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Key Due Diligence Items in Purchasing Commercial Real Estate

Buying commercial real estate can be a good investment opportunity. Commercial properties typically offer more financial reward than residential investments, but commercial investments are often more complicated and come with more risks. That is why it is particularly important to exercise great care when conducting your due diligence.

In a commercial transaction, as in a residential transaction, you will have a period to conduct your necessary due diligence. Since commercial real estate is significantly more complicated than residential acquisitions, there is much more to investigate during your due diligence period. A few of the more important due diligence items in commercial real estate transactions are discussed below. If you are considering purchasing commercial real estate, this post is important to review.

Zoning

A thorough and careful assessment of whether the current use of the property and/or the intended use of the property conforms to the municipal zoning code is critical. If the property is in violation of the zoning regulations, you will be in for a major headache down the road.

If you are purchasing a commercial property and do not intend to change the use, one thing you can and should do to determine whether the property complies with the zoning regulations is to request a certificate of zoning compliance from the City or Town planning and zoning department. The zoning officer will conduct an examination of the property and if the property is compliant, s/he will issue a certificate of compliance stating that the property contains no violations. This will provide you with a certain level of assurance that there are no violations at the property. In addition to obtaining this certificate from the town, a contractual representation by the seller that there are no violations will also provide you with protection. The Seller representation and zoning compliance certificate may also serve as a basis for a lawsuit against the Seller and/or Town if it in fact turns out there is a zoning problem after you close.

If you intend to change the use or substantially alter the Property (e.g. construct an addition), in addition to zoning compliance certificate, you should also carefully research whether your intended use is permitted by the zoning regulations. For example, if the property is currently vacant and you intend to lease to a medical practice, you should make sure the zoning regulations permit the use of the property as a medical practice. Similarly, if you intend to physically alter the property, such as construct an addition, you should make sure that the planned alterations are permitted by the zoning regulations (e.g. bulk, setback, and height requirements). You should consider sitting down with staff from the planning and zoning department to go over your project and the intended use so there are no surprises down the road with the zoning regulations. You may need to obtain a permit for your intended use and this should be accounted for when drafting the purchase and sale agreement.

The due diligence contingency provision is important in any real estate transaction but is of particular importance in a commercial transaction. The due diligence provision should be carefully drafted so as to allow you to investigate the zoning regulations and determine whether your intended use and/or alterations are permitted by the zoning regulations. If it is anticipated that you will need a permit from the town, such as a special permit, you should strongly consider a contingency provision that makes the deal contingent on obtaining the necessary permit.

As you can see, zoning issues are significantly more complicated in commercial real estate transactions. This is why it is imperative to carefully conduct your zoning due diligence and include the necessary provisions in the contract to protect you.

Title

It is essential to conduct a careful review of the title of any real property before moving forward to closing, but there are often complicated nuances in the title of commercial real estate that any investor should be ready for if thinking about purchasing commercial property. For example, there may be more complicated leases with commercial tenants than your typical residential tenants. Such leases may contain provisions such as options to purchase, covenants not to lease space to tenants that would cause competition to a particular tenant, longer terms, expansion provisions (giving tenants rights to expand into additional space in the future), and sublease arrangements with subtenants. Reviewing the tenant leases is important in any real estate transaction but of particular importance in commercial transaction due to the various additional provisions that may appear in commercial leases.

Moreover, there are various other types of title issues you may encounter in commercial transactions that typically do not appear in residential. For example, I have encountered several commercial deals where a municipal redevelopment contract was recorded against the title and governed the development of the property, and also contained certain restrictions on the use. This meant that at some time in the past, the town gave a sweetheart deal to a developer (usually in an area in need of redevelopment) and the developer in return promised to build a certain type of building that promoted certain uses. Both deals closed, but my clients had to confirm that the intended use not only conformed to the zoning regulations but also to the redevelopment contract as well. This is one example of a title issue that may appear in a commercial deal that would not manifest in a residential transaction.

As a final point, title insurance is generally more complicated in a commercial deal. Title insurance is a form of indemnity insurance which insures against title defects, unrecorded deeds and easements, boundary line disputes, among other potential title problems. Title insurance is generally required by lenders to protect their mortgage. The lender will typically require a more comprehensive title insurance policy with endorsements typically not required on a residential purchase. These endorsements may insure zoning, usury, environmental liens, mineral rights, along with other matters. Certain endorsements may also be required for certain types of loans such as construction loans.

In summary, you should be ready to face more complicated title issues in commercial real estate transactions. With the proper knowledge and guidance, you should be able to navigate any title issue that comes your way.

