R. Kymn Harp Robbins, Salomon & Patt, Ltd.

R. Kymn Harp
Robbins, Salomon & Patt, Ltd.

 2016 Update:

Are you planning to purchase, finance, develop or redevelop any of the following types of commercial real estate in the USA?

  • Shopping Center
  • Office building
  • Large Multifamily/Apartments/Condominium Project
  • Sports and/or Entertainment Venue
  • Mixed-Use Commercial-Residential-Office
  • Parking Lot/Parking Garage
  • Retail Store
  • Lifestyle or Enclosed Mall
  • Restaurant/Banquet Facility
  • Intermodal logistics/distribution facility
  • Medical Building
  • Gas Station
  • Manufacturing facility
  • Pharmacy
  • Special Use facility
  • Air Rights parcel
  • Subterranean parcel
  • Infrastructure improvements
  • Other commercial (non-single family, non-farm) property

RSP_LogoHD (3)A KEY element of successfully investing in commercial real estate is performing an adequate Due Diligence Investigation prior to becoming legally bound to acquire or finance the property.  Conducting a Due Diligence Investigation is important not just to enable you to walk away from the transaction, if necessary, but even more importantly to enable you to discover obstacles and opportunities presented by the property that can be addressed prior to closing, to enable the transaction to proceed in a manner most beneficial to your overall objective. An adequate Due Diligence Investigation will assure awareness of all material facts relevant to the intended use or disposition of the property after closing. This is a critical point. The ultimate objective is not just to get to Closing – but rather to confirm that the property can be used or developed as intended after Closing.

The following checklists – while not all-inclusive – will help you conduct a focused and meaningful Due Diligence Investigation.

BASIC DUE DILIGENCE CONCEPTS

Caveat Emptor:  Let the Buyer beware.

Consumer protection laws applicable to home purchases and other consumer transactions seldom apply to commercial real estate transactions. The rule that a Buyer must examine, judge, and test for himself, applies to the purchase of all commercial real estate in the USA.

Due Diligence:   Black’s Law Dictionary, West Publishing Company defines Due Diligence as follows:

Such measure of prudence, activity, or assiduity, as is proper to be expected from, and ordinarily exercised by a prudent (person) under the particular circumstances; not measured by any absolute standard, but depending upon the relative facts of the specific case.

Contract representations and warranties are NOT an adequate substitute for Due Diligence. A breach of a representation or warranty will simply mean you have the right to sue – which is time consuming and expensive.

The point of commercial real estate due diligence is to avoid transaction surprises and confirm that the property can be used and function as intended.

Questions and Answers signpostBasic transaction due diligence will focus on the fundamental elements of any storyline: Who, What, Where, When, Why and How.  These are key elements of inquiry that must be answered for any transaction, whether or not the transaction involves commercial real estate as its principal focus.

Property due diligence for commercial real estate will focus on four (4) primary areas of concern:

  • Market Demand
  • Access
  • Uses
  • Finances

For a detailed discussion of the four primary areas of concern, see my article: Commercial Real Estate Due Diligence: Do You Know the Four Areas of Inquiry?

Before focusing on the four areas of concern for property due diligence, transaction due diligence requires that we consider for whom the Due Diligence Investigation is being conducted. The scope, intensity, and focus of any Due Diligence Investigation of commercial real estate will depend upon the objectives of the party for whom the investigation is being conducted.  These objectives may vary depending upon whether the investigation is being conducted for the benefit of: (i) a Strategic Buyer (or long-term lessee); (ii) a Financial Buyer; (iii) a Developer (whether ground-up development, or redevelopment for adaptive reuse); or (iv) a Lender.

If you are a Seller, understand that to Close the transaction, your Buyer and its Lender must address all issues material to their respective objectives – some of which require information only you, as Owner, can adequately provide. If you are a Seller, please see my article: Perfect Seller for guidance.

GENERAL DUE DILIGENCE OBJECTIVES

(i)  A Strategic Buyer (or long-term lessee) is acquiring the property for its own use, and must verify that the property is suitable for the intended use.

