Due Diligence in Purchase Agreements

Before acquiring property, it is essential that a buyer perform a “due diligence” review of the conditions of the property, its operations and the surrounding neighborhood to determine if the buyer’s preliminary estimates of the property’s value are accurate. The outcome of this due diligence review will determine whether it is feasible for the buyer to proceed with the purchase of the property.

1. Due Diligence Period. The due diligence period within which the buyer has to conduct its property review is usually specified in the purchase agreement. The due diligence period typically commences with the date various documents are provided to the buyer and ends after the agreed upon period has elapsed. In some instances, the due diligence period may vary for different due diligence items.

The seller prefers a short due diligence period (especially if the buyer is entitled to a return of all of the buyer’s earnest money deposit where the buyer determines not to proceed with the purchase). A short due diligence period forces the buyer to quickly reach a conclusion about proceeding with the purchase. If the buyer elects not to proceed with the purchase following the buyer’s due diligence, the seller can quickly get the property back on the market. Conversely, the buyer prefers a long due diligence period. In some instances, the buyer may have to pay monthly non-refundable extension fees (but applicable to the purchase price if the buyer closes) to obtain a long due diligence period.

2. Extent of Due Diligence. The type and extent of due diligence a buyer will conduct depends on, among other things, the type of property the buyer is planning to acquire, its cost, and the purpose of the acquisition. If the property is improved, the building systems, equipment, and structural condition require special attention. Where the property is unimproved, the ability to develop the property for the buyer’s intended purpose is of paramount concern. If the buyer will occupy the property and use it for the buyer’s business, a different analysis will be conducted. Similarly, special concerns exist where the buyer is purchasing the property for investment purposes.

3. Property Review. The buyer should begin as soon as possible to compile the documents and reports required to analyze the property. The buyer’s due diligence analysis should consider, among other things, the following:

1. Delivery of Documents. The purchase agreement should obligate the seller to provide to the buyer all documents in the seller’s possession or control pertaining to the operation, management and valuation of the property within a short period of time after execution of the purchase agreement. If the seller has in its possession a Level 1 environmental assessment indicating actual or potential environmental contamination on the property, the buyer may determine quickly in its due diligence period that it does not want to buy the property. The quicker the buyer makes a decision, the less money the buyer will expend on due diligence.

1. Lender Requirements. In determining the level of the buyer’s review of the property and the length of the due diligence period, the buyer should be sure to consider any requirements which may be imposed by the buyer’s prospective lenders, paying particular attention to those items which require a long lead time. Such items include an appraisal, obtaining letters regarding code compliance from applicable governmental authorities, obtaining consultants’ reports (such as soils reports and environmental assessments), and obtaining estoppel certificates and subordination, non-disturbance and attornment agreements from tenants of the property.

1. Economic Feasibility. Due diligence should include a financial review of the property to confirm that the buyer’s preliminary estimates of value are warranted.

1. Income Producing Property. When the buyer is acquiring income producing property, the buyer should analyze the sources of the income from the property using three tools: (i) the buyer’s review of the leases, (ii) the rent roll prepared by the seller, and (iii) tenant estoppels from the tenants. In reviewing these three different sources of essentially the same information, the buyer can get a good understanding of property. A divergence in information suggests a possible problem with the seller, the property or its tenants.

Among other things, the buyer’s lease review should focus on determining if the tenants have extension options, expansion options, options to purchase, rights of refusal, early termination rights, landlord improvement allowance reimbursement rights, exclusive use rights, continuous occupancy obligations or any other special tenant right. Any of these provision in a lease could affect the buyer’s determination of the value of the property.

1. Estoppel Certificates. The purpose of estoppel certificates is to obtain each tenant’s understanding of the status of its lease. The estoppel certificate can also be introduced into evidence during the course of litigation if a tenant contradicts any statement made in the estoppel certificate.

