In that case, tenant Hikene sought to lease larger retail space in a shopping center from the landlord, Crestwood Shops, LLC.  The parties entered into a five-year lease, but following commencement of the term, Hikene identified several problems with the new space, including mold on the premises, a defective HVAC system, and foundation issues.  As Hikene made preparations to renovate the new space, she brought the issues with the property to Crestwood’s attention.

Communications between Hikene and Crestwood became increasingly contentious, and both parties thereafter agreed to correspond in writing only.  Following her continued dissatisfaction with Crestwood’s response to the space issues, she stated in an email her desire to terminate the lease if the problems were not corrected by a date certain.  The next day, Crestwood responded that they accepted Hikene’s request to be released from the lease as of the stated date.

Hikene sought a declaratory judgment that the lease was not terminated, arguing that she did not agree to conduct her business transactions electronically and that she did not intend her email to be an offer to terminate the lease.  The court disagreed, ruling that the parties consented to the conduct of business through email, and that Hikene’s email constituted an offer to terminate that satisfied the statute of frauds.  In coming to its decision, the Court noted that the UETA instructs fact-finders to consider the “context and surrounding circumstances, including the parties’ conduct.”  Following this directive, the court determined that Hikene’s March 17 email insisting that the parties communicate through email demonstrated her willingness to transact business through email.

Clarity Is Key

As the legal regimes associated with electronic communications evolve, a variety of measures are available to parties to a lease in order to avoid being bound without intent.  For instance, landlords and tenants transacting electronically may ensure that a lease proposal or draft lease document is not exploited as an offer by including the following common language in each cover transmittal:  “Nothing herein shall be deemed or construed to be an offer by [sender], and [sender] shall not be bound unless and until such time as all parties have delivered fully-executed documents.”  And persons transmitting via email should always be aware that their electronic signature may be deemed to have the same legal effect as their handwritten signature.

As a general proposition, if a party wishes to confirm that it will not be bound by electronic correspondence, it is always wise to do so in writing.  The requirement in the UETA that a party must agree to conduct business electronically need not be established by an explicit statement; rather, it may be satisfied by an interpretation of context and conduct.  To be clear, parties to a lease are advised to reduce to writing their consent, or withdrawal of consent, to be bound in this manner.

Not long ago, commercial leases would take weeks to negotiate, draft and finalize.  Like virtually every other area of commerce, technology has streamlined the leasing process such that today, leasing transactions are completed with lightning speed.  Leasing professionals should be mindful of the hazards of doing business electronically and should consider the legal consequences of every email.

David P. Resnick is a member of the Board of Editors of the Commercial Leasing Law & Strategy newsletter.  He is a Shareholder at Robbins, Salomon & Patt, Ltd. in Chicago, concentrating his practice in commercial real estate development and finance.  Seth Corthell is an attorney based in Chicago, Illinois.

Reprinted with permission from the May 2017 edition of the Commercial Leasing Law & Strategy ©2017 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

It is not uncommon for commercial real estate investors to pool their funds for real estate investments. To obtain project financing, equity requirements remain relatively high. Loan to value ratios are in the 60% to 70% range in many circumstances. Even a modestly priced commercial project with a $5,000,000 price tag may require equity in the range of $1,500,000 to $2,000,000. The greater the price tag, the higher the equity requirement. A Real Estate PPM is an important tool when raising funds from outside investors for a real estate project.

TYPICAL INVESTMENT STRUCTURE

Private real estate investments are typically structured through a manager-managed limited liability company (LLC), with the project promoter or its affiliate named as the manager. Oftentimes, the business terms of the transaction will include a cumulative preferred return to equity investors, an attractive internal rate of return to equity investors until all capital is returned, and a waterfall that provides for a disproportionate percentage of distributable cash to be used toward repayment of the equity investment until it is repaid in full, followed by a permanent allocation of profits and losses based on percentage of ownership.

OUTSIDE INVESTORS – PROS AND CONS

The advantage to the promoter in raising capital from outside investors is that it places the promoter in a position to acquire and control more and larger real estate projects. A disadvantage to promoters is that they must give up a meaningful piece of project ownership and anticipated profits in return for using other people’s money.

