Real estate typically plays some part – whether ancillary or integral – in nearly every asset purchase, stock purchase, or merger transaction. Therefore, it’s important to understand what due diligence might be required for the real estate assets involved in the transactions you may be considering, and the potential risks of not performing that due diligence.
Real estate due diligence consists of conducting specific research and investigations on the real property assets so that the parties can:
1. account for the real estate risks that arise in the decision making processes,
2. modify the structure of the deal to resolve the real estate issues,
3. account for the diligence items requiring significant lead time to make sure the transaction closes on time, and
4. identify the potential costs required for a successful closing.
At the outset of the due diligence process, it’s important to inventory all of the properties included in the transaction, confirm those that are owned versus those that are leased, and request any related documentation for each property. This should take place during the earliest stages of the transaction in conjunction with the preliminary negotiations of a term sheet, and well in advance of the negotiations and execution of final transaction documents. Due diligence can then be broken down into five main categories.
Title Review
You cannot effectively purchase property from someone who does not own the property. Surprisingly, ownership of the assets is frequently overlooked. It is possible that individual owners of the seller entity purchased the property as individuals and forgot to transfer title to the property to the seller entity prior to selling his or her own interests in the company. This type of oversight adds the problem of obtaining and recording corrective title instruments prior to the deal closing.
For the greatest protection, a prospective purchaser should obtain a title policy that insures over specific title concerns. Depending on the policy type and proposed transaction, coverage may still apply under existing title policies after closing. If coverage applies, the purchaser may prefer to rely on the existing policies in lieu of obtaining new policies, especially if the policies are relatively recent, and the insured amounts closely approximate the current market value of the property. If it’s available, a “date-down” endorsement that brings the coverage current may be more cost-effective than a new policy.
Title policies, however, are costly and could exceed certain budgets depending on the value of the applicable properties. A cheaper option would be to request a title report or title commitment for a smaller fee. The title report or commitment is a current status of title showing ownership, liens, encumbrances, restrictions, and any other recorded matters against the property. This course of action does not insure the value of the transaction, but allows the purchaser to identify the issues that could place the transaction at a risk of failure. For example, restrictions found on the property could prevent the prospective purchaser from operating the property as desired or unpaid liens on the property could subject it foreclosure.
Survey & Zoning
Obtaining updated surveys and zoning reports will increase your upfront costs, and may delay the transaction due to the significant turnaround time involved in these tasks. But this upfront investment may be well worth it if the deal includes:
1. property headquarters,
2. specialized facilities, like power plants or specialized manufacturing facilities, or
3. recently completed significant construction on the property.
Surveys show access drives, boundary lines, easements and encroachments. It’s important to confirm boundary lines have a starting and ending point that meets, there is access to the property from a main road, proper utility easements exist, and all of the improvements reside within the property lines. Surveys will also help you understand the title or commitment report by listing which exceptions actually affect the property and plotting those exceptions, if applicable, on the map. And title companies usually require an updated survey before they will issue title insurance.
Zoning reports disclose:
1. whether the use of the property is permitted in that zoning district,
2. whether any non-conformities exist, and whether such non-conformities are legally non-conforming,
3. whether any re-build restrictions exist if there is a casualty event, and
4. whether there are any open zoning, building or fire code violations.
These reports provide an in-depth review of the issues that need to be resolved to ensure compliance with zoning and local code requirements. If you’re the purchaser, you should consider the ultimate objective of purchasing the property to determine whether re-zoning may be required by the local jurisdiction.
Lease Review
For transactions involving leases, there are several important concepts to consider. First, confirm that all lease documents provided are complete. Review the lease file for possible references to any material agreements that might be missing from the file. For instance, are there any references to guarantees, environmental agreements, development agreements or tax agreements? Obtaining these additional documents will provide you with a clearer picture of any legal exposure you may assume with the transfer of the lease.