(ii)  A Financial Buyer is acquiring the property for the expected return on investment generated by the property’s anticipated revenue stream, and must determine the amount, velocity, and durability of the revenue stream. This will likely include a consideration of credit-worthiness and market demand of long-term tenants, lease rental rates at the property compared to lease rental rates for comparable properties in the marketplace which may impact lease renewal rates, lease duration and expiration dates of all property leases to gauge exposure to mass-vacancies, tenant co-occupancy requirements and other factors that may impact the durability of the revenue stream generated by the property. A sophisticated Financial Buyer will likely calculate its yield based upon discounted cash-flows rather than the much less precise capitalization rate (“cap rate”), and will need adequate financial information to do so.

(iii) A Developer is seeking to add value by changing the character or use of the property – usually with a short-term to intermediate-term exit strategy to dispose of the property; although a Developer might plan to hold the property long-term as a Financial Buyer after development or redevelopment.  The Developer must focus upon whether the planned change in character or use can be accomplished in a cost-effective manner.

(iv)   A Lender is seeking to establish two basic lender criteria:

 1.   Ability to Repay – The ability of the property to generate sufficient revenue to repay the loan an a timely basis; and

2.   Sufficiency of Collateral – The objective disposal value of the collateral in the event of a loan default, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.  Particularly in light of the collapse of the commercial real estate market during the Great Recession of recent years, a Lender may pay particular attention to the overall loan coverage ratio, sources of equity, debt coverage ratio, and, similar to a Financial Buyer, may be concerned with the credit-worthiness and market demand of long-term tenants, lease rental rates at the property compared to lease rental rates for comparable properties in the marketplace which may impact lease renewal rates, lease duration and expiration dates of all property leases to gauge exposure to mass-vacancies, tenant co-occupancy requirements and other factors that may impact future value of the collateral.

The amount of diligent inquiry due to be expended (i.e. due diligence) to investigate any particular commercial real estate project is the amount of inquiry required to answer in the affirmative each question that must be answered yes, and to answer in the negative each question that must be answered no, to address all material concerns of the party for whom the Due Diligence Investigation is being undertaken.

The following Due Diligence Checklists are offered as helpful guides to assist in focusing on important issues to be considered in connection with a commercial real estate transaction.

I.  THE PROPERTY

1. Exactly what PROPERTY does the Purchaser believe it is acquiring?

  • Land?
  • Building?
  • Fixtures?
  • Other Improvements?
  • Other Rights?
  • The entire fee title interest including all air rights?
  • All development rights?

2.  What is Purchaser’s planned use of the Property?

3.  Does the physical condition of the Property permit use as planned?

  • Commercially adequate access to public streets and ways?
  • Sufficient parking?
  • Structural condition of improvements?
  • Wi-fi ready with access to high speed internet?
  • Environmental contamination?
    • Innocent Purchaser defense vs. exemption from liability
    • All Appropriate Inquiry

4.   Is there any legal restriction to Purchaser’s use of the Property as planned?

  • Zoning?
  • Private land use controls?
  • Americans with Disabilities Act?
  • Availability of Licenses?
    • Liquor license?
    • Entertainment license?
    • Outdoor dining license?
  •  Drive through windows permitted?
  • Other legal restrictions or impediments?

5.   How much does Purchaser expect to pay for the Property?

6.   Is there any condition on or within the Property that is likely to increase Purchaser’s effective cost to acquire or use the Property?

  • Property owner’s assessments?
  •  Real estate tax in line with value?
  • Special Assessment?
  • Required user fees for necessary amenities?
  • Drainage?
  • Access?
  • Parking?
  • Other?

7.   Any encroachments onto the Property, or from the Property onto other lands?

8.   Are there any encumbrances on the Property that will not be cleared at Closing?

  • Easements?
  • Covenants running with the land?
  • Liens or other financial servitude?
  • Leases?

