Commercial Properties and Related Due Diligence Issues for Owners
Most people involved in real estate use the phrase “caveat emptor” or “buyers attention”.
Buying real estate carries risks: invisible structural defects, hidden pollution and other inappropriate conditions that are not advertised on an agent’s website. Buyers are not expected to buy blindly – even the least experienced buyer will do some “due diligence” to learn more about the asset they are trying to purchase. On-site inspections, assessments, environmental tests and other site-specific analyzes are often carried out in order to minimize these risks and, hopefully, to eliminate them – in order to make “buyers watch out” “buyers aware”. Less discussed are the challenges and problems sellers face during the due diligence process. Considering the risks of due diligence can help sellers minimize liability during a potential deal or give them the flexibility to move quickly with minimal cost in the event the sale does not close.
Landowners looking to transfer their property often view due diligence as a “you problem” left to the prospective buyer and their agent during the due diligence phase of the sales contract. This approach is understandable, the buyer takes the risk of acquiring an unknown quantity and loses most if he acquires a defective property or property that is unsuitable for the intended use. However, there are also risks for a seller. On-site inspections can cause damage to property or damage to the parties conducting the inspections. Lengthy due diligence times required to create architectural plans or obtain building permits requested by the buyer can tie the property with no guarantee of completion of the transaction. There is also the possibility that the preparation of the site will result in a tangible lien, more commonly referred to as a “building lien,” which can encumber the seller’s ownership of the property. Understanding these concerns and taking appropriate steps to identify and protect against them in the sales contract is important in minimizing a seller’s risk.
Household liability and property damage
Most landowners know they can be held liable for injuries to others on their property. The same principle of location liability applies to a prospective buyer and their agents who may need to access a seller’s property to conduct due diligence. Often these agents are outside companies (e.g. environmental inspectors, engineers or architects) who are commissioned by a buyer. If these parties are injured on site, costs may arise for the seller. Even if the seller is ultimately guilty of the breach, legal prosecution costs may arise to defend against a claim. There is also the possibility that property may be damaged during on-site visits. There are two ways to mitigate these risks: the buyer must take out building liability insurance and the buyer must indemnify the seller from any claims or property damage related to due diligence. Both options can and should be addressed in the sales contract, which is finalized prior to an on-site due diligence.
Authorization problems
Most sellers have met eligible buyers, but in this case “Eligibility” refers to the zoning or other governmental permits or permits obtained by a buyer prior to closing. Sometimes the seller pursues these claims himself in order to make the property more marketable or to increase its value. More often, the sales contract provides for the buyer to allow some time prior to closing to make any necessary claims, which often allows the buyer to terminate the contract prior to closing if those approvals are denied. In these situations, a seller faces two challenges: the property is not available for sale to another party, while the buyer exercises his or her claims with no guarantee of completion of the transaction and without the flexibility to sell the property at a higher price, when the market changes; and if the buyer acquires the rights, the property may be unsuitable for other uses (e.g., if a buyer receives a reallocation to pursue a particular use, the property may be unsuitable for previously approved uses).
If a buyer wants to bind a property while making claims, he should compensate the seller for that time out of the market and for the risk that the property’s market price changes during the term of the contract. The former can be achieved by including deposit requirements in the sales contract and these deposits are not refunded after certain dates or certain milestones in the claims process. For example, a buyer who intends to reallocate a contractually agreed property may be obliged to place funds in an escrow account upon conclusion of the contract and lose the right to return these funds after six months. Additional deposits may be provided in the agreement to compensate the seller for the time the property remains out of the market or to allow the buyer to extend the purchase period so that he can continue to pursue claims that were made during the original Eligibility period may not be reached.
The risk that the market price of the property will move up during the term of the purchase agreement can also be addressed in the purchase agreement. The contract can simply take into account some price fluctuations by setting the purchase price for a longer term deal higher than for a shorter deal, or by incorporating escalation conditions that reflect a set price increase over time (e.g. a percentage price increase when closing delayed by more than 180 days) or to enable the seller to obtain a new appraisal during the contract period, which may change the purchase price. Whatever option a seller may pursue, they should be aware of the value of giving a buyer time to pursue their claims and of including provisions in the sales contract that compensate them for the loss of opportunities that arise during the sale the term of the contract.
Sellers should also be aware of the dangers of binding claims. Buyers can seek and obtain government approvals that restrict the permitted use of the property – which is not an issue if the buyer closes the transaction after approval, but can be a significant burden for a seller if the transaction is not completed and they are an asset that has depreciated. For example, a buyer may agree to “downzoning” from more intensive to less intensive zoning in order to gain approval for a proposed project. If this approval is given and the buyer does not close the property, the seller now has a demarcated property and can have no other recourse from the purchase contract other than the right to withhold a deposit paid by the buyer. Sellers should consider this option when determining the amount of a down payment and should also consider additional contractual terms that will compensate them in the event a buyer fails to perform the sales contract after eligibility. Contractual penalties, contingent fiduciary funds that become non-refundable after the claim, or contractual terms that allow the seller to require certain performance of the sales contract are all options that can protect a seller in such situations.
Construction links
Most due diligence is limited to examining the property in its current condition or feasibility studies to determine whether a planned use is compatible with the property. Less often, buyers try to improve the property before it closes or use a third party to plan future improvements. An existing tenant may enter into an agreement to purchase the property and seek approval from the seller to improve the property before it closes. Or maybe a buyer is hiring an architect to design improvements to the property. Both situations can entitle external companies to a “building lien” if they are not paid in full for their work. You can find more information on building liens here, but the risk for a seller is that the building lien will be attached to the property for sale even though the seller has never entered into a contract with the pledgee and has no obligation to pay.
This problem can be solved fairly easily by adding two important terms to the sales contract. First, ask the buyer to indemnify the seller from any potential pledgee assigned by the buyer. Second, require the buyer to release any liens asserted against property or default. Together, these provisions should protect the seller from the costs and risks associated with a pledgee depositing a lien on the property.
© 2021 Ward and Smith, PA. All rights reserved.National Law Review, Volume XI, Number 190