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Due Diligence or What You Don’t Know Can Hurt You
Can You Handle Your Next Lease Negotiation Alone?
DUE DILIGENCE OR WHAT YOU DON’T KNOW CAN HURT YOU
Due diligence is like sweeping a field for mines. Not quite as dangerous, to be sure, but you never get thanked for the ones (i.e. the problems) that you find. The purpose of this article is to provide to buyers a brief summary of some do’s and dont’s and hopefully some useful checklists, which follow each section, and to both sellers and buyers a few practical hints. To keep the reader (not to mention the writer) awake, each subject is headed with an example of a particularly nasty example of what might crawl out from under that particular rock or an (in)appropriate witticism.
1. Overview; or Any Idiot Can Spend $100,000 on Due Diligence Legal Fees. Like a good tailor, the smart investor needs to know how much due diligence is . . . well, due, at the very outset. This is because the key to understanding due diligence is that it never starts later than when the purchase agreement is negotiated. How much is enough is largely a matter of experience, but in general it is determined by the nature of the project and of the investment. For example, a review of income history is more significant for an office building than for a hotel that you’re converting into condominiums. One size never fits all.
Of course, we all want Italian tailoring at K-Mart prices. You won’t find it, but sometimes you’ll get the opposite. Be very careful of costs; law firms thrive on due diligence because it is one of the relatively few tasks that can profitably be delegated to young and inexperienced attorneys. You know how much is enough; they don’t. It is always possible to identify more questions to ask, so that if the instruction is just “protect me,” then the process is open-ended. The client must decide, as a business matter, the boundaries of its due diligence program. Not to worry; if you don’t, I guarantee you’ll never make the same mistake again.
2. The Contract Negotiation; or The Relationship is Always Strongest on the First Date. In the contract negotiation, the first key due diligence issue is to get the seller to produce copies of the documents. If the seller merely gives you the right to rummage around its office and make your own copies, it’ll be harder to prove later on that a document was not produced. Second, the buyer’s approval period should not run until the last document is produced. Third, the buyer must have the right to disapprove any matter in its sole discretion. Practice hint: it’s a good idea to add an omnibus right to approve “the suitability of the property for Buyer’s investment purposes” – this enables a justification-free “out” should the buyer wish to walk from the deal. Fourth, get all the access and inspection rights that you are going to need. Some sellers are wary of allowing invasive or destructive testing, which may be essential for the buyer. Remember, the best chance of getting what you need is right at the beginning, when the parties are most co-operative. Well, maybe the date analogy isn’t quite accurate.
Checklist (for contract clauses):
Seller must produce all documents
Approval period runs from delivery of last document
Access and inspection rights
3. Leases; or Oh, You Mean the Tenant Has the Right to Buy the Building Too? Leases are the keystone of all income producing properties. You must see every one, together with all extensions, modifications and side letters. If there is one thing that you are going to review yourself, let it be the leases; a close reading is essential not only to spot what is there (e.g., rights of first refusal, rights of offset, landlord obligations, dependent covenant clauses) but what is not, such as incomplete operating pass-through provisions. You really must review the leases yourself; leaving it to a third party is very dangerous, because especially in large projects, it is simply too easy to overlook something important. Remember that any lease ambiguities can sometimes be clarified in the estoppel certificates.
All Leases - entire copies plus any addendum or riders.
Rent Roll(s) showing all tenants, rents, escalations, commencement dates/expiration dates, option terms, security deposits, and tenant status.
Management company reports
4. Tenant Files; or No-One Knows the Building Like the Tenants. There may be no issues in the leases or even raised in the estoppel certificates, but you’ll always learn a lot by looking at the tenant correspondence files. These are a mine of information about management, operation and ownership issues in the building, and tenant payment history. Even better, go and talk to the tenants . . . unless the purchase agreement contains a confidentiality clause (in which case access to the tenant correspondence files is all the more important).
Tenant correspondence files
5. Insurance; or How Come No-One’s Willing to Insure Me? Depending on how old the building is, insurance policies can be a very valuable resource. The seller should be required in the purchase agreement to obtain for the buyer a copy of the insurance company’s most recent risk assessment for the building, together with a claims history. This can reveal anything from leaking roofs to uneven paving.