9.   If the Property is subject to any Leases, are there any?

  • Security Deposits?
  • Options to Extend Term?
  • Options to Purchase?
  • Rights of First Refusal?
  • Rights of First Offer?
  • Rights of Early Termination?
  • Maintenance obligations?
  • Duty of Landlord to provide utilities?
  • Real estate tax or CAM escrows?
  • Delinquent rent?
  • Prepaid rent?
  • Tenant mix/use controls?
  • Tenant co-occupancy covenants?
  • Tenant exclusives?
  • Tenant Parking requirements?
  • Leasehold easements?
  • Strict covenants of quiet enjoyment?
  • Automatic subordination of Lease to future mortgages?
  • Other material Lease terms?

10.  New Construction?

  • Availability of construction permits?
  • Site plan approvals?
  • Soil conditions?
  • Utilities?
  • Curb cuts?
  • Traffic control requirements?
  • NPDES (National Pollutant Discharge Elimination System) Permit?
    • Storm Water Pollution Prevention Plan required?
  • Other governmental approvals required?

II.   THE SELLER

1.   Who is the Seller?

  • Individual?
  • Trust?
  • Partnership?
  • Corporation?
  • Limited liability company?
  • Other legally existing entity?

2.   If other than a natural person, does the Seller validly exist and is Seller in good standing?

3.   Does the Seller own the Property?

4.   Does the Seller have authority to convey the Property?

  • Board of Director approval?
  • Shareholder or Member approval?
  • Other consents?
  • If foreign individual or entity, are any special requirements applicable?
    • Qualification to do business in jurisdiction of Property?
    • Federal tax withholding?
    • U.S. Patriot Act compliance?
    • Bank Secrecy Act/Anti-Money Laundering Compliance?

5.   Who has authority to bind the Seller?

6.   Are sale proceeds sufficient to pay off all liens?

 III.   THE PURCHASER

1.   Who is the Purchaser?

2.  What is the Purchaser/Grantee’s exact legal name?

3.  If Purchaser/Grantee is an entity, has it been validly created and is it in good standing?

  • Articles of Incorporation – Articles of Organization or Formation?
  • Certificate of Good Standing?

4.  Is the Purchaser/Grantee authorized to own and operate the Property and, if applicable, finance acquisition of the Property?

  • Board of Director approvals?
  • Shareholder or Member approvals?
  • If foreign individual or entity, are any special requirements applicable?
    • Qualification to do business in jurisdiction of the Property?
    • U.S. Patriot Act compliance?
    • Bank Secrecy Act/Anti-Money Laundering compliance?

5.  Who is authorized to bind the Purchaser/Grantee?

IV.  TRANSACTION STRUCTURE

1.  Is transaction a cash purchase?

2.  Purchase with lender financing?

  • Bank financing?
  • Insurance company financing?
  • Hard money loan?
  • Seller financing?
    • Installment Agreement for Deed?
    • Seller provided mortgage?

3. Tax-deferred exchange pursuant to Section 1031 of the Internal Revenue Code?

  • Replacement property identified?
  • Qualified Intermediary selected?
  • Key time periods determined to comply with Section 1031 exchange rules?
  • Reverse exchange?
  • Other Section 1031 compliance issues?

4.  Public-Private Partnerships with municipal or other governmental economic incentives?

  • Tax increment financing?
  • Sales tax revenue sharing?
  • Business district financing?
  • Special service area financing?
  • Municipal General Obligation loan?

5.  Third-party Source Payments?

  • Naming rights agreements?
  • Sponsorships?
  • Concession agreements?

V.   PURCHASER FINANCING

A. BUSINESS TERMS OF THE LOAN

1.  What loan terms have the Borrower and its Lender agreed to?

  • What is the amount of the loan?
  • What is the interest rate?
  • What are the repayment terms?
  • What is the collateral?
    • Commercial real estate only?
    • Real estate and personal property together?
    • First lien?
    • Junior lien?
  • Is it a single advance loan?
  • A multiple advance loan?
  • A construction loan?
  • If it is a multiple advance loan, can the principal be re-borrowed once repaid prior to maturity of the loan; making it, in effect, a revolving line of credit?
  • Are there reserve requirements?
    • Interest reserves?
    • Repair reserves?
    • Real estate tax reserves?
    • Insurance reserves?
    • Environmental remediation reserves?
    • Other reserves?

