Articles

Due Diligence ö A Key to Investing in Commercial Real Estate

By

Lino V. Martire, Esq.

Planning to purchase or finance Commercial or Industrial Real Estate? Shopping Center? Office Building? Restaurant property? Parking Lot? Storefront? Gas Station? Manufacturing facility? Warehouse? Logistics Terminal? Medical Building? Nursing Home? Hotel/Motel? Pharmacy? Bank facility? Sports and Entertainment Arena? Other?

An essential component to investing in commercial real estate is performing an adequate Due Diligence Investigation to assure you know all material facts to make a wise investment decision and to calculate your expected investment yield.

The following checklists are designed to help you conduct a focused and meaningful Due Diligence Investigation. As always, the assistance of specialists, such as attorneys, accountants and real estate agents and brokers is always advised.

WHAT DILIGENCE IS DUE?

The scope, intensity and focus of any due diligence investigation of commercial or industrial real estate depends upon the objectives of the party for whom the investigation is conducted. These objectives may vary depending upon whether the investigation is conducted for the benefit of (i) a Strategic Buyer (or long-term lessee); (ii) a Financial Buyer; (iii) a Developer; or (iv) a Lender.

If you are a Seller, understand that to close the transaction your Buyer (and its Lender) must address all issues material to its objective - some of which require information only you, as Owner, can adequately provide.

WHAT ARE THE GENERAL OBJECTIVES?

The general objectives of a purchaser or lender vary depending upon the goal of that party:

(i) A "Strategic Buyer" (or long-term lessee) is acquiring the property for its own use and must verify that the property is suitable for that intended use.

(ii) A "Financial Buyer" is acquiring the property for the expected return on investment generated by the property's income stream, and must determine the amount, velocity and durability of the revenue stream. A sophisticated Financial Buyer will likely calculate its yield based upon discounted cash-flows rather than the must less precise capitalization rate ("cap rate"), and will need adequate financial information to do so.

(iii) A "Developer" is seeking to add value by changing the character or use of the property - usually with a short-term to intermediate-term exit strategy to dispose of the property; although, a Developer might plan to hold the property long term as Financial Buyer after development or redevelopment. The Developer must focus on whether the planned change is character or use can be accomplished in a cost-effective manner. A developer conducting due diligence will focus on issues involving market demand, access, use and finances.

(iv) A "Lender" is seeking to establish two basic lending criteria:

1. "Ability to Repay" - The ability of the property to generate sufficient revenue to repay the loan on a timely basis; and

2. "Sufficiency of Collateral" - The objective disposal value of the collateral in the event of a loan default, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.

The amount of diligent inquiry due to be expended to investigate any particular commercial or industrial real estate project is the amount of inquiry required to answer each of the following questions to the extent relevant to the objectives of the party conducting the investigation:

I. THE PROPERTY

1. Exactly what PROPERTY does Purchaser believe it is acquiring?

(a) Land?
(b) Building?
(c) Fixtures?
(d) Other Improvements?
(e) Other Rights?
(f) The entire fee title interest including all air rights and subterranean rights?
(g) All development rights?

2. What is Purchaser's planned use of the Property?

3. Does the physical condition of the Property permit use as planned?

(a) Commercially adequate access to public streets and ways?
(b) Sufficient parking?
(c) Structural condition of improvements?
(d) Environmental contamination?
(i) Innocent Purchaser defense vs. exemption from liability
(ii) All Appropriate Inquiry

4. Is there any legal restriction to Purchaser's use of the Property as planned?

(a) Zoning?
(b) Private land use controls?
(c) Americans with Disabilities Act?
(d) Availability of licenses?
(i) Liquor license?
(ii) Entertainment license?
(iii) Outdoor dining license?
(iv) Drive through windows permitted?
(e) Other impediments?

5. How much does Purchaser expect to pay for the property?

6. Is there any condition on or within the Property that is likely to increase Purchaser's effective cost to acquire or use the Property?