Insurance Policy; including all riders, risk assessments, and disclosure affidavit for carrier
6. Physical; or You Mean it Isn’t Supposed to Lean Over Like That? You need to check out: seismic; soils; building structure; mechanical and system components (e.g. plumbing, electrical, elevator, HVAC). Find out how big the building actually is; some markets are notorious for having floor areas that get bigger each time a lease is signed. Thorough inspections can almost be guaranteed to find some defects or problems, so that buyers often use the due diligence process as a tool for renegotiating the price. This may be particularly true where the buyer is using either in-house inspection teams or independent contractors with whom they do repeat business. Seller’s practice hint: try to get a “no nickel and dimes” clause in the purchase agreement (e.g., individual defects costing less than $X to correct, or defects in the aggregate costing less than $Y, will be deemed acceptable). Also, provide that if the buyer terminates the agreement for a “due diligence” reason, then it must provide copies of its reports as a condition to the return of its good faith deposit; it’s a valuable “package” for the next buyer. Buyers’ practice hint: if the seller asks for this, require reimbursement for the cost of the reports.
7. Financial; or I Didn’t Realize that Andrew Fastow Was on Day Release. You must see a financial operating history of the property. An examination of rent rolls, payment histories, and credit files of existing tenants can be very helpful. The expense side of the ledger is just as important, as it will show aberrations such as unusual spikes – or troughs – in spending.
Measurement of usable and rentable size of the building.
As-built plans and specifications.
Engineers (soils, geotechnical, electrical, plumbing, HVAC, elevator, roofing).
Access to, and availability of additional, telecommunications services.
Utilities - adequacy, availability of any desired upgrades, physical connection arrangements.
Utility bills: Water, Sewer, Gas, Electric (at least two years of monthly statements).
All recent appraisals, engineering reports, environmental reports.
Annual profit and loss statements (P&L’s) 3 - 5 years
Monthly P&Ls (1-2 years)
Balance sheet (3 years)
Rent Roll including term, deposit, and payment history
Tax returns- 3 years
Bank statements showing deposits for last twelve months
Complete audit of building operations (operational audit).
8. Environmental; It Used to be a WHAT? No due diligence inquiry can omit environmental analysis; even an empty field can have pesticide residue or storage tanks on or under it. Generally, the first step is to conduct a “Phase One Assessment”, which usually comprises a visual inspection and an analysis of federal, state and/or county records to establish past and present uses of the property. If justified by the findings of the Phase One Assessment, a buyer may wish to obtain a “Phase Two Assessment” report, which may include subsurface drilling and sampling, monitoring, well installation and sampling, ground penetrating radar, and asbestos and lead sampling. Sometimes the Phase Two Assessment may also include an investigation of special environmental concerns, such as "sick building," lead paint, electromagnetic fields, poisonous insulation, and other "problem" building materials. Some states have specific environmental review procedures.
Phase One Environmental Report
If recommended, Phase Two Environmental Report
9. Service Contracts, or Piggy Properties Gets Paid for all Lease Renewals
and Moron Management Has an Annuity. The buyer needs to review all service agreements. This would include any agreements for trash removal, landscape maintenance, parking lot operation, window cleaning, and so on. Most service contracts are terminable on fairly short notice, but there are some major exceptions. The main ones are property management agreements, which sometimes have long termination notice periods, billboard agreements and, for some odd reason, elevator maintenance contracts. As noted above with respect to leasing, a potentially significant area of exposure is for the payment of brokerage commissions on the exercise by tenants of renewal options or other rights under their leases. Because service agreements can be binding on buyers, it should be possible even in an “as is” deal to obtain a representation from a seller that it has not entered into any service agreement which it has not disclosed to the buyer.
Checklist: all agreements which relate to the ownership, management, operation, leasing and maintenance of the building.