2.  Are there requirements for Borrower to open business operating accounts with the Lender? If so, is the Borrower obligated to maintain minimum compensating balances?

3.  Is the Borrower required to pledge business accounts as additional collateral?

4.  Are there early repayment fees or yield maintenance requirements (each sometimes referred to as “prepayment penalties”)?

5.  Are there repayment blackout periods during which the Borrower is not permitted to repay the loan?

6.  Is a profit participation payment to Lender required upon disposition?

7.  Is there a Loan Commitment fee or “good faith deposit” due upon Borrower’s acceptance of the Loan Commitment?

8.  Is there a loan funding fee or loan brokerage fee or other loan fee due Lender or a loan broker at Closing?

9.  Is there a Exit Fee due to Lender upon the loan being paid off?

10. What are the Borrower’s expense reimbursement obligations to Lender? When are they due?  What is the Borrower’s obligation to pay the Lender’s expenses if the loan does not close?

B.  DOCUMENTING THE COMMERCIAL REAL ESTATE LOAN

Does the Purchaser/Borrower have all information necessary to comply with the Lender’s loan closing requirements?

Not all loan documentation requirements may be known at the outset of a transaction, although most commercial real estate loan documentation requirements are fairly typical.  Some required information can be obtained only from the Seller. Production of that information to Purchaser for delivery to its lender must be required in the purchase contract.

As guidance to what a commercial real estate lender may require, the following sets forth a fairly typical Closing Checklist for a loan secured by commercial real estate.

COMMERCIAL REAL ESTATE LOAN CLOSING CHECKLIST

1.  Promissory Note

2.  Personal Guaranties (which may be full, partial, secured, unsecured, payment guaranties, collection guaranties, so-called “bad boy” guaranties, or a variety of other types of guaranties as may be required by Lender)

3.  Loan Agreement (often incorporated into the Promissory Note and/or Mortgage in lieu of being a separate document)

4.  Mortgage (sometimes expanded to be a Mortgage, Security Agreement and Fixture Filing)

5.  Assignment of Rents

6.  Security Agreement

7.  Financing Statement

8.  Evidence of Borrower’s Existence in Good Standing, including:

  • Certified copy of organizational documents of borrowing entity (including Articles of Incorporation, if Borrower is a corporation; Articles of Organization (or in Delaware, Articles of Formation) and a written Operating Agreement, if Borrower is a limited liability company; certified copy of trust agreement with all amendments, if Borrower is a land trust or other trust; etc.)
  • Certificate of Good Standing (if a corporation or LLC) or Certificate of Existence (if a limited partnership) or Certificate of Qualification to Transact Business (if Borrower is an entity doing business in a State other than its State of formation)

9.  Evidence of Borrower’s Authority to Borrow, including:

  • Borrower’s Certificate
  • Certified resolutions
  • Incumbency Certificate

10. Satisfactory Commitment for Title Insurance (which will typically require, for analysis by the Lender, copies of all documents or record appearing on Schedule B of the title commitment which are to remain after Closing), with required commercial title insurance endorsements, often including:

  • ALTA 3.1 Zoning Endorsement modified to include parking (although, if the Property is a multi-user property, such as a retail shopping center, an ALTA 3.0 Zoning endorsement may be appropriate)
  • ALTA Comprehensive Endorsement No. 1
  • Location Endorsement (street address)
  • Access Endorsement (insuring commercially reasonable vehicular and pedestrian access to public streets and ways)
  • Contiguity Endorsement (the insured land comprises as single parcel with no gaps or gores)
  • PIN Endorsement (insuring that he identified real estate tax permanent index numbers (PIN) are the only applicable PIN numbers affecting the collateral, and that they relate solely to the real property comprising the collateral)
  • Usury Endorsement (insuring that the loan does not violate prohibitions against excessive interest charges)
  • other title insurance endorsements applicable to protect the intended use and value of the real estate collateral, as may be determined upon review of the Commitment for Title Insurance, Survey and documents of record, or arising from the existence of special issues pertaining to the transaction or the Borrower