 An advantage to outside investors is that they may realize high investment returns and certain tax advantages by participating in a real estate investment. A disadvantage is that they typically have little direct control over the project and must rely upon the knowledge, skill and efforts of the promoter to make money. Of course, if the outside investors don’t possess the knowledge and skill themselves, relying on an experienced real estate promoter may be their best bet for taking advantage of the opportunities real estate investment has to offer.

DUE DILIGENCE AND THE REAL ESTATE PPM

Whether investing in a stabilized real estate project, a project to be newly constructed, or a value-add project requiring redevelopment, renovation, or adaptive reuse, careful evaluation of the benefits and risks always require knowledgeable investigation using due diligence.

A good place for an outside investor to begin is by closely reading the investment PPM (private placement memorandum) which an outside investor should expect to receive from the promoter before making an investment. A well drafted Real Estate PPM will describe the project, the relevant history and experience of the promoter, sources of funds, uses of funds, material terms of the investment, including transfer restrictions, the exit strategy, and the identifiable risks of the investment and the project.

The Real Estate PPM, however, is only the beginning. A conscientious investor needs to go beyond the statements in the PPM to gain an understanding of the underlying real estate project itself, not unlike a conscientious lender would – but even more so, since the interest of an equity investor is subordinate to the interest of any secured lenders. If the prospective investor does not have the direct knowledge and expertise to evaluate and understand the underlying real estate project, it is highly advisable for the prospective investor to hire an advisor, attorney or consultant who has the skill-set to conduct the evaluation.

PPM – A DEFENSE DOCUMENT

Promoters sometimes resist preparing a fully developed PPM because they believe (naively) that it is an unnecessary burden and needless expense. Realistically, however, it is essential and its cost is a cost of raising money from outside investors.

Some promoters discount the value of a carefully prepared PPM because they think of it as a marketing brochure. With that belief, they conclude that their investors don’t need an expensive marketing brochure prepared by a lawyer. In truth, a PPM is not a marketing brochure. It is a critical defense document. Like insurance, it is only a waste of money if you never need it. Even the most well thought-out real estate project may not turn out as planned, or may not result in the impressive profits anticipated at the outset. In that case, believe it or not, there is a meaningful risk that the investors will sue – especially if they end up losing money.

Anytime a person is making a passive investment with the expectation that profits will be derived solely through the efforts of another, the investment is, by definition, an investment contract and, by extension, a security.  The party offering the security is required by law to make a whole host of disclosures to make sure the investor is fully informed of all material facts and risks. Failure to adequately describe the investment and disclose known and foreseeable risks exposes the promoter to serious potential liability under applicable securities laws and regulations.

When the investors sue, it will be for on a variety of theories, including breach of contract, fraud in the inducement, common law fraud, negligent misrepresentation, and violation of applicable securities laws. The investors will allege that the promoter made all kinds of promises and told the investor all kinds of things regarding the project and the investment, which the promoter knew, or should have known, were false.  The investor will also claim the promoter concealed or failed to disclose facts and risks known to the promoter which, if disclosed, would have caused the investors to decline making the investment. Since securities laws provide investment rescission rights and impose near strict liability on a broad range of promoters and persons controlling the investment, the promoter and its principal advocates can be exposed to significant personal liability absent an effective and reliable defense.

A well-crafted PPM can be highly effective in providing a strong defense by spelling out, in writing, all the material details and assumptions of the project and the investment, and all known and foreseeable risks inherent in the project and the investment. It will also limit the right of the investors to rely upon only the matters expressed in the PPM, and will clarify the distinction between statements of fact, and forward looking projections which constitute matters of opinion or belief which cannot reasonably be relied upon. As such, the Real Estate PPM is a powerful defense tool that no real estate promoter seeking investment from outsiders should go without. If things go poorly, it will be the firewall between the investors’ loss and the personal liability of the promoter.

INVESTOR RELIANCE ON PPM

From the investors’ perspective, the PPM is a valuable tool as well. If meticulously crafted, it will disclose the material details of the project and the investment, and will point out risks the investor should consider, even if they are risks the investor is willing to accept.   The investor will have the right to rely upon the facts and details set forth in the PPM unless expressly qualified or limited. If the PPM misstates the facts or omits to disclose known or knowable risks, the PPM can serve as a powerful piece of evidence in a claim against the promoter. It is precisely this evidentiary risk that impels promoters to dot the i’s and cross the t’s to make sure the PPM is complete and accurate – which makes it a valuable source of information for the prospective investor.

