Due Diligence in a Commercial Purchase and Sale Transaction

Posted on 10-19-2016 by
Tags: Lexis Practice Advisor , sale transaction , texas , commercial purchase , real estate

Purpose of Due Diligence and the Role of the Practitioner

Performing due diligence is an important part of the purchasing process, and is certainly something that each buyer of commercial real estate should undertake prior to closing. Due diligence allows a purchaser to gain additional—and often very important—information about the property in question, and may show areas that must be remediated prior to closing. In rare instances, due diligence may expose a flaw that cannot easily be remediated, and may be significant enough to kill the transaction. The ability of counsel to conduct smart, cost-effective due diligence on behalf of a client is vital, and has the opportunity to create outsized value for the client. The ability of sophisticated counsel to spot problem issues, and alert the client to the same, is an invaluable trait that third-party due diligence consultants simply may not possess. Thus, a practitioner’s role in the due diligence process is extremely important, and should not be overlooked by a client.

Initial Steps in Performing Due Diligence

In performing the initial steps of due diligence, the buyer should request copies of any due diligence reports in the seller’s possession. This can provide a head start to the buyer and its consultants in conducting follow-up due diligence, saving the buyer both time and money as many consultants will give discounts if they can start with a prior report. Furthermore, existing reports can help establish what the seller knew prior to the acquisition of the property by the buyer. This can be of significant value in the event of subsequent litigation not only to the buyer but also to the seller. Additionally, with a disclosure of due diligence items from the seller, the buyer will have an opportunity early on to take the items into account in setting the purchase price.

When the seller agrees to provide certain due diligence materials, the purchase agreement should clearly state how long after the purchase agreement is executed the seller has to deliver the due diligence. In addition, the buyer should make sure that the time period to review seller-provided due diligence does not commence until it has everything the seller is obligated to provide. The purchase agreement should also create an obligation on the part of the seller to notify the buyer if it discovers that anything contained in the due diligence is incorrect or if the condition of the property changes between the execution of the purchase agreement and the closing of the transaction. If the seller fails to deliver the agreed-upon due diligence, the buyer will want, at a minimum, the right to terminate the purchase agreement and recover any consideration it paid. The buyer may also want to establish a monetary penalty to create a financial impetus to deliver the due diligence items as well as to compensate it for its out-of-pocket costs associated with its own due diligence undertakings.

Even after a seller provides due diligence items regarding the property, the buyer still needs to conduct its own due diligence, even if this appears to be duplicative in nature. Some circumstances may have changed since the seller undertook its own due diligence, such as the condition of the property, the guidelines for performing certain tasks (such as survey standards), and the law related to certain conditions (such as building codes).In addition, the buyer may want to be in privity of contract with the consultant conducting the due diligence (i.e. be a named recipient of the due diligence report). Similarly, if the purchaser plans to finance the property, it is likely that the lender in question will likely want to be a named recipient of any due diligence report created by purchaser’s due diligence professional.

The Client Questionnaire and the Due Diligence Checklist

The best way for a practitioner to ensure that they are obtaining all information needed/wanted by a client through the due diligence process is to utilize a client questionnaire. This has the benefit of clarifying the goals of the transaction, as well as clarifying the amount of due diligence needed, the timeframe within which due diligence needs to be conducted, and who is responsible for conducting the due diligence.

Once complete, this information can be moved to a due diligence checklist, with individuals assigned to each task or category of information. A checklist has the added benefit of acting as a completion tracker, allowing the practitioner and the client to view—in real time—the status of the due diligence process.

Important Areas to Focus on in Due Diligence

While due diligence can take many forms, it is generally important to focus on a few core issues when determining the scope of the due diligence sought in a purchase transaction. The following are issues which a practitioner should take into account when core due diligence is being drafted:

  • The type of property that is being acquired;
  • The circumstances surrounding the buyer’s acquisition of the property, including whether the same is being purchased as part of a short-sale or foreclosure transaction;
  • The history of the property, including a detailed review of the chain of title;
  • Information needed by a lender to facilitate financing for the transaction; and
  • The buyer’s intended use for the property, especially with regard to zoning, etc.

Type of Property

The type of property at issue has a dramatic effect on the type and extent of due diligence to be conducted. For instance, if purchasing an industrial facility, environmental concerns may be of much greater importance than if purchasing a newly-completed skyscraper office building. If purchasing a shopping center or office building, a review of existing leases is a must for the would-be purchaser. Additionally, franchise agreements, zoning regulations, collective bargaining agreements, and/or liquor permits may arise as important areas to focus on, depending on the type of property being purchased.

Circumstances Surrounding the Purchase of the Property

It is important for the practitioner to understand the circumstances surrounding the acquisition of the property. If the property is very desirable, and there are multiple suitors, the seller may provide less opportunity to conduct due diligence. Similarly, if a property is being auctioned, a buyer may have little or no opportunity to conduct suitable due diligence.

History of the Property

Knowing the history of the property is very important for the due diligence process. For instance, if the property is being sold as a vacant commercial lot, but history shows that it was, at one time, used as a smelter or other industrial sight, a practitioner should recommend extensive environmental testing as part of the due diligence process. Similarly, a purchaser will want to know if property being acquired is in a historic flood plain, or if the area has a history of soil subsistence, thus making it potentially unstable. Without such history it may be difficult for a purchaser to focus its due diligence appropriately, and issues may be missed that will become important—or cause great expense—at a later time.

Involvement of a Lender

If a purchaser plans to use a lender to help finance a property acquisition it is wise for a practitioner to begin working with such lender early in the process to develop a due diligence strategy that meets the lender’s underwriting standards and needs. If the property is income-producing, a lender may need to see a significant amount of rent and other financial history to support the income and loan-to-value ratios used as a part of underwriting criteria. While a seller may be reticent to share some of this information, it is important for a practitioner to work closely with seller’s counsel to obtain all information needed by the lender.

Intended Use of the Property

It is important for the practitioner to understand the purchaser’s intended use of the property. Depending on the intended use, complex and inflexible zoning laws may come into play, or other land use restrictions may need to be investigated. This is especially true where a purchaser plans to develop vacant land, or plans to convert the property from one use to another. Having a firm grasp on the property’s intended future use will allow a practitioner to foresee legal pitfalls that may later cost a purchaser a substantial amount of money.

Additional Information

For access to comprehensive coverage regarding commercial lease transactions, as well as a host of other forms and commentary related to this subject, please click here to visit Lexis Practice Advisor.

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