Where the buyer is purchasing a ground lease interest, the buyer should obtain an estoppel certificate from the ground lessor to confirm the terms of the ground lease. Of critical importance is the term, the rent, the absence of termination rights, control over the improvements and assignment and subletting rights. The consent of the ground lessor to the purchase should also be obtained.

1. Tenant Financial Statements. If possible, the financial statements of the tenants should be reviewed where the property is being acquired for investment purposes. Since tenants provide the income stream the buyer is relying on in making its investment, it is a good idea to determine whether the tenants have the financial wherewithal to pay the rents required of them in their leases. If a tenant’s financial ability to perform is uncertain, the value of the lease rents may need to be discounted. Buyers and lenders will also discount the value of a lease if the tenant has been granted termination rights.

1. Property Expenses. The buyer should review the operating statements for the property for the prior 2 to 3 years to determine, among other things, the regular expenses of the property, the extraordinary anticipated expenses (i.e., expected capital improvements to items in need of constant repairs), and the timeliness as of the tenants’ payments. In addition, the buyer should review the property management records and maintenance records (especially pertaining to the heating, ventilating, and air conditioning system, the elevators, and the roof) for the property.

In some instances, the buyer may want to interview tenants to obtain the tenant’s view of the property’s management and maintenance history. It is useful to determine whether the tenants are happy with the property and whether the tenants are interested in renewing their leases or if they have any complaints regarding the operations of the property or its management.

Part of the review of the operating statement should include an analysis of whether there are any unusual proration issues. With respect to income properties, certain obligations of tenants are adjusted at the end of the year. If the tenants have paid too much over the year, then either the seller or the buyer will owe a credit to the tenants. These include common area maintenance or operating expense payments, and adjustments in percentage rent. Also, if tenants are making payments regularly into a common area reserve account, the parties should consider assigning to the buyer a portion of those reserves for use with respect to future maintenance or replacements.

1. Physical Condition.

(1) Scope of Review. The construction of the property and its adequacy for the buyer’s proposed uses should be reviewed. The extent of the review will depend upon the type of property, its cost, and its proposed use.

The buyer should employ a structural engineer and such other professionals as may be prudent to determine the condition of the structure, roof, electrical, plumbing, HVAC, elevators and other building components. Price estimates should be obtained to the extent the property requires repair.

Also an analysis should be undertaken to determine if the property complies with current codes (including the Americans with Disabilities Act), and, if not, the cost of compliance. Even if the property is in compliance with codes, it is important to understand the possible code compliance costs which may be incurred if the property is altered (i.e. a requirement that seismic retrofits be performed on unreinforced masonry brick buildings.)

Soil reports, engineering and architectural studies, wetlands review, grading plans, topographical maps, feasibility studies, flood plain reviews, and reports from environmental experts, seismologists, geologists, and insurance consultants should be obtained to the extent applicable. To the extent wetlands exist on the property, an analysis of whether the proposed development (including mitigation alternative) must be considered.

Where the property is unimproved, the buyer needs to confirm the existence of access rights (including the right to install and use curb cuts) and the cost to obtain a utility connection with sufficient capacity for the buyer’s intended use.

(2) Buyer Indemnity. The buyer should be responsible for the costs of any tests or studies the buyer conducts related to the property (unless otherwise specifically provided for in the purchase agreement) and any liability arising in connection with such studies. The seller often obtains an appropriate indemnity from the buyer. If the seller is concerned about the financial strength of the buyer, the seller can require evidence of insurance or the delivery of a performance bond.

(3)       Use of Reports. Most professionals will not allow their reports to be released to anyone other than the party who originally ordered the report. If the seller wants the benefit of such reports, the seller should negotiate for such right when negotiating the purchase agreement.