PROJECT DUE DILIGENCE BY INVESTOR

Even with the inclusion of necessary facts and disclosures in the Real Estate PPM, a detailed analysis and discussion of certain real estate fundamentals underlying the project may not fall within the purview of the PPM. If the disclosed risks are carefully crafted with broad language, in may be up to the prospective investor, in the exercise of due diligence, to evaluate the underlying project to confirm the suitability of the property for its envisioned use.

Due diligence by the investor is always appropriate. If the prospective investor does not have the knowledge on its own to understand real estate fundamentals, it is incumbent upon the investor to engage a real estate professional who possesses the necessary knowledge.  Regardless of whether a failure to adequately disclose and address gaps in the underlying project fundamentals is sufficient to expose the promoter to liability, imposing liability on the promoter is not the object of the investment. The object of the investment is to put the investor’s money to work in a profitable venture that will yield a favorable return – not a lawsuit.

*                      *                      *

Whether raising money from outside investors, or considering an investment in a real estate project as a passive outside investor, a well-crafted Real Estate PPM is a vital component and critical step. Ignore it at your own peril.

Thanks for listening,

Kymn

WHY DEVELOP AIR RIGHTS?

Prime commercial land is limited. Prices per square foot can be astronomical. Demand for efficiency to maximize return on investment is growing. No wonder developers and property owners are looking to the sky, with varying degrees of success, to capture all the value they can from each urban parcel. Air rights development may be the solution you are looking for.

Owners and developers, and people in general, are conditioned to think of potential development sites as flat surfaces with essentially two dimensions: north/south and east/west. They see only the surface of the land, and envision the building they will construct for the particular purpose they have in mind; a bank, a drugstore, a restaurant, a strip mall, a parking garage, an office building. If the parcel is larger than they need, they may envision subdividing the parcel to make two or more lots. In most cases, however, they think primarily in terms of land coverage for the type of building they need. They visualize only the two dimensional space depicted on their Site Plan or Plat of Survey.

In 30 out of 50 states, including Illinois and all other Mid-Western states, the “Rectangular Survey System” is in effect. The Rectangular Survey System was adopted in 1785 to meet the needs of the Federal Government as it faced the challenge of dividing vast areas of undeveloped land lying west of the original 13 colonies. The system, developed under the direction of Thomas Jefferson, essentially divides the United States into rectangles, measured in relation to lines known as Meridians and Base Lines.

Development lots are instinctively viewed as the two-dimensional surface of land visually representing a potential development parcel. Descriptions of a parcel typically refer to “a parcel of land X feet by Y feet” located in relation to an intersection or other identifiable landmark.

Once a parcel is “developed”, or designated for development, by construction of improvements on the land, it is natural to think of the parcel as being unavailable for further development (unless the existing improvements are to be demolished).

Classic examples of this are single story commercial buildings at prime commercial locations, a multi-deck parking garage or mid-rise building in a downtown development area, railroad tracks or spurs cutting across valuable urban land and, in some cases, roadways and alleys.

Each of these situations represent, potentially, under-utilization of valuable real estate. Finding a way to develop the “air” above these existing or planned improvements maximizes the economic utility of these parcels and can be like creating “money from thin air.”

The practice of finding ways to utilize the “space above” is often referred to as “air rights development”. Air rights development requires thinking in three dimensions, and requires serious design consideration and legal planning but, when land values are at a premium and zoning permits, the economic return may be dramatic.

Though often overlooked, virtually all of Chicago’s downtown business district is a “city in the air“. People tend to think of streets and street level entrances to buildings in the downtown Chicago “loop” as being at “ground level”. This is simply not the case. Most of what is thought of in the Chicago Loop as being at “ground level” is located 12 to 22 feet above the earth’s surface. This explains the vast network of “lower” streets and passageways in downtown Chicago, such as “Lower Wacker Drive”, “Lower Dearborn Street”, “Lower State Street”, etc. which most people seldom traverse. It also explains why, in 1992, the Chicago Loop business district was virtually shut down by “the Great Loop Flood of ’92”, but few people got wet or even saw any water as office and retail buildings were closed and workers were sent home because of “flooding”.

