Due Diligence in Buying Commercial Real Estate:
Acreage, Apartments or a Building
Due diligence prior to a real estate closing helps
buyers and investors assess risk and achieve their expectations for the
Due Diligence Periods and the
Enforceability of Purchase Contracts
Wikipedia defines due
diligence as reasonable steps taken by a person in order to satisfy a
legal requirement, especially in buying or selling something. Due diligence is
generally considered to be the series of steps a buyer takes prior to closing on
the purchase, to identify all facts and characteristics of the property so that
the buyer can make an informed decision on whether to buy.
Whether you are a real estate
broker working for a client or you are an investor, the goal is to realize a
good investment in the property. Due diligence prior to closing helps the
parties assess the risk of the investment and achieve their expectations for the
Practice Tip: You want to
purchase a fully leased retail building with five store leases in effect. You’ve
opened escrow and are waiting for a title commitment. Your broker sends you a
copy of the leases, and, during review of the leases, you learn that two of the
leases expire in two years or less and one of the leases expires in six months.
Based on these terms, three of the five stores will require new tenants soon. In
a growing economy, you might like this flexibility to permit you to increase
rents in the near future, but in a failing economy the financials of this
building will change negatively very soon. Here, due diligence on the leases is
Who performs due diligence?
Typically, due diligence activities are conducted by a team composed of the
buyer and the buyer’s professionals, including an accountant or tax advisor,
attorneys, an escrow company and, depending on the type of transaction, an
architect, engineer/surveyor, appraiser, environmental consultant and property
Practice Tip: If you are
actively buying properties or expect to buy, compile your team of professionals
in advance of a purchase. Assign the role of project manager to someone on your
team and task him/her to keep track of pending and completed due diligence
activities, due dates (e.g., the end of the due diligence period, closing date,
etc.), the person assigned each activity, and analysis and conclusions reached
by the team on each activity. The team should meet periodically to keep on top
of the results of their due diligence efforts.
When is due diligence
Some due diligence should be performed even before a letter of intent
or purchase and sale agreement is inked. The results of this early, important
due diligence may suggest that you not spend any more time or effort going
forward with the transaction or that you offer a reduced purchase price
reflecting the results of your due diligence on the property.
Practice Tip: Efficient and
inexpensive due diligence can be conducted on the seller and the property prior
to contracting to buy. Substantial information exists online, including these
resources associated with Phoenix-area properties:
Maricopa County Recorder’s
Properties in the County owned by the seller
Liens and loans on title to the seller’s property
Conditions, covenants and use restrictions
History of ownership of the property
Arizona Corporation Commission
Clerk of the Superior Court of Maricopa County
Substantial due diligence should be conducted during the “free look,”
“investigation” or “due diligence” period described in the purchase and sale
agreement. Typically, this period lasts from 10 to 90 days, but can vary with
the transaction. Also, the purchase and sale agreement will usually require that
all due diligence occur before the end of this period, and due diligence not
timely performed is typically deemed waived. During the due diligence period,
but not afterward, the buyer will generally be permitted to terminate the
Which due diligence
activities are common?
Common due diligence activities involve investigating the
history of the property, the condition of title, property boundaries and
physical characteristics, and contracts, including leases if applicable.
Checklists of due diligence activities keep the buyer and real estate agent
organized and on top of various due dates and the persons responsible for
performing the activities. Findings can be exchanged among the due diligence
DUE DILIGENCE ACTIVITY
Review of Historical Documents Concerning the Property
The title commitment and/or title policy issued
on the seller’s purchase of the property may disclose former leases and liens.
Local government zoning and building files may
disclose variances and special use permits that indicate building or use
violations and proposed nearby development or redevelopment plans.
records of historic permits, licenses and contracts may disclose the presence of
hazardous substances and prior uses.
A zoning verification letter to confirm current
zoning and uses, special use permits and variances can be obtained from local
Review of online government records can reveal
the status of real estate and franchise tax liabilities, operating licenses and
Seller’s policies and procedures manuals can
reveal compliance or non-compliance with various laws on employment, taxation,
use and other business conduct.
Review of Buyer’s Title Commitment and Schedule B
Exceptions Described in the Commitment
Discloses ownership of the property.
Discloses other persons/entities claiming an
interest in the property (tenants, easement owners, contractors and lenders).
May disclose past or current uses of the
property or use restrictions.
Discloses recorded development agreements
between an earlier developer and the local governments.
Discloses litigation involving the property.
Review of an ALTA Survey of the Property
When compared against the title commitment, the
survey can reveal unrecorded easements, boundary encroachments and adverse
The survey should be certified to the buyer,
seller (if seller pays for the survey or is the carryback lender), title insurer
and buyer’s lender. The certification of the registered surveyor is essentially
a warranty of the survey’s accuracy.
Onsite Property Inspection
Discloses the condition of the roof, windows,
flooring and mechanical infrastructure.
Allows the development of a list of furniture,
fixtures and equipment in or on the property and the ownership thereof.
Allows a comparison between the actual
condition of the property versus the construction plans, engineering and
architectural drawings, licenses and permits to identify variations and
Determines whether the property has been
maintained and inspected periodically.
Review of Contracts, Warranties and Licenses Concerning
Maintenance agreements may document the need
for and extent of future capital expenditure requirements.
Ongoing contracts, such as a property
management agreement, landscaping agreement or HVAC maintenance agreement, may
be unacceptable to the buyer, and buyer may want them to be terminated at
Tenant estoppel agreements obtained prior to
closing document whether, and to what extent, a tenant has claims against the
landlord/seller for breaches of landlord’s obligations under the lease.
Warranties on construction of the buildings and
equipment may be in effect and can be assigned to the buyer.
Review and Summary of Leases
A summary of lease terms is useful to
determining the value of the property.
A review of the leases will reveal tenant
rights to lease extensions, purchase of the property or early terminations of
A review of the leases will reveal the leases’
term length and amounts of current and future rentals.
Tenant estoppel certificates can confirm that
no landlord or tenant defaults exist.
A review of the leases can reveal landlord
commitments to maintenance, signage, exclusive parking and exclusive use
The importance of conducting
organized, concerted efforts to determine all there is to know about a potential
investment in commercial real estate cannot be understated. A wise buyer
intending to invest in commercial real estate conducts an investigation into
historic records concerning the property maintained by the seller and local
governments, the condition of the property’s title, a physical examination of
the property, its physical characteristics and infrastructure, and various
contracts – such as leases – that affect the property. These due diligence
activities maximize the investment decision and minimize post-acquisition risk.
Janet Jackim represents
buyers, sellers, borrowers, lenders, developers, landlords and tenants of
commercial real estate in Arizona. Janet has been practicing law, with an
emphasis on commercial real estate and business, since 1978, and she has
completed thousands of commercial real estate transactions. Janet can be
contacted at 480-425-2616 (office) or 480-513-9288 (cell) or