10. Title and Survey; or Roadway? What Roadway? This is a task normally undertaken by the buyer’s attorney. The seller should be required to deliver (or more accurately, to cause the seller to have the title company deliver) copies of all title records. It’s a good idea to ask the title company to plot the easements, as it makes it easier to review the survey when it comes. Buyers should obtain ALTA extended coverage insurance under the 1970 form of policy, as this does not include an exception for creditors’ rights or an arbitration requirement, which were introduced in later versions. A close review of all documents is essential, even of existing loan documents when the loan is not being assumed.
Checklist: ALTA title report, legible copies of all exceptions, and survey.
11. Litigation; or Why Can’t We Close Without Aunt Jane’s Signature? Pending litigation may affect the seller, any of its constituent entities, or the property itself. In addition to getting representations in the purchase agreement, a litigation search can and should be obtained. Some claims can reveal defects in the building while others may go the very ability of the seller to deliver title (for example, where a group of heirs own the property and disagrees as to key elements of the deal – i.e., the “Grubby Group” syndrome).
Checklist: litigation search (state and federal courts).
12. Governmental; or You Mean That Shack is a Historical Landmark? It’s probably a good idea to check the status of the building with local authorities to see whether there are any specific issues with it. Examples are zoning, historical landmark designation, special licenses (e.g. liquor), air rights, certificates of compliance and Americans with Disabilities Act issues. This review should include an analysis of whether, even if the building satisfies these requirements on an existing basis, it will continue to do so if any contemplated renovations or expansions are carried out. Sometimes an existing building is “Grandfathered” under existing rules or regulations, so that once an expansion project is underway the building will have to be brought up to code to remain in compliance.
Checklist: check local authority records and indexes.
Conclusion: There are no hard and fast rules for due diligence. It’s a daunting combination of heads-up batting and sheer drudgery, but it’s worth every penny and every hour.
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Can You Handle Your Next Lease Negotiation Alone?
Whether you own or lease commercial property, you should identify and know how to protect your interests before you sign your next lease. The following is not a complete checklist, but illustrates some of the key issues. How many of them are you familiar with?
1. Tax Increases. Most leases provide that a Proposition 13 tax increases (e.g., on sale of a property) are passed through to tenants. While it is unrealistic in this market for tenants to avoid such increases entirely, some protections may be negotiable, such as by limiting the amount of the increase, or restricting increases to those caused by certain sales.
2. Government Requirements. Who pays for government mandated improvements to the building? Leases should distinguish between those requirements which are not triggered by tenants specific use (the cost of which should be amortized over their useful life and only the amortized portion passed through to tenants as an operating cost), and those which are (for which tenants should be solely responsible).
3. Parking. Tenants should check that leases address their parking rights, including monthly rates, any reserved spaces or areas, and any visitor validation program.
4. Building Standards. To what standard must landlords maintain their buildings? Leases are often silent on this, and may be vague as to services (for example, what does Ajanitorial cover?).
5. Pass-Throughs. Gross leases should describe which building expenses landlords may pass through (generally, increases over the expenses incurred during a base year are passed through), how tenants shares are calculated (in a multi-tenanted office building), and what landlords administrative or management fees are. Tenants should always negotiate for a right of audit. Where tenants have an extension option, the Abase year should be updated upon exercise of the option.
6. Nondisturbance. If a landlord=s lender forecloses, leases which are legally junior or subordinate to the lenders mortgage are wiped out - they simply terminate as a matter of law. Tenants should always obtain from their landlord's lender an agreement to recognize their leases and not to disturb their possession so long as they are not in default. Tenants often fail to ask for this protection, which is generally easy to obtain.
7. Self Help. If their landlord defaults, tenants usually do not have the right to fix the problem and deduct the cost from the rent. From landlord's perspective, giving tenants this right is quite dangerous, yet it is included in some of the standard lease forms.
So, how did you do? Remember, if you are a landlord, that your broker is not an attorney and has probably told you so in writing, so don't expect him or her to act as one. Remember too, if you are a tenant, that leases are never written in your favor. For landlords and tenants alike, having an experienced real estate attorney review your lease before you sign it can save you far more than it costs.
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