The point of these observations is to reveal that “development of air rights” is not new. It is also not “. . . some exotic legal manipulation of doubtful efficacy dreamed up by big city lawyers for use only in big cities”. Development of so-called “air rights” is little more than efficient use of a limited resource when use becomes economically feasible and beneficial.

WHAT ARE “AIR RIGHTS”?

“Air rights” are part of the “bundle of rights” constituting fee simple title to real estate. The term “air rights” generally refers to the right of the owner of fee simple title of a parcel of land to use the space above the land. If this right did not exist, it would not be possible to

Due diligence is essential when investing in, developing or financing commercial real estate. You must know the right questions to ask, and where to find the answers. The object is not simply to get to closing, but to assure that the project will function as intended after closing.

Due diligence is a standard of conduct. It is the amount of diligent inquiry due under the circumstances of your particular transaction. It requires that you determine, confirm and answer “yes” to every question required to be answered in the affirmative, and that you determine, confirm and answer “no” to every question required to be answered in the negative, for your project to proceed to closing and function as intended after closing.

In commercial real estate transactions, there are two layers of due diligence:

1. Transaction due diligence; and
2. Property due diligence.

TRANSACTION DUE DILIGENCE

In any commercial transaction, transaction due diligence requires that we ask and know the answers to fundamental questions in seven particular areas of concern. These areas of concern include the six elements of every story-line, plus authority of the parties to act.  Transaction due diligence requires that you determine, confirm and know the answers to each of the following:

1.  Who are the parties to the transaction?

a.  Seller

b. Buyer

c. Lender

d. Tenants

e. Other

2. What property is included?

a. Real estate

b. Personal property

c. Franchise agreements or rights

d. Other

3. Where is the property located?

4. Why is the property being acquired? – Intended use?

5. When must it Close? And other critical dates?

a. Due diligence period

b. Title delivery deadline

c. Survey delivery deadline

d. Financing deadlines

e. Section 1031 identification period and replacement property acquisition deadlines

f. Other critical dates

6. How will the transaction be structured?

a. Sale

b. Lease

c. Section 1031 exchange

d. Seller financing

e. Other transaction structure issues

7. By what authority are the parties acting?

a. Board approval, if necessary

b. Shareholder approval, if necessary

c. Governmental approvals, if necessary

d. Manager authority under LLC Operating Agreement

e. LLC member consent, if necessary

f. Landlord consent, if necessary

g. Lender consent, if necessary

h. Any other required consents or approvals or other sources of authority

When the “what” of Transaction Due Diligence is commercial or industrial real estate, the next step is to conduct an investigation of the property using all appropriate due diligence. Property due diligence is describes below.

PROPERTY DUE DILIGENCE

Property due diligence has four additional areas of concern. As discussed below, the four major areas of concern for property due diligence are market demand, access, use and finances. All of the questions concerning the property that need to be asked and answered when investing in, developing or financing commercial or industrial real estate fall within one or more of these four major areas of concern.

Property due diligence requires that you determine, confirm and know the answers to each of the following:

 1. Market Demand

a. How will the property be used?

b. Who are the intended users?

c. Is there a need – and more importantly, will there be a need at the time the project is completed?

2. Access

a. How will users get to the property?

b. Are there adequate traffic controls, stoplights, stop signs, etc.?

c. Adequate drives for customers and deliveries?

d. Sufficient roadway stacking room at nearby intersections?

e. Lawful curb-cuts?

f. Full access vs. right-turn only?

g. Adequate parking for business needs (which may be more than zoning requirements)?

h. ADA compliant/handicap accessible?

i. Any other access requirements or impediments?

3. Use

a. Any private land use controls/restrictions on use?

b. Proper zoning?

c. Sufficient parking as required by zoning?

d. Sufficient occupancy capacity?

e. Adequate utility service?

f. If buyer is acquiring the property for its own use, are there any existing tenants or users that must be terminated or removed? Can they be lawfully  removed?

g. Environmental issues? (which may be as much a finance issue as a use issue)

h. Other use requirements or issues?