1. Financing. If there is an existing debt to be assumed or if the property is to be purchased subject to an existing loan, it is advisable to not only review the note, deed of trust and other loan documents, but also to obtain the lender’s consent to the transfer (this is imperative if the loan documents contain a due on sale clause). The lender should provide the buyer with an estoppel certificate confirming the following information:
2. Principal balance of loan
3. Monthly payments
4. Interest rate
5. No defaults
6. Maturity date and amortization schedule
7. Completeness and accuracy of copies of delivered loan documents

When reviewing the loan documents, it is important not only to confirm the accuracy of the lender’s estoppel certificate, but also to review the documents for any terms which could severely limit the buyer’s flexibility, such as prohibitions on prepayment or unrealistic release provisions. The terms of the release provisions are especially important if the buyer is acquiring the property for development purposes with the anticipation of selling portions of the property as and when the development of such portions of the property are completed for sale.

1. Service Contracts. The service contracts affecting the property (such as for landscaping services) should be reviewed to determine whether they are in default and whether they are contracts the buyer wants to assume. In some instances the buyer may be forced to assume the contracts because the term of the applicable contract extends beyond the closing date. If a notice is required to be given to the service provider to terminate its services under the service contract, the seller should be asked to give that notice to terminate in time for closing.

1. Construction Contracts. Construction contracts, especially with new or recent construction, should be reviewed to determine whether there are any guaranties or warranties to be assigned and the procedure for accomplishing such assignment.

1. Possession Concerns. Where the buyer intends to occupy the property at closing, the buyer must review any existing leases to confirm that such leases will terminate on or before the anticipated closing date. If the tenants are to vacate the property simultaneously with the closing, the buyer can, among other things, require that a portion of the sale proceeds be held in escrow to pay for eviction expenses.

1. Permits and Licenses. The permits and licenses pertaining to the property should be reviewed to determine whether all applicable permits and licenses are in effect. Is the elevator operated under a current permit? An examination of the applicable ordinances should also be undertaken to confirm that all necessary licenses and permits are transferable to the buyer or that such licenses or permits will be issued at closing.

1. Taxes. The tax notices for the property should be reviewed to confirm that the operating statement contains the correct figures for taxes, and to determine whether there are any special assessments or any special deferrals of taxes. If there are deferred taxes, such as arising from farm use, open space land, senior citizens deferral, or historic use, the effect of disqualification may mean additional taxes, penalties, and interest. The purchase agreement should specify who will bear the consequences of disqualification. If such party is the seller, the buyer may require either a holdback of a portion of the purchase price or an indemnity which survives the recording of the deed to the Property.

1. Survey. In many instances, a survey should be obtained. If the buyer is financing its purchase, the survey must comply with the requirements of the buyer’s lender and the requirements of the title company. This invariably means that a survey will be required which will allow for the issuance of an extended coverage title insurance policy. In 1992, ALTA (American Land Title Association) and ACSM (American Congress on Surveying and Mapping) issued new standards for what matters should be disclosed on a survey for purposes of title insurance.

Typically, items shown on the survey are the buildings, encroachments, and easements. Often, surveys can include much greater detail, including, among other things, each parking space, the street addresses of the buildings, flood zone designation, exterior dimensions of buildings, curb cuts, wires and cables, and indications of subterranean uses (such as manholes and catch basins). The more information and more detail provided to the buyer by the surveyor, the better informed the buyer will be regarding the property it is purchasing.

If no survey is to be performed, at a minimum, the legal description in the preliminary title report should be checked against the map of the property and the metes and bounds description should be checked to determine if it closes (commercial software exists which can “map” the boundaries of the property from the legal description). A physical inspection of the property should be conducted to check for encroachments from the property onto adjoining property or from adjoining property onto the property to be purchased.

1. Personal Property. If there is personal property to be conveyed at closing, a check of UCC Financing Statements from the Secretary of State’s office should be requested to determine whether there are any liens against such personal property. The parties should consider allocating by agreement the purchase price between the personal property and the real property for tax basis and depreciation purposes.

1. Title Review.

(1)       Property Purchased. The first step in the title review process is the review of the preliminary report to be sure that the property referred to in the preliminary report is estate being purchased. This is especially important where the property acquired is a lesser estate than fee simple.