(a) Property owner's assessments?
(b) Real estate tax in line with value?
(c) Special Assessment?
(d) Required user fees for necessary amenities?
(i) Drainage?
(ii) Access?
(iii) Parking?
(iv) Other?

7. Any encroachments onto the Property, or from the Property onto other lands?

8. Are there any encumbrances on the Property that will not be cleared at Closing?

(a) Easements?
(b) Covenants Running with the Land?
(c) Liens or other financial servitudes?
(d) Leases?

9. Leases?

(a) Security Deposits?
(b) Options to Extend Term?
(c) Options to Purchase?
(d) Rights of First Refusal?
(e) Rights of First Offer?
(f) Maintenance Obligations?
(g) Duty on Landlord to provide utilities?
(h) Real estate tax or CAM escrows?
(i) Delinquent rent?
(j) Pre-Paid rent?
(k) Tenant mix/use controls?
(l) Tenant exclusives?
(m) Tenant parking requirements?
(n) Automatic subordination of Lease to future mortgages?
(o) Other material Lease terms?

10. New Construction?

(a) Availability of construction permits?
(b) Utilities?
(c) NPDES (National Pollutant Discharge Elimination System) Permit?
(i) Phase 2 - Permit required if earth is disturbed on one acre or more of land.
(ii) If applicable, Storm Water Pollution Prevention Plan (SWPPP) is required.

II. THE SELLER

1. Who is the Seller?

(a) Individual?
(b) Trust?
(c) Partnership?
(d) Corporation?
(e) Limited Liability Company?
(f) Other legally existing entity?

2. If other than natural person, does Seller validly exist and is Seller in good standing?

3. Does the Seller own the Property?

4. Does Seller have authority to convey the Property?

(a) Board of Director Approvals?
(b) Shareholder or Member approval?
(c) Other consents?
(d) If foreign individual or entity, are any special requirements applicable?
(i) Qualification to do business in jurisdiction of Property?
(ii) Federal Tax Withholding?
(iii) US Patriot Act compliance?

5. Who has authority to bind Seller?

6. Are sale proceeds sufficient to pay off all liens?

III. THE PURCHASER

1. Who is the Purchaser?

2. What is the Purchaser/Grantee's exact legal name?

3. If Purchaser/Grantee is an entity, has it been validly created and is it in good standing?

(a) Articles or Incorporation - Articles of Organization
(b) Certificate of Good Standing

4. Is Purchaser/Grantee authorized to own and operate the Property and, if applicable, finance acquisition of the Property?

(a) Board of Director Approvals?
(b) Shareholder or Member approval?
(c) If foreign individual or entity, are any special requirements applicable?
(i) Qualification to do business in jurisdiction of the Property?
(ii) US Patriot Act compliance?
(iii) Bank Secrecy Act/Anti-Money Laundering compliance?

5. Who is authorized to bind the Purchaser/Grantee?

IV. PURCHASER FINANCING

A. BUSINESS TERMS OF THE LOAN:

What loan terms have the Purchaser, as Borrower, and its Lender agreed to?

(a) What is the amount of the loan?
(b) What is the interest rate?
(c) What are the repayment terms?
(d) What is the collateral?
(i) Commercial real estate only?
(ii) Real estate and personal property together?
(e) First lien? A junior lien?
(f) Is it a single advance loan?
(g) A multiple advance loan?
(h) A construction loan?
(i) If it is a multiple advance loan, can the principal be re-borrowed once repaid prior to maturity of the loan; making it, in effect, a revolving line of credit?
(j) Are there reserve requirements?
(i) Interest reserves?
(ii) Repair reserves?
(iii) Real estate tax reserves?
(iv) Insurance reserves?
(v) Environmental remediation reserves?
(vi) Other reserves?
(k) Are there requirements for Borrower to open business operating accounts with the Lender? If so, is the Borrower obligated to maintain minimum compensating balances?
(l) Is the Borrower required to pledge business accounts as additional collateral?
(m) Are there early repayment fees or yield maintenance requirements (each sometimes referred to as "pre-payment penalties")?
(n) Are there repayment blackout periods during which Borrower is not permitted to repay the loan?
(o) Is there a Loan Commitment fee or "good faith deposit" due upon Borrower's acceptance of the Loan Commitment?
(p) Is there a loan funding fee or loan brokerage fee or other loan fee due Lender or a loan broker at closing?
(q) What are the Borrower's expense reimbursement obligations to Lender? When are they due? What is the Borrower's obligation to pay Lender's expenses if the loan does not close?

