CRE Basics: Due Diligence

By Maura O'Connor

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What is Due Diligence, and When is it Done?  “Due diligence” means an appropriate investigation into all aspects of a parcel of real property to be conveyed to the purchaser (or lender).  What amount of diligence is “due” depends upon the circumstances, including the risks created by the prior use of the property, the monetary value of the transaction, and the budget available.  The information disclosed by a due diligence review is typically used either to confirm that a deal can be closed on the original terms, or, if the diligence discloses surprises, as leverage for a buyer or tenant or lender to renegotiate its deal prior to becoming irrevocably committed to close. 

Due Diligence in Purchases or Leases of Property.  In a purchase of commercial real property, a buyer will typically make an offer for a particular piece of real property at a set price, but the offer will be contingent upon the buyer’s (and it’s lawyers’) review and investigation of every aspect of that property:  its condition, financial feasibility for the buyer’s purposes, environmental history, title (who owns it, what interests in the property have been given away), allowed uses and the like.  Usually, the buyer will demonstrate that it is serious about buying the property by making a “good faith” deposit of a certain amount of money into escrow, which amount will be applied to the purchase price if the sale closes.  (That deposit will usually be returned to the buyer if the buyer terminates the transaction before a certain date, which is often referred to as the date the money “goes hard.”)  The period until the money goes hard is often referred to as the “due diligence period,” the “inspection period,” or the “review period.”  Most often, the seller gives the buyer access to its relevant records and to the property so that the buyer can complete its due diligence review of the property takes place during that time. 

The process for doing diligence when leasing property is similar, although some tenants (such as those renting an office in an office building) may be able to rely on more extensive covenants by the landlord in the lease, and therefore do less due diligence than a buyer would.  However, some tenants, such as a single tenant in an industrial building which will operate the property itself on a “triple net” basis, paying all costs (including maintenance), taxes and insurance on the property as if it were its owner, should perform due diligence as if it were buying the property.  Such a tenant does not want to sign a lease, move in, and then find out it has serious problems with its newly leased premises:  for example, that the HVAC units don’t work, the foundation is cracked, toxic chemicals have been spilled on the property, its planned use is not allowed, or it doesn’t have enough parking.

Due Diligence in Real Estate Financing Transactions.  When a buyer is financing part or all of its purchase price for a piece of real property, or is refinancing to lower its interest rate or because its mortgage loan is maturing, its lender typically hires counsel to negotiate, document and close the loan.  Since the remedies for enforcing loans secured by real estate may be constrained by state laws, and since the real estate collateral is frequently the main source of repayment if the borrower fails to do so, the lender typically underwrites the property as if it were buying it:  if the borrower defaults, the lender typically will be “buying” the real property at a foreclosure of the property.  For this reason, the lender and its counsel typically undertake significant due diligence on a property, sometimes to the surprise of the buyer, who frequently just wants to get its loan done.  It is important for a buyer to provide all information sought by the lender and its counsel as quickly as possible to facilitate the timely closing of the loan and the underlying purchase transaction.  In more strict lending environments, like the present environment, lenders simply will not close until and unless their requirements are met – and the lack of financing can kill an otherwise good purchase transaction.  (In a workout or deed in lieu, the lender frequently does due diligence to make sure that if it takes back the property or gives other concessions, its collateral remains a good source of collections.)

Due Diligence:  Buyer Beware.  As noted, during the "due diligence" period, the buyer or tenant investigates the relevant aspects of the property to confirm that the property is acceptable for its use and other needs.  (Frequently the buyer or seller starts its due diligence while the definitive deal documents are still being negotiated; if so, the binding documents are usually signed before the due diligence period is complete.) 

During the due diligence period, the prospective purchaser or tenant and its lawyers must complete all inspections for condition (physical and environmental) and suitability for its purpose, and must confirm that its team can obtain all needed entitlements and governmental permissions.  In California and many other states, most commercial property deals are completed on an “As-Is” basis, with the seller or landlord providing limited or no warranties.  For this reason, a buyer or tenant needs to do its diligence up front, or to be willing to back out of the deal if needed.  Once the sale or lease is complete, the buyer or tenant has little or no recourse other than through expensive (and usually unsatisfying) litigation.  