4. Finances

a. Financing

i.   Appraised value?

ii.  Loan to value – equity requirement?

iii. Terms of financing?

iv.  Lender required due diligence expenses?

v.  Lease subordination required?

x. Subordination Non-Disturbance and Attornment (SNDA) Agreements?

y. Tenant Estoppel Certificates?

vi.  Other lender requirements?

b. Financial Metrics

i.  Real estate taxes and special assessments?

ii. Rehab/repair costs?

iii. User fees and recapture costs?

iv.  Environmental remediation costs?

v.   Leases?

1.  Lease income?

2. Security deposits?

3. Rental abatement?

4. CAM and operating expense reconciliations?

5. Landlord obligations to Tenants for build-out, etc.?

vi.  Other financial benefits and burdens affecting the property?

RESOURCES

Many of the white papers and posts on this blog delve more deeply into due diligence issues and concerns.   You may find particularly useful my post Due Diligence Checklists: for Commercial Real Estate Transactions.

Should you need assistance, we have a number of attorneys at Robbins Salomon & Patt, Ltd. who are experienced commercial real estate practitioners and can help. Do not hesitate to reach out to us. We are always looking for new clients with interesting or challenging projects.

Enjoy!

When something breaks in a commercial space, who is obligated to make the repair?

Absent a covenant in a lease obligating the landlord to make repairs, a landlord generally has no obligation to repair the leased premises, unless the landlord has actual knowledge of a defect at the time of entering into the lease and fraudulently conceals it. Baxter v. Illinois Police Federation, 63 Ill.App.3d 819, 380 N.E.2d 832, 835, 20 Ill.Dec. 623 (1st Dist. 1978); Elizondo v. Perez, 42 Ill.App.3d 313, 356 N.E.2d 112, 113, 1 Ill.Dec. 112 (1st Dist. 1976).

It is clear, however, that when a lease provides express covenants assigning responsibilities between landlord and tenant for repair and maintenance of leased property, those covenants will supersede any implied or common-law covenants and shall determine the responsibilities and liability of the respective parties. McGann v. Murray, 75 Ill.App.3d 697, 393 N.E.2d 1339, 1342, 31 Ill.Dec. 32 (3d Dist. 1979); Hardy v. Montgomery Ward & Co., 131 Ill.App.2d 1038, 267 N.E.2d 748, 751 (5th Dist. 1971). An express covenant to repair will not be enlarged by construction. Kaufman v. Shoe Corporation of America, 24 Ill.App.2d 431, 164 N.E.2d 617, 620 (3d Dist. 1960). The ordinary meaning of the word “repair” is to fix, mend, or put together that which is torn or broken. It involves the idea of something preexisting that has been affected by decay. Sandelman v. Buckeye Realty, Inc., 216 Ill.App.3d 226, 576 N.E.2d 1038, 1040, 160 Ill.Dec. 84 (1st Dist. 1991).

A general covenant of a tenant to keep the premises in repair merely binds the tenant to make only ordinary repairs reasonably required to keep the premises in good condition. Quincy Mall, Inc. v. Kerasotes Showplace Theatres, LLC, 388 Ill.App.3d 820, 903 N.E.2d 887, 230, 328 Ill.Dec. 227 (4th Dist. 2009); Sandelman, supra, 576 N.E.2d at 1040. It does not make the tenant responsible for making structural repairs. Kaufman, supra, 164 N.E.2d at 620; Expert Corp. v LaSalle National Bank, 145 Ill.App.3d 665, 496 N.E.2d 3, 5, 99 Ill.Dec. 657 (1st Dist. 1986); Mandelke v. International House of Pancakes, Inc., 131 Ill.App.3d 1076, 477 N.E.2d 9, 12, 87 Ill.Dec. 408 (1st Dist. 1985).

Alterations or additions of a structural or substantial nature that are made necessary by extraordinary or unforeseen future events not within the contemplation of the parties at the time of lease execution are ordinarily the responsibility of the landlord. Expert Corp., supra, 496 N.E.2d at 5. Likewise, renewals or replacements that would last a lifetime rather than maintain the condition of the premises are extraordinary repairs outside the scope of a tenant’s obligations under a general covenant of repair. Sandelman, supra, 576 N.E.2d at 1040; Schultz Bros. v. Osram Sylvania Products, Inc., No. 10 C 2995, 2011 WL 4585237 at *3 (N.D.Ill. Sept. 30, 2011). When a deficiency is so substantial and unforeseen that it would be unreasonable to expect the tenant to make repairs that basically benefit not the tenant but the landlord, those repairs may be deemed structural. Baxter, supra, 380 N.E.2d at 835.