Second, depending on the importance of the lease to the transaction, a summary of the material terms may be important. These material terms include rent escalations, termination date, security deposits, renewal rights, assignability, and any unusual terms such as a purchase option. Assignability may cause the biggest headache for M&A transactions since it is common for leases to prohibit any transfer of a tenant’s interest without the landlord’s prior consent. Any transfer without prior consent could be a default under the lease, which could be grounds for termination of the lease by the landlord. Unfortunately, transfer may be broadly defined in leases to include by operation of law – like a merger – or purchase of substantially all of the tenant’s assets in an asset sale. Reviewing the assignment provision is critical given that some lease assignments might also trigger:
1. a transfer cost due to the landlord,
2. recapture rights by the landlord,
3. changed lease terms,
4. a new guaranty agreement,
5. termination rights, or
6. a purchase option.
On the other hand, landlords can be slow in responding to such requests and typically have no incentive to cooperate. A tenant may be inclined to take a risk and not pursue its landlord’s consent if the rent due under the lease is above the current market value, given that a landlord may be more likely to waive its right to terminate the lease so as to avoid having to re-let the property at a lower rental rate.
Ensure that your due diligence is prioritized for any headquarter leases or other critical leases that are material to the business’ operations.
Environmental Review
The environmental condition of real property may present major economic risks. Although a seller may be agreeable to providing representations and warranties regarding the presence of hazardous materials or any current violations of environmental law, the purchaser may want to alleviate any issues by obtaining a Phase I environmental report. The Phase I report – which is a non-invasive routine checkup on the property – may also be required by the lender financing the transaction. The Phase I report may take weeks to complete but should reveal any environmental risks posed by the property, such as old storage tanks from previous uses on the property or spills of hazardous materials. If these issues are present, the purchaser may want to order a Phase II environmental report, which is much more invasive, much more expensive, and takes much more time.
Although obtaining an environmental report requires additional time and money, the report would indicate the type of cleanup and other expenditures required to restore the property, which should be accounted for in the transaction costs and may provide the purchaser with leverage to negotiate the ultimate purchase price of a deal. Additionally, purchasers would not otherwise qualify for liability exemptions under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”) unless they take the time and money to obtain a current Phase I review report.
The type and structure of the transaction is another important consideration. If structured correctly, in an asset transaction the purchaser generally will not be responsible for the environmental liabilities of the seller that are unrelated to the properties being transferred, unless a third party is able to prevail against the purchaser on a claim of successor liability. On the other hand, the purchaser in a stock transaction or merger will automatically succeed to all of the seller’s environmental liabilities. Accordingly, the environmental due diligence should be larger in scope for a stock or merger transaction.
Transfer Taxes
Transfer taxes and other related fees can be a silent killer in M&A transactions. Transferring title to a property often requires a payment of fees that is assessed as a percentage of either the sale price or property’s fair market value. Even a transfer of an entity, as opposed to real property, can trigger the transfer tax obligation in some jurisdictions. Local counsel should be retained to help assess exposure to such taxes since the rates vary according to jurisdiction, with some of the highest rate found in Philadelphia and New York City. Each jurisdiction has its own set of transfer taxes, rules and exemptions depending on the type of assets and the transfers involved. The transfer tax analysis should be a priority due diligence item occurring prior to contract execution because the exposure may be material. The parties should negotiate who will pay the transfer taxes and potentially allocate the amounts into the overall pricing decision.
Representations and Warranties
In normal real estate purchase transactions, the seller will provide to the buyer a list of representations and warranties in the purchase agreement. They are used to (1) make sure that the purchaser is obtaining the proper due diligence materials by having the seller certify to certain items, and (2) obtain disclosures from the seller regarding what they know about the condition of the property and any title issues or violations of applicable law. These representations and warranties are required to be true as of the execution of the agreement through the closing date, and sometimes beyond.
Alternatively, M&A deals rely on post-closing indemnification claims due to confidentiality concerns. Given that real estate due diligence takes a back seat in many M&A deals, the parties to such transactions should be more inclined to negotiate broader representations and warranties concerning the real estate assets involved. Although the representations and warranties should not replace due diligence, they will be a good security blanket to rely on in the event damages arise from a breach of such representations and warranties as they apply to real estate and environmental matters in the deal.