Environmental

Another major differences between due diligence in commercial and residential real estate transactions is that environmental due diligence is often required in commercial transactions. Lenders will often require some form of environmental due diligence before allowing you to close the deal. Such environmental due diligence is typically performed by retaining environmental professionals to conduct a “Phase 1 environmental site assessment,” and if necessary, a “Phase 2” and “Phase 3” site assessment.

An environmental site assessment is a report prepared by an environmental company for a prospective purchaser that identifies potential or existing environmental contamination liabilities. The environmental site assessment is conducted in sequential stages, with the first stage called a “Phase 1.” If the first stage of investigation reveals existing or potential contamination, then a “Phase 2” and possibly a “Phase 3” are necessary to determine wither contamination exists or the extent of such contamination, along with remediation strategies.

A Phase I site assessment is a non-intrusive site investigation and does not typically involve the sampling of soil, air, groundwater, and/or building materials. During the Phase I investigation, the environmental professionals will conduct a visual inspection of the site and research records from various public sources to identify any present or potential environmental contamination based on the history of the site and neighboring sites. The research will investigate potential soil contamination, ground and surface water quality, along with the presence of hazardous substances on the site, and will include researching files from various municipal and state departments including the planning and zoning department, health department, fire department, and the Department of Environmental and Energy Protection (DEEP). The Phase I will likely include interviewing the current owner and others with knowledge of the site. If the research and interviews conducted during the Phase I reveal no contamination or potential contamination, a Phase II site assessment is unnecessary. If the phase I does reveal such contamination or potential contamination, a Phase II will then be required.

A Phase II is generally more involved than a Phase I. A Phase II, unlike a Phase I, involves investigations which collect samples of soil, groundwater, and other materials to test to determine whether such samples contain contamination. Common substances tested include petroleum, hydrocarbons, solvents, and sometimes asbestos and mold. Depending on the substances tested, a Phase II could take significantly longer than the initial Phase I test.

If the Phase II reveals contamination, a Phase III will likely be required. The Phase III aims to determine the extent of the contamination and may involve further testing, often more extensive than the Phase II testing. The Phase III will typically provide strategies for a remediation along with recommendation for site monitoring after the cleanup. Remediation methods can vary greatly depending on the type of and extent of contamination, ranging from soil excavation to more complicated soil vapor extraction systems.

It is essential to understand whether there is any contamination on the site before closing the deal. This is particularly important in Connecticut that has a statute called the Connecticut Transfer Act on the books, which regulates the transfer of certain types of polluted sites and requires a party to file certain forms that certify that the site is clean or if polluted, will be remediated.

Moreover, remediation can be very expensive and may make your investment economically unfeasible. Therefore, it is important to have the right environmental professionals conduct your investigations to understand what types of environmental issues are on the site. It is also essential to make sure the contract contains a carefully drafted due diligence clause that allows you to conduct such environmental site inspections and terminate the contract if the results are unsatisfactory.

Financial Due Diligence

Financial due diligence in commercial real estate transactions is complicated and involves a careful review of numerous legal and financial documents. This investigation is critical to assess whether the investment is economically feasible and will generate the desired revenue. Some of these documents should be reviewed by your attorney while others should be reviewed by your accountant/financial professionals. The following are some of the key documents that you should review with your attorney and accountant during your financial due diligence:

  1. Tenant files, including leases, amendments, subleases, and any related documents
  2. Service / maintenance agreements
  3. Utility Bills
  4. Tax documents
  5. Insurance policies and any pending claims
  6. An accounting of all income and expenses related to the property, including rent rolls, tenant delinquencies, taxes, maintenance, security deposits, insurance premiums, management fees, security, budgeted capital improvements, etc.
  7. A list of all personal property being conveyed with the real property
  8. A list of any pending litigation

As mentioned above, the financial due diligence is key in determining whether the investment makes economic sense. It is therefore essential to make sure that the due diligence contingency in the contract includes financial review and requires the Seller to provide the relevant documents.

In Summary

In summary, commercial real estate transactions are significantly more complicated than residential transactions and involve risks not present in residential transactions. This is why it is imperative to conduct extensive due diligence and assemble the proper team of financial, environmental, and legal professionals. Moreover, it is important that your due diligence provision in the real estate contract is carefully drafted to allow you to conduct extensive investigations and to terminate the contract if any such investigations are not to your satisfaction. I have extensive experience drafting contracts and helping buyers conduct their due diligence, and I would be happy to help you and your team in your next deal.

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