Basic questions to ask in doing due diligence on any type of property.  The type of investigation that a lawyer should perform in any real estate transaction depends upon both the type of transaction and the kind of land which is being purchased or encumbered.  However, some basic questions common to all types of land are these:

• What interests in the land are being sold or encumbered, and are they sufficient for the buyer’s/lender’s purposes?
• Who owns the land?
• What is the land used for?
• Where is the land located?
• How has the land been used in the past?
• What does the buyer want to use the land for in the future, and may the buyer do so?

The common goal of all of these questions is to find out precisely what the seller is selling and what the buyer is buying.  (Or, what the landlord is offering to rent, and the tenant is going to get if it leases the property.)  This sounds simple; but that is deceptive.  The challenge is to be able to find out about the property while relying only on sources of information that are known to be highly accurate (and, if possible, on sources that carry liability insurance against their own errors).

The lawyer performing a due diligence review must determine precisely what rights to the property the owner (or landlord) has and is able to sell or encumber, since the owner (or landlord) cannot sell or encumber interests in (or lease) property that it does not have.  In addition, the owner may not be aware of various problems with the property, such as environmental problems or potential claims, which may adversely impact the rights of the owner or any buyer (or lender). 

The property owner often doesn’t know exactly what it is selling or encumbering:  developers of real property often give away many different interests in their land in order to develop it, and later owners often are unaware of the resulting limitations on their property rights.  For example, an innocuous-sounding “utility easement” shown as an exception on the title report for a property may reflect power lines running along the outside border of an industrial property, creating no practical difficulties at all; but it might instead disclose a high pressure gas line that cannot be moved, running through a part of the property upon which the prospective purchaser plans to build a new building.  A careful review of the diligence documentation, including the title documents and a survey of the property, would disclose whether the “utility easement” would be a problem for the buyer or tenant before the diligence period ends – in time to renegotiate or terminate the transaction. 

Keeping track of the information obtained about the property.  Regardless of the type of transaction, if time allows, most experienced real estate lawyers put together some sort of checklist to keep track of all of the information they need to gather before closing a transaction.  This checklist is usually circulated to the client, and often to the other parties.  One of the most effective ways to keep track of the information gleaned about a property – as well as what issues still need to be addressed – is to make a combined closing/diligence checklist.  Such a checklist should include the names, addresses, phone numbers and other contact information about each of the parties to the purchase or lease agreement, their lawyers, the title insurance company and the escrow company.  Items that are to be delivered by the seller/landlord or buyer/tenant (including items to be delivered to any lender financing the deal) at or before the closing, such as a title report, survey, specific information about the property, escrow instructions, certificates from governmental authorities and evidence of appropriate corporate or partnership action and authority should be included.  Items to be delivered by the purchaser (or lender), such as any initial and additional deposits, escrow instructions, and evidence of appropriate corporate or partnership action and authority should also be included. 

The contents of such a checklist vary by type of transaction.  A checklist for acquisition of real property should include confirmation of the title to the property, completion of a title review to make sure there are no exceptions to title that would preclude the buyer’s use, confirmation that all property taxes have been paid, evidence of zoning suitable for the use to be made of the property,, with more detail about the land, any restrictions on development of the land, information about the condition of the existing improvements on the land, and the terms of any construction and/or purchase financing.  A real estate financing checklist would also typically include an approved loan application, payment of an underwriting fee, evidence of insurance, confirmation that all easements and other interests in the property will not interfere with the lender’s lien against the real estate, to name a few items. In addition, a well drafted closing/diligence checklist will include a list of those few things that must be handled after the transaction closes.

The process of doing diligence is not necessarily the most exciting part of doing real estate deals, but it is one of the most important, as doing it correctly can make the difference between a purchase or lease that is a good deal and one that is plagued by post-closing problems and expensive disputes.  Due diligence is rather like diplomacy:  it can be dull and time consuming, but it is necessary to avoid much bigger problems later.

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