In addition, the estate described in the preliminary report should include all easements, options, and other ancillary real property rights which the buyer will require in connection with the use and ownership of the property. The buyer should review the legal descriptions of the parcels of the property set forth in the preliminary report and compare such legal descriptions with the survey to be sure that the legal descriptions are accurate, that they describe the parcels the buyer thinks it is acquiring and that they include all necessary ancillary real property rights. For example, if the parcel to be acquired does not abut a public road, the buyer should be sure that the buyer has access to a public road by an easement and that the buyer’s interest in such easement is insurable.

(2)       Seller. The buyer should review the preliminary report to confirm that the seller is the owner of the property the buyer desires to purchase.

(3)       Review of Exceptions.

(a) General Exceptions. A preliminary title report will list five standard general exceptions. The general exceptions pertain to (i) taxes and assessments not shown as liens in the public record, (ii) unrecorded interests in the property which could be determined by a physical inspection of the property, (iii) mining claims and reservations and water rights, (iv) construction liens, and (v) discrepancies, conflicts in boundary lines, shortages in area, encroachments or any other facts which a correct survey would disclose. Some or all of the general exceptions can be deleted by obtaining an extended coverage policy of title insurance.

(b)       Special Exceptions. It is very important that the buyer examine the underlying documents for each special exception to determine whether there are obligations or conditions in the underlying documents which are not acceptable to the buyer. This analysis also applies to any unrecorded document which is referred to in a recorded document.

For example, easements (whether exceptions or interests to be conveyed to the buyer) need to be reviewed with the survey to determine their location, whether improvements are built in the area of the easement, and whether the easement affects the ability of the buyer to use the property for its intended purpose. Easement agreements should also be reviewed to determine whether the easement agreements impose unacceptable obligations upon the buyer or are subject to the risk of termination. The existence of a risk of termination should be a matter of grave concern if such easement is essential to the buyer’s use of the property.

(4)       Permitted Exceptions. Once the buyer has reviewed the exceptions listed on the preliminary title report, the buyer and seller will engage in a procedure by which they will collectively determine the “permitted exceptions.” The buyer prefers that the purchase agreement require the seller to remove all exceptions the seller is capable of removing. The seller will want to provide that, even if it is possible for the seller to remove an objected-to exception, the seller is not obligated to remove the exception (usually due to cost of removal). The seller will prefer that the buyer either accept the objected-to exception and close with it or elect to terminate the purchase agreement.

1. Litigation. Most litigation affecting the property will be disclosed on the preliminary title report. However, the seller should also disclose any litigation relating to the seller and the property.

1. Liabilities of Ownership/Contamination. A careful review needs to be made of the environmental condition of the property. Environmental laws create strict, joint and several liability for owners and operators of land. This liability extends to people having no responsibility for the contamination. Because the cost of cleanup can be very high, even in excess of the value of the property, it is extremely important that the buyer determine prior to its purchase of the property the scope of the environmental risks to which the buyer will be subject. This is especially true with respect to commercial and industrial property. But is also true with respect to farm property if petroleum or pesticides have been used or disposed of in connection with the operation of the property.

(1)       Applicable Regulations. Hazardous substances are regulated under federal, state and local laws and these laws affect virtually every real estate transaction. Regulations govern not just the soil, asbestos, PCB, but also the ground water, surface water, and air. Contamination in any of these areas may create potential liability. Even if the buyer is purchasing the property through a limited liability company, a corporate entity or other entity attempting to shield the owners from personal liability, the courts may, in some instances, construe environmental statutes to disregard corporate formalities and impose liability on members and shareholders.

(2)       Innocent Purchaser. Although CERCLA and some other statutes contain an “innocent purchaser defense” to liability with respect to pre-existing contamination, this defense is rarely available to buyers. This defense requires that the buyer “had no reason to know” of the existence of the contamination. To obtain the benefit of this defense, one must have investigated the environmental condition of a property prior to purchase to the rigorous standard of “best business and kind transfer principles.”