B. DOCUMENTING THE COMMERCIAL REAL ESTATE LOAN

Does Purchaser have all information necessary to comply with the Lender's loan closing requirements?

Not all loan documentation requirements may be known at the outset of a transaction, although most commercial real estate loan documentation requirements are fairly typical. Some required information can be obtained only from the Seller. Production of that information to Purchaser for delivery to its lender must be required in the purchase contract.

As guidance to what a commercial real estate lender may require, the following sets forth a typical Closing Checklist for a loan secured by commercial real estate.

Commercial Real Estate Loan Closing Checklist

1. Promissory Note

2. Personal Guaranties (which may be full, partial, secured, unsecured, payment guaranties, collection guaranties or a variety of other types of guarantees as may be required by Lender).

3. Loan Agreement (often incorporated into the Promissory Note and/or Mortgage in lieu of being a separate document)

4. Mortgage [sometimes expanded to be a Mortgage, Security Agreement and Fixture Filing]

5. Assignment of Rents and Leases

6. Security Agreement

7. Financing Statement (sometimes referred to as a "UCC-1", or "Initial Filing")

8. Evidence of Borrower's Existence In Good Standing; including

(a) Certified copy of organizational documents of borrowing entity (including Articles of Incorporation, if Borrower is a corporation; Articles of Organization and written Operating Agreement, if Borrower is a limited liability company; Certified copy of trust agreement with all amendments, if Borrower is a land trust or other trust; etc.)
(b) Certificate of Good Standing (if a corporation or LLC) or Certificate of Existence (if a limited partnership) or Certificate of Qualification to Transact Business (if Borrower is an entity doing business in a State other than its State of formation)

9. Evidence of Borrower's Authority to Borrow; including

(a) a Borrower's Certificate;
(b) Certified Resolutions
(c) Incumbency Certificate

10. Satisfactory Commitment for Title Insurance (which will typically require, for analysis by the Lender, copies of all documents of record appearing on Schedule B of the title commitment which are to remain after closing), with required commercial title insurance endorsements, often including:

(a) Affirmative Creditors Rights Endorsement (extending coverage over policy exclusion 7 and policy exclusions 3(a) and 3(d) as they relate to creditor's rights matters)
(b) ALTA 3.1 Zoning Endorsement modified to include parking
(c) ALTA Comprehensive Endorsement 1
(d) Location Endorsement (street address)
(e) Access Endorsement (vehicular access to public streets and ways)
(f) Contiguity Endorsement (the insured land comprises a single parcel with no gaps or gores)
(g) Usury Endorsement (insuring that the loan does not violate any prohibitions against excessive interest charges)
(h) other title insurance endorsements applicable to protect the intended use and value of the collateral, as may be determined upon review of the Commitment for Title Insurance and Survey or arising from the existence of special issues pertaining to the transaction or the Borrower.

11. Current ALTA Survey (3 sets), [typically prepared in accordance with 2005 Minimum Standard Detail for ALTA/ACSM Land Title Surveys, certified to the lender, Buyer and the title insurer, including items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from the Surveyor's "Optional Survey Responsibilities and Specifications" referred to as "Table A"].

