Real Estate Due Diligence Explained
When buying or selling real estate, most transactions involve a due diligence period. The due diligence period is defined in the purchase and sale agreement (the "Contract") and is a time for the buyer and seller to investigate and review the property being sold and bought.
Real estate due diligence means investigating, researching and analyzing information about the property to determine whether or not the buyer wants to go forward with the transaction and whether the buyer needs anything fixed in order to feel comfortable buying the property. The buyer will often spend the due diligence period finding out as much information about the property as possible to make a fully informed decision on whether to buy the property, what terms to request in the Contract, and whether or not it is in the buyer’s best interest to move forward with the transaction .
The due diligence period is significant to a transaction because it gives the buyer the opportunity to consider whether or not the property meets the buyer’s needs and, if needed, negotiate repairs with the seller. It also gives the buyer the chance to terminate the transaction during the due diligence period if the buyer feels there are more issues with the property than it wants to deal with before moving forward with the purchase. A buyer must be careful, though, because if it fails to timely exercise the buyer’s right to terminate for any reason during due diligence it loses the right to terminate and is locked into the transaction.
Because of the value of the property and the potential problems that may arise during due diligence, it is smart for a buyer to hire at least one professional to do their due diligence searches due to the many unknowns that exist when buying a piece of real property. It’s in the buyer’s best interest to investigate the property before making the final, huge financial commitment of owning real property.
Categories of Due Diligence Documents
A typical due diligence review of a property includes a review of the following documents:
A. ALTA/ACSM Land Title Survey: This "professional survey report" is prepared for an owner, lender or other third-party claiming rights in the property. It shows the location and dimensions of buildings, structures and other permanent improvements and their locations within or without the property boundary lines. It also includes property lines, easements, rights-of-way, flood zones, streets or highways, public ways and any other permanent features of the property that may affect the use of the property.
B. Title Deed: Upon the purchase of real estate, a new title deed is prepared conveying the property from the seller to the buyer. At the time of closing, the seller delivers the executed deed – notarized and with a proper witnesses’ certificate – to the buyer. The buyer then records the deed at the county Recorder’s Office.
C. Title Report: This report shows the status of title to a particular piece of property. After a title company determines the status of title, it issues a Title Insurance Policy insuring the status of title. The policy will list all exceptions which the insurer will not cover. The Title Company also issues an ALTA/ACSM Land Title Survey Policy insuring a specific survey map which it has approved of a particular parcel of land and the improvements shown on it.
D. Appraisal: This instrument is used to secure a loan for the purchase of property. The lender has the property appraised and the lender then orders the appraiser to prepare a report describing the property to be purchased, its real estate improvements and its condition.
E. Environmental Assessment: Written reports on the environmental condition of the property are obtained. Examples of such reports are:
F. Soil reports: Earth materials and ground water which are located at, near or directly beneath the surface of the property in question.
Property Inspection Reports
"Education and knowledge are the two most important factors in making the right decision."
If you are purchasing a commercial property, our experienced real estate lawyers will help you with the due diligence process. There are numerous forms of due diligence checks that you should do before proceeding with negotiations on the purchase agreement as well as before closing to ensure your best interests are protected.
The aim of due diligence is to reduce your risk by confirming that the conditions of the property meet your expectations. Some of the elements of due diligence are property inspection reports, which are part of the physical due diligence process and provide you with the information needed to identify the potential risks of the property. Ultimately, you want to be confident or understand any potential risks involved concerning the property you are purchasing prior to closing and understand the necessary repairs or reinvestment that may be required in the future. Property inspection reports usually cover the interior and exterior of all improvements and physical attributes on the land including: Generally, these reports are prepared by licensed professionals and contractors and not the sellers even though the sellers may order them, but at the buyers expense. In some circumstances, the seller will have prior reports (at buyers expense) that you can review instead of conducting new reports. When the property inspection reports are ordered and received, you should read the findings to determine if you: It is important to keep everything in context and understand that fixing issues found in the reports should be considered in light of the potential benefits of the property.
Deeds and Property Ownership History
Title deeds and ownership history are fundamental components of real estate due diligence as they serve to verify the ownership of the property, check the chain of title and provide information related to encumbrances against the property such as mortgages, liens or security interests. Title deeds also set out rights, restrictions and obligations associated with the property such as easements, rights of way, right of first refusals, etc.
Verifying the ownership of a property is intuitive as it involves confirming the identity of the owner named in the relevant title deed. However, the process of doing so may prove somewhat complicated where corporate entities or multiple parties are named as the legal owner of the property. This is because further research is required to obtain information on the principals or directors of the corporate bodies or the other legal owners. One way to confirm the identity of those associated with a property is to obtain a corporate status certificate from the Ministry of Finance. A corporate status certificate will usually confirm a company’s name, list its principals, confirm the name of its share registra, confirm if the company is in good standing, state its registered office address or location and refer to the dates of its incorporation and last annual return.
The chain of title, or history of the owner of the respective property, must also be checked in order to confirm ownership. If ownership is not immediately clear from the title deed, the history of the geographical location of the property must also be verified. In addition, instruments affecting the property should be examined in order to confirm that all previous owners properly discharged any mortgages, charges, liens, encumbrances and guarantees or security interests against the property which they may have created or agreed to.