(3)       Minimum Review. Although neither case law nor regulations specifically define what constitutes appropriate inquiry, it is clear that a significant level of site assessment must be made. As a threshold matter, the buyer should hire an environmental consultant to perform a “level I” or “phase I” environmental assessment. If the acquisition is to be financed, the lender should be consulted prior to hiring the environmental consultant and defining the scope of the environmental assessment. While there is no hard and fast rule as to what is included within a level I assessment, generally the following is included:

1. Examine all available documentation (including historical archives, title records, and aerial photographs) and interview people knowledgeable about the property’s history.

2. Physically inspect property for asbestos, urea-formaldehyde foam insulation, underground storage tanks, transformers, signs of contamination and signs of potential sources of contamination.

3. Evaluate neighboring property including historical review, agency records review and physical inspection.

4. Consider sampling and chemical analysis.

Special consideration should be given to the current and former uses of the property to determine whether hazardous materials have been used, disposed or stored on the property. The property, including property used only for agricultural uses, needs to be checked for asbestos, polychlorinated biphenyls (PCBs), storage and handling of fuels, wastes, chemicals, air emissions, water discharges, water supply, waste disposal, pesticides, herbicides and other agricultural chemicals, and fill. It is a good idea to check with applicable regulatory authorities to determine whether the site or surrounding sites are considered contaminated. The parties should consider requesting an environmental questionnaire from the owner and tenants to determine whether the uses of the property include or included the use of hazardous materials.

(4)       Indemnity. Even if the buyer obtains an indemnity from the seller regarding pre-existing contamination, the buyer will still be liable for remediation costs to the extent the seller is unable to pay.

1. Zoning and Land Use Regulation. The buyer should conduct a thorough review of the zoning laws and other applicable laws regulating use of the property to confirm the zoning of the property and to assess whether the existing zoning will permit the planned use. The buyer should also determine if the proposed use is consistent with any applicable comprehensive plan applicable to the area and if there is any litigation pending regarding zoning matters. The buyer should request a letter from the local jurisdiction confirming that the buyer’s intended use is allowed under all applicable laws.

All aspects of the codes should be reviewed, not just the zone designation. For example, in the City of Portland, not only are there zoning provisions to consider, but there are also “overlay” zones which may restrict development of the property. In addition, compliance with other laws need also be considered, such as the Americans With Disabilities Act, building codes, subdivision and partitioning requirements, planned community or condominium laws, and storm water discharge laws.

If the buyer expects to renovate or remodel the property, the buyer should be sure to consider whether the renovation or remodeling of the property may trigger enforcement of certain requirements under the Americans With Disabilities Act or laws requiring seismic retrofits. In some instances, the compliance costs for required code upgrades can exceed the anticipated renovation costs.

If the buyer wants to obtain land use approvals during the due diligence period, the buyer will want the seller to agree to cooperate the procurement of such approvals. For example, any application pertaining to the land use designation of the property will require the signature of the title owner. The seller should agree to this request as long as the buyer reimburses the seller for all costs related to such applications, and so long as any changes requested by the buyer do not become effective until after the purchase of the property closes.

The buyer should check for compliance problems with all applicable governmental and quasi-governmental entities with jurisdiction over the property. Consider the Oregon Department of Transportation, Tri-Met, the local water district and the sewerage agency. Is Light Rail coming? Is a condemnation action pending? Are assessments pending or threatened? Answers to these questions may affect the buyer’s decision to close the purchase.

1. Miscellaneous. If the property is operated under a business name, steps should be taken to assign the rights to the name to the buyer. Special rights in the property such as mineral rights and water rights, should also be reviewed. If water rights are an issue, the sufficiency of these rights and the method of conveyance of these rights should be considered.

CONCLUSION. It is extremely important that a buyer perform a thorough due diligence review of a property. Such a review will hopefully uncover all matters which may adversely affect the value of the property before the buyer is unconditionally obligated to proceed with the purchase. This will enable the buyer to evaluate whether it is appropriate to proceed with the acquisition and on what terms.