12. Current Rent Roll

13. Certified copy of all Leases (3 sets)

14. Lessee Estoppel Certificates

15. Lessee Subordination, Non-Disturbance and Attornment Agreements [sometimes referred to simply as "SNDAs"].

16. UCC, Judgment, Pending Litigation, Bankruptcy and Tax Lien Search Report

17. Appraisal (must comply with Title XI of FIRREA (Financial Institutions Reform, Recovery and Enforcement Act of 1989, as amended)

18. Environmental Site Assessment Report (sometimes referred to as Environmental Phase I and/or Phase 2 Audit Reports)

19. Environmental Indemnity Agreement (signed by Borrower and guarantors)

20. Site Improvements Inspection Report

21. Evidence of Hazard Insurance naming Lender as the Mortgagee/Lender Loss Payee; and Liability Insurance naming Lender as an "additional insured" (sometimes listed as simply "Acord 27 and Acord 25, respectively)

22. Legal Opinion of Borrower's Attorney

23. Credit Underwriting documents, such as signed tax returns, property operating statements, etc. as may be specified by Lender

24. Compliance Agreement (sometimes also called an Errors and Omissions Agreement), whereby the Borrower agrees to correct, after closing, errors or omissions in loan documentation.

It is useful to become familiar with the Lender's loan documentation requirements as early in the transaction as practical. The requirements will likely be set forth with some detail in the lender's Loan Commitment - which is typically much more detailed than most loan commitments issued in residential transactions.

Conducting the Due Diligence Investigation in a commercial real estate transaction can be time consuming and expensive in all events.

If the loan requirements cannot be satisfied, it is better to make that determination during the contractual "due diligence period" - which typically provides for a so-called "free out" - rather than at a later date when the earnest money may be at risk of forfeiture or when other liability for failure to close may attach.

CONCLUSION

Conducting an effective due diligence investigation in a commercial real estate transaction to discover all material facts and conditions affecting the Property and the transaction is of critical importance.

Unlike owner occupied residential real estate, when a house can nearly always be occupied as the purchaser's home, commercial real estate acquired for business use or for investment is impacted by numerous factors that may affect its use and value.

The existence of these factors and their affect on a Purchaser's ability to use the Property for its intended use and on the Purchaser's projected investment yield can only be discovered through diligent investigation and attention to detail.

The circumstances of each transaction will determine what degree of diligence is required. The level of diligence required under the circumstances is the diligence that is due. As always, have a specialist in that particular investigation area provide you with assistance.

"LETTERS OF INTENT"

(a.k.a. "Term Sheets" and "Memorandum of Understanding")

What are they? When do you use them?

A letter of intent (commonly referred to as a "LOI") is often an important "tool" in the negotiation of sophisticated business transactions that ordinarily require significant time, investigation, analysis and expense to arrive at the terms of a definitive agreement. The LOI is often used as a "roadmap" or reminder of the basic terms of a proposed deal so that the parties can proceed with the costly groundwork that necessarily precedes a complex transaction without, in most cases, committing to a binding agreement before all of the details are worked out. In these cases, the LOI is designed to set the stage for further negotiations on the details of a transaction. (Sample terms include, price, definition of assets, due diligence items, financing, conditions of sale, representations and warranties, etc.)

The LOI provides assurances that each side is serious about the deal and willing to negotiate in good faith so that the parties can feel more confident in committing the resources necessary to complete the deal. In less complex deals, the LOI is useful for other reasons, such as to avoid later misunderstandings, to maintain momentum for the deal, or create a sense of moral obligation, if not a legal obligation, to proceed. Sometimes the parties intend to lock in a deal quickly with a more detailed agreement to follow. A buyer may want to bind a target before a competitor enters the bidding, for example, or perhaps the buyer needs a LOI to obtain financing for the acquisition.

Potential Pitfalls

The LOI may create a binding contract! A LOI that is not carefully drafted may impose obligations and liabilities that one or both sides did not intend. In some cases, the actual terms outlined in the LOI may be binding and enforceable. If the court considers the LOI a binding contract, it is an enforceable agreement. You are exposed to enforcement of contract remedies including monetary damages.

In deciding whether a LOI is binding, courts have generally examined:

• The language of the LOI;
• The context of the negotiations;
• Whether either or both parties have partially performed their obligations;
• Whether the parties have reached agreement on the essential terms or whether there are any material issues left to negotiate; and
• Whether the letter of intent describes a complex transaction that customarily involves definitive written agreements.

