Cover your bases | Rushing through due diligence can doom a commercial real estate deal
Mick Jagger famously sang that “Time is on my side.” Unfortunately, that’s not always the case in commercial real estate. One of my jobs as a broker is to ensure that a deal moves along at a reasonable pace for all parties involved. When preparing a contract, we are careful to plot and define specific timelines and important dates to ultimately reach a closing or lease execution. Assertive decision making and avoiding delays will often make or break a deal. In other words, while time may be on your side for now, it won’t be forever.
The time spent between putting a property under contract and closing the sale is referred to as the due diligence period. Due diligence is simply defined as the time period in which a buyer is given the opportunity to have experts inspect the property, examine the title and review any leases in place to determine whether they are ready to purchase. It is an important step in the real estate transaction process and it should not be rushed or overlooked. I even encourage tenants to do their homework on a property before signing a lease. Simple things like talking to existing tenants, finding out about the management company/landlord and gauging traffic during rush hour gives comfort to a tenant signing a long-term lease.
However, this period can be a time of contention and stress for a property owner. From their perspective, their property is being picked apart and the buyer/tenant is looking for reasons to get a better deal. That is why it’s so important to put a reasonably defined time limit on the diligence period (30-45 days is a standard buyer’s diligence period). When the period runs out, the buyer/tenant’s escrow or security monies go “hard,” meaning their deposit becomes nonrefundable.
Contingency planning
The first, and most common, condition in a diligence period is the building inspection. A professional building inspector is typically hired, on the buyer’s dime, to ensure that the buyer has a full understanding of the property’s condition. If anything unexpected comes up, the buyer can request it be fixed by the seller, negotiate a lower purchase price or void the deal. We typically recommend requesting a minimum 21 days from the date a contract is signed to complete a building inspection (obviously, larger commercial properties may need more time).
A thorough title search is also standard practice; in fact, any lending institution will require one. This search is an examination of the public records to determine what, if any, defects there may be in the chain of title. Among other things, the lender will need this to confirm there are no outstanding liens that would be superior to the mortgage. The title search is usually completed after the other major diligence contingencies are complete and can take anywhere from five to seven business days.
In this volatile market, a clearly defined financing contingency is extremely important. A typical contract will not only spell out how long a buyer has to secure financing, but under what conditions. Outline what the loan to value ratio will be, the highest acceptable mortgage rate and how long the amortization period will be. If any of these items can’t be secured, the buyer has the right to void the deal. A typical financing contingency period is 30 days, but we recommend a longer period for more complicated transactions or properties.
Other important contingencies to include in a contract, if applicable, are a zoning/approvals review, ADA-compliance confirmation, air quality tests, environmental scans and wetland determinations (if buying land). Each of these can vary in timing. A zoning issue can often lead to significant delays because you’ll need to involve municipal leadership. If there is a concern over zoning or use approvals, we recommend requesting a minimum of 60 days (90 to be really safe) to get the proper approvals.
Purchasing an investment property with existing leases in place requires further fact checking. A review of all income and operating expenses, tenant financials and options is in order and typically takes seven to 10 days after receiving the documents. Estoppels certificates, which outline what each tenant is paying and the length of their remaining term, also need to be gathered prior to closing. This document also reflects what each tenant has paid in security deposits and acknowledges that there are no outstanding claims or offsets against the current landlord. Typically, each tenant is required to sign an estoppels certificate prior to closing — no small feat for larger multi-tenanted commercial properties.
Having a clearly defined timeline in writing is paramount to a successful real estate transaction. It ensures that the buyers and sellers have a full understanding of the property and helps avoid costly pitfalls. Time IS on your side — if documented and tracked properly.
Justin Lamontagne, associate broker at CBRE/The Boulos Co. in Portland, can be reached at jlamontagne@boulos.com. Read more of Justin’s columns here.
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