Environmental and Zoning Assessments
Depending on the nature of the property, the due diligence phase may also involve an environmental assessment of the property. The purpose of such an assessment is to determine whether there are any conditions, current or past, on the property that could pose a risk to the environment. The buyer will be interested in any issue which has the potential to affect the environment, including groundwater and soil contamination, as well as issues related to underground storage tanks. It is important to assess this type of information as early as possible in the buying process, since contamination and other risk conditions can be costly to remediate, or impossible to remediate entirely. This information is also beneficial during lease negotiations, where the buyer may seek to retain the right to remediate any issues, or at least obtain a proportionate reduction in rent while any remediation is being performed. In addition to contaminants on site, the buyer should be aware of any past uses of the property that could give rise to a claim of a hazard. Such claims could be brought by neighbors or government authorities. For instance, if the property has been mined, it may be that there are now pits or other hazards which could create liability. The Environmental Protection Act also creates a number of potential categories of liability which the buyer should evaluate carefully . Similarly, buyers of properties used for industrial purposes should keep in mind the class of an industrial use of a property, and how that relates to the zoning of the property as a whole, as well as the buildings and structures separately. The best practice is to determine the use classifications, and compare these to the zoning. The most straightforward classification issue is provision of on-site parking spaces. Requirements can vary widely, and are dependent not only on the zoning classification, but also on the nature of the use. Seasonal or temporary uses of property can also raise issues, along with maintenance and other activities. A buyer of a commercial use property facing such issues may seek to include some flexibility in the lease or purchase agreement to make changes if needed. Of course, the ability to make such changes depends on the process for applying for a variance or special permit with the applicable municipality. Environmental assessments and zoning compliance documents can be very important parts of the overall due diligence process. While many real estate transactions do not involve issues relating to hazardous materials, past use or zoning violations, any possibility of an issue in these areas should be explored thoroughly, prior to closing any real estate transaction. Identifying and understanding the nature of any issues early can save significant amounts of money, and headaches, depending on the history of the property.
Financial and Tax-Related Records
An important document to review before any closing is the Statement of Account or Escrow Statement. It will show you property tax information as well as what could be an outstanding tax lien. State statutes in many jurisdictions will allow non-payment of property taxes to form a lien which takes priority over other encumbrances against property. If your seller has not paid his or her property taxes and there has been a failure to comply with the requirements of the statute to establish a tax lien, even though the relevant period has not expired, you should still demand evidence from the seller that the taxes are being promptly paid. If they are not, you may want to make your buyer’s offer conditional on your seller paying all past due taxes prior to closing.
One area of tax documents that you should be concerned about are "mechanics liens." A mechanics lien is an encumbrance placed on real property due to non-payment for work performed, repairs made or material provided. This is a relatively common occurrence and can cloud a sale and possibly undermine it. A mechanics lien will prevent a title company from writing a title policy unless the debt that gave rise to the mechanics lien is satisfied.
As part of the due diligence process, you should review the most recent title policy. The title policy will contain a list of exceptions. Examination of the exceptions is essential in order to determine whether the property is free of defect. You need to verify that there are no unwritten easements, claims of ownership by a third party for a portion of the subject property or other defects.
Unpaid condominium and cooperative fees also can be a concern.
Other taxes can be of importance as well to due diligence considerations. Where the seller has personally guaranteed its obligation to pay an indebtedness, a lender generally has available a variety of rights and remedies it may exercise to enforce its rights. For example, the loan documents may permit the lender to accelerate the loan payment date and declare the entire indebtedness immediately due and payable. The lender may also be able to place the seller in bankruptcy in order to foreclose on pledged assets or to obtain a judgment against the seller and to seek to enforce the judgment through garnishment of wages or through the foreclosure of liens on real estate owned by the seller.
Assessment of Legal Disclosures
While the due diligence checklist deals with physical property condition and title matters, disclosure obligations are also important in real estate sales. Unlike the due diligence checklist which identifies what is being "assessed", disclosures are more about what "must be disclosed". Without compliance by the seller, the buyer may have damage claims or even the right to rescind the purchase and sale agreement altogether. Disclosure obligations are also important to buyers viewing the property from across the globe or regionally. Without proper disclosure "secrets" that would matter to a buyer may not be uncovered.
The seller may be required to disclose (and indemnify the buyer for any claim that arises due to the nondisclosure) any representation or omission that materially and substantially impairs the value of the property being sold. Also, many states require disclosures to be delivered to potential purchasers cataloging known matters concerning the property, including physical defects. Purchsers, for the most part, pick up the cost and burden of reviewing disclosures in more detail.
But, unlike a great number of disclosures, some disclosures are designed solely to protect the seller. The disclosure may fricanime the price adjustment and/or unpaid debt consent rights. Financial representations make the buyer open to price reduction claims. Other disclosures may give the seller the right to consent to the assignment, or subletting, per its right of consent under the lease. As a general rule, these types of disclosures will run with the land and also be included in the final sale agreement.
Disclosures are tools used in real estate transactions both ways. In commercial real estate, in the owners favor or the purchaser’s favor.
Conclusion: Significance of Comprehensive Due Diligence
At its core, conducting thorough due diligence is the cornerstone of making wise purchasing decisions when acquiring real estate. In commercial real estate transactions, the importance of due diligence is magnified by the potential risks and legal exposure that accompany these agreements. Imperatively , the extensive documentation associated with due diligence provides both buyers and sellers with the necessary insight into potential liability and structural deficiencies, while serving the common goal of promoting confidence that a transaction will proceed to closing. As such, remaining aware of and attuned to the due diligence process is essential to a commercially reasonable real estate transaction.