In order to shift to the tenant the responsibility to make structural or extraordinary repairs to the leased premises, a lease must

RESALE DISCLOSURE CHALLENGES – When the Commercial Condominium Association is “Inactive”

• Section 18.3 of the Illinois Condominium Property Act provides that a unit owners’ association will be responsible for the overall administration of the property through its duly elected board of managers. 765 ILCS 605/18.3.
• Section 19 of the Illinois Condominium Property Act sets forth a specific set of records that the board of managers of every association is required to maintain. 765 ILCS 605/19.
• Section 22.1 of the Illinois Condominium Property Act provides that “in the event of any resale of a condominium unit by a unit owner other than the developer such owner shall obtain from the board of managers and shall make available for inspection to the prospective purchaser, upon demand . . .” a fairly comprehensive list of condominium instruments, and other documents and information, concerning the makeup and financial condition of the owners association, insurance coverage, litigation, reserves, assessments, and the like.  765 ILCS 605/22.1.

Remarkably, perhaps as an aftermath of the Great Recession during which resales of commercial condominiums were infrequent, it is not rare to find that the owners association for a commercial condominium has become inactive or only slightly active. Record keeping and budgeting may have become ‘streamlined”, addressing little more than collecting minimal assessments to pay insurance premiums on common elements. The owner’s association may have no formal budget, no capital reserves, extreme deferred maintenance, scant, if any, record of meetings of the board of managers, and no centralized or organized record keeping system beyond a box in a filing cabinet in the back-office of one of the unit owners.

Because of the infrequency of unit transfers in recent years, and the possible inexperience of a record-keeper who may have gotten the record-keeping job by default – when the last remaining board member left following foreclosure of his or her unit during the Great Recession – obtaining and providing the resale disclosure documents and information required by §22.1 can be a challenge.

This challenge presents practical problems for the unit seller, unit buyer and the unit buyer’s proposed mortgagee when attempting to resell a commercial condominium unit. Not the least of these problems is delay and frustration in moving toward closing – which may ultimately sour a prospective buyer and its lender, and lead the buyer to back away from acquiring the unit at all.

Deferred maintenance of common elements affecting any unit in the condominium association could have an adverse financial impact on all unit owners.  For example, if a commercial or industrial condominium association is comprised of multiple commercial/industrial buildings, a required roof replacement, foundation repair, or other structural repair for any of the buildings, or a recognized environmental condition in the common areas, could be expensive, with the cost shared among all unit owners. Accordingly, when investigating the condition of a commercial/industrial condominium unit being considered for acquisition, due diligence may require having all common elements in the association inspected, rather than merely looking at the unit being considered for acquisition. This may be more expensive and may take more time than might ordinarily be expected when purchasing a stand-alone building that is not a condominium unit.

PRACTICE TIP

Consider when drafting a purchase agreement under these circumstances, who should bear the cost of inspecting all common elements in the association? Ordinarily the cost of “due diligence” is a buyer’s expense. But if extraordinary inspections of association common elements beyond the specific unit being acquired is required in the exercise of due diligence because the selling unit owner did not demand that the owners’ association be operated by a board of managers in compliance with the Illinois Condominium Property Act, should the buyer bear this extraordinary expense, or should the seller?

There is no easy solution for this challenge, especially for a buyer planning to purchase a unit in one of these inactive associations. The best advice may be to become proactive – whether as an existing unit owner or upon becoming a new unit owner, to reactivate and invigorate the owners’ association and its board of managers, and to take steps to run the owners association in a businesslike manner, in compliance with the Illinois Condominium Property Act.

Generally speaking, owners of commercial condominiums are business people. They should demand that the association be run like they would run any business or investment property they invest in, if they expect to be successful.

If you have a viable solution to this challenge, please comment with your insights and practical suggestions.

Thank you in advance for participating in this discussion.

Kymn