In practice, parties to a LOI often intend parts of it to be non-binding and other parts to be binding. Economic terms and similar "business points" are often intended to be non-binding and subject to change based on the outcome of due diligence and further negotiations. Binding terms typically relate to confidentiality obligations, "no-shop" or "standstill" clauses, breakup fees, payment of expenses and termination. Problems arise when the parties do not clearly express which terms are supposed to be binding and which are not.

The LOI may create a contract to negotiate! A LOI may impose an obligation to conduct good faith negotiations toward a binding agreement consistent with the terms outlined in the LOI.

In California, the case of Copeland vs. Baskin Robbins, decided in 2002, established precedent in this regard. In Copeland, the California Court of Appeals imposed liability for the breach, of an implied covenant of good faith and fair dealing on a party who terminated negotiations under a LOI. Even though the Court in Copeland recognized the LOI itself was not a binding expression of the transaction, it did hold that the LOI constituted a contract to negotiate. Copeland also recognized that where a contract to negotiate exists, California law will imply a covenant of good faith and fair dealing to the contract negotiations and the party who breaches such a covenant will be responsible for "reliance" (out of pocket costs and possibly lost opportunity costs) damages. The Court reasoned that since business negotiations can be a slow, complex and expensive process, public policy favors protecting parties to a business negotiation from bad faith practices of the other party in terminating the negotiations or making capricious demands.

The following are sample disclaimer terms used to avoid the obligation to negotiate in good faith:

• Language disclaiming any agreement to negotiate and explicitly recognizing a right to terminate negotiations for any reason or no reason. Alternatively, a time limitation on negotiations after which either party may cease negotiations for any reason or for no reason may be appropriate;
• Language stating that the LOI is nonbinding in the sense of being ineffective to constitute an actual agreement on the subject transaction;
• Language specifically addressing each party's responsibility for costs and expenses incurred in the negotiation and other possible "reliance" damages. In some circumstances it may also be appropriate to address enforcement costs and to specify that the prevailing party is entitled to recover its enforcement costs; and
• Language in subsequent correspondence between the parties and their agents reiterating that there is no agreement to negotiate.

Avoiding the Pitfalls of the LOI

The following are some general guidelines to help you avoid unintended consequences when entering into a LOI:

• State clearly which terms are binding and which are non-binding. This can be accomplished by dividing the LOI into separate binding or non-binding sections, or by using separate binding agreements to handle matters that must be enforceable, like no-shop/standstill and confidentiality provisions.
• Use tentative or conditional language like "preliminary" and "proposed transaction" while avoiding mandatory terms like "shall", "will" and "must" that suggest an agreement has been reached.
• Be careful when making a LOI "subject to" further action. Such language may be construed as creating a valid contract subject to a condition subsequent, which may create an obligation to deal in good faith toward completion of the deal and therefore limit a party's freedom to simply walk away.
• If the LOI is intended to be non-binding, be careful not to require performance that is more consistent with a binding agreement. Usually, performance occurs after an agreement is reached, not during the negotiation period, so requiring certain performances may be viewed as intent to create a binding agreement. Moreover, performance may give rise to a promissory estoppel claim, i.e. ö one party relied to its detriment on the other party's word. If a party knows that the other will incur substantial costs in reliance on the letter of intent, that party may be prevented from arguing that the letter is non-binding.
• Specify a deadline at which negotiations will end if a definitive agreement is not reached.
• Limit the length of the LOI and the level of detail and specify essential terms that have not been agreed upon. A comprehensive LOI that covers most of the essential terms of a transaction is more likely to be held enforceable.

Conclusion

A LOI is a valuable tool in negotiations toward a final contract. However, there are pitfalls which accompany this negotiation tool which you must be concerned with. Each party to a LOI is well-advised to consult legal counsel before signing a LOI that may have serious and unintended consequences for them.

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