11. Current ALTA/NSPS Land Title Survey (3 sets), prepared in accordance with the 2016 (or current) Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys, with such Table A Additional Requirements as the Lender may determine necessary.

12.  Current certified Rent Roll

13.  Certified copy of all Leases (4 sets – 1 each for Buyer, Buyer’s attorney, Title Company, and Lender)

14.  Lessee Estoppel Certificates

15.  Lessee Subordination, Non-Disturbance and Attornment Agreements (sometimes referred to simply as “SNDAs”)

16.  UCC, Judgment, Pending Litigation, Bankruptcy  and Tax Lien Search Report

17.  Appraisal – complying with Title XI of FIRREA (Financial Institutions Reform, Recovery and Enforcement Act of 1989, as amended)

18. Environmental Site Assessment Report (sometimes referred to as Environmental Phase I and/or Phase 2 Audit Report) prepared in accordance with ASTM Standard e1527-13 (or current)

19. Environmental Indemnity Agreement (signed by Borrower and Guarantors)

20. Site Improvements Assessment Report (sometimes an ASTM Property Condition Assessment prepared in accordance with ASTM Standard e2018-08 (or current) is required)

21. Evidence of Hazard Insurance naming Lender as the Mortgagee/Lender Loss Payee; and Liability Insurance naming Lender as an “additional insured” (sometimes listed simply as “Acord 27” and “Acord 25”, respectively); and sometimes a separate “Agreement to Provide Insurance”

22.  Legal Opinion of Borrower’s Counsel

23.  Credit Underwriting documents, such as signed tax returns, property operating statements, etc. as may be specified by the Lender

24. Compliance Agreement (sometimes also called an Errors and Omissions Agreement), whereby the Borrower agrees to correct, after Closing, errors or omissions in the loan documentation

*****

It is useful to become familiar with the Lender’s loan documentation requirements as early in the transaction as practical. The requirements will likely be set forth in some detail in the Lender’s Loan Commitment – which is the contract that serves as the road map for the loan transaction between Borrower and Lender. In Illinois, to be binding, the Loan Commitment must be in writing and be signed by the Lender.

Conducting the Due Diligence Investigation (that is to say, investigating all property and transactional concerns material to the commercial real estate transaction with all diligence due under the circumstances) can be time consuming and expensive. It can be made less so by knowing what to look for, devising a due diligence plan, and focusing on those matters that are of material concern.

If the loan requirements cannot be satisfied, it is better to make that determination during the contractual “due diligence period” – which typically provides for a so-called “free out” when the Borrower/Purchaser can receive the return of part or all of its earnest money deposit and avoid full liability under the purchase agreement for failure to move forward – rather than at a later date when the earnest money may be at risk of forfeiture or when other liability for failure to Close may attach.

CONCLUSION

Conducting an effective Due Diligence Investigation in a commercial real estate transaction to discover all material facts and conditions affecting the Property and the transaction is of critical importance. Doing so will help identify risks which may be present in any commercial transaction, so the risks can be adequately shifted or otherwise mitigated. A properly focused investigation conducted with appropriate due diligence may disclose previously unrecognized opportunities as well as potential problems.  An appropriate Due Diligence Investigation requires intentional and focused attention to all details material to the Property and to the transaction by a skilled professional, or group of professionals, who can recognize significant issues and opportunities.  An investigation that is not properly focused may miss critical issues and may be overly broad and excessively expensive.

RSP_LogoHD (3)Recommendation:  Exercise Due Diligence.

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