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Legal Due Diligence for Commercial Real Estate Transactions

This is the third article of a seven part series I will be writing to help guide commercial real estate buyers through all of the steps involved in the purchase of commercial property.

Sellers of real property have a duty to disclose known defects on a property to potential buyers.  These can include physical defects as well as financial defects and legal defects.  However as a buyer of commercial real estate you should never rely solely on a seller’s word when determining whether to complete a transaction.  You must perform your own due diligence.  In this article we will be discussing the legal due diligence issues you need to be aware of.

Due diligence is the process of verifying all of the statements of facts and potential downfalls of a property you are considering purchasing. Proper due diligence is not a simple matter and normally takes weeks or sometimes a few months to accomplish.  Every commercial real estate transaction should have a due diligence period clause.  This gives the buyer anywhere from 30-60 days (or more) to research the property.  Also, due diligence can be expensive to perform.  You will most likely need to hire experts to research the property and their fees are an out of pocket expense which is normally non-refundable.  However, failure to perform in-depth due diligence on a property can potentially bankrupt you so do not skimp when it comes to getting this information.  If you find something wrong with the property during the due diligence period then you can either go back to the seller and renegotiate the contract or cancel the deal completely.  Also, if you find the seller of the property made an intentional misstatement of facts concerning the property (also known as lying), you can sue the seller for reimbursement of your due diligence costs and possibly further damages as well.

Legal due diligence is extensive and requires experts to perform the research for you.  The basic steps in the legal due diligence process are as follows.

Title Inspection and Survey

This is the place most legal due diligence starts because if something is wrong here then there is no reason to proceed with any other steps until it is resolved.   After signing the contract you will want your own title company to run a search on the property for liens and encumbrances as well as making sure the chain of title is clean.  Never use a company recommended to you by the seller for any due diligence you perform. You want to make sure the company you use always has your best interest first. The title company will order an abstract report on the property (think of it as a background check) as well as a survey.  Between these two documents they will be able to tell you if the property has any liens on it, easements, encumbrances, inaccurate legal descriptions or if somewhere along the chain of transfers of this property any errors were made.  If a title defect is discovered then the seller must correct it or the closing cannot take place. 

Environmental Inspection

The most used Environmental Inspection Report is called a Phase I Environment Site Assessment.  This explores the past use of the property and the surrounding areas looking for any potential onsite or nearby offsite environmental problems and liabilities.  These reports normally cost several thousand dollars and take a significant amount of time to complete so they should be done as soon as you have determined the status of title on the property and are ready to continue.  The purpose of this inspection is to determine if the property contains any hazardous materials or poses a threat in any way to its surroundings. This could be caused by underground storage tanks located on the property or runoff from the property into the water table or any other number of hazards listed by the Environmental Protection Agency. While the report is expensive, the cost of cleaning up an environmental hazard can be astronomical.  While not every deal will require you to obtain a Phase I Environment Site Assessment many lenders will require it as part of their loan guidelines. 

Inspection for Building Code Violations

The most common forms of building code violations include unauthorized construction either in the structure itself or in a subsequent addition that was made, substandard electrical or plumbing work or improper materials used during construction.  If there is a violation then you need to present it to the seller who must get the violation either approved by the City Board of Directors or cure the violation which could involve gutting or tearing down the structure.

Zoning Code Compliance

Every property has a specific use permitted by the city zoning board.  For example, a property can be zoned as commercial, residential or agricultural.  You need to review the city's zoning ordinances and make sure that the property's use complies with what it's legally zoned for.  If its use turns out to be illegal then the city can order the property to be shut down.  This is even more critical when you are purchasing vacant land with plans to conform it to your own use.  If you want to build residential homes on the property and it is only zoned for commercial use then you are going to have to get a variance from the city zoning commission before you can begin construction.  These can take up to six months to obtain so make sure your contract allows you time to get this resolved before you are obligated to buy.

Service and Vendor Contracts

Be sure to review all of the service and vendor contracts that may attach to the property and make sure you have the right to choose to discontinue the services if you so choose.  These types of services may include maintenance contracts, landscaping, cleaning services and food supply.  Also be sure to check if any equipment is still under warranty and if the warranty is transferable.

Obtain a list of all personal property items such as equipment, tools, computers, furniture, supplies and appliances that will be remaining with the property after the transfer.  These should all be itemized and included in the contract to avoid and confusion after closing.  Normally you can use a Bill of Sale to document these specific items and have it included for signatures as part of the closing documents. 

Don't miss part four of this series where I will be discussing the Physical and Financial aspects of a buyer's due diligence. Please leave your questions or comments!

Disclaimer: Nothing stated in this article should be taken as the giving of legal advice.  As always, you should check with a licensed, competent real estate attorney who specializes in your field when unsure of how to proceed.


Daniel Doran About the author: Dan has over 20 years of experience as a real estate attorney, title closer and mortgage lender. Dan is now working with BuildingsByOwner to help educate commercial real estate investors on how to sell and lease their properties privately.


Igor Asnis Says:
Oct 08, 2014

Dan, how can I get in contact with you? I am broker of record and in need of disclosure for my company. Thank you.

Oct 16, 2014

Once you have purchased the property, the next thing that you should do is to make it profitable. In case you do not have time to manage your property, you can hire the services of property managers. They can develop marketing strategies that attract tenants or buyers to your property. They can also deal with other management tasks, such as collecting rents, maintenance, as well as making property improvements. With their help, you will be able to generate returns from your investment in a short amount of time.

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