Anatomy of a Real Estate Transaction–Due Diligence Inspection Period

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Merriam-Webster defines “development” as setting forth or making clear by degrees or in detail. In music, the development is elaboration of “a musical idea by working out of rhythmic and harmonic changes in the theme.”

In the sonata allegro form frequently used in classical concerti, sonatas, and symphonies, the development follows the exposition, where the themes of the music are established. While the exposition in sonata allegro form frequently follows a standard pattern, the development section is more fluid. It is in the development section that composers most demonstrate their creativity and individuality.

In the development, the composer explores the themes introduced in the exposition. The composer may accomplish this through many methods including key changes, changing themes through fragmentation or augmentation, rhythmic changes, tempo changes, repetition, and adding countermelodies along with the themes. Things which seemed unimportant during the exposition may suddenly be in the forefront during the development.

As the development section ends, the intensity of the music may increase as the composer drives the music forward. However, almost always the development ends with a release of the musical tension and return to the original tonic key.

Like musical compositions, most real estate transactions share a common pattern. And like the sonata allegro section, the second stage of the real estate transaction involves an exploration, but of the real estate, rather than musical themes.

This is the third in a series of articles about the Anatomy of a Real Estate Transaction. This article discusses what happens after the parties sign a real estate purchase contract (Contract) during the due diligence inspection period (Due Diligence Period).

What is the Due Diligence Inspection Period?

Although not every Contract uses the terms “due diligence period” or “inspection period,” nearly every Contract includes a Due Diligence Period. Nearly every Contract, whether residential or commercial, allows the buyer to cancel the Contract at the end of the Due Diligence Period. And usually, if the buyer cancels Contract, the buyer’s earnest money deposit is refunded.

The Contract usually requires the seller to provide the buyer with certain information about the real estate. For home purchases, the seller frequently provides only disclosures required by law. However, a commercial real estate buyer may review thousands of pages of lease, financial, maintenance, and other records in addition to on-site inspections.

In a home purchase, the Due Diligence Period might involve little more than hiring a home inspector. In a commercial real estate transaction, the Due Diligence Period usually is more complicated and usually involves several different inspectors. These may involve structural, environmental, pest, zoning, title, survey, and maybe others depending upon the real estate.

Title and Survey Examination

Every real estate transaction should involve a title and survey examination. In a home purchase, the title company must review the title to issue the title insurance required by the mortgage lender. The mortgage lender also will require a minimal survey.

For commercial real estate, the buyer should order a title commitment from a title company and should order an ALTA survey, which meets requirements of the American Land Title Association. A title commitment will show what liens, encumbrances, and restrictions are on the real estate.

At minimum, the buyer should request that the ALTA survey should show the locations of any easements and identify any encroachments, even though those may be optional survey items. Selection of additional optional ALTA survey items may be warranted, depending upon the real estate. Title and survey review is highly specialized and should be done by buyer’s real estate attorney.

Zoning and Permit Due Diligence

Just because real estate is being used in a particular way does not mean that the real estate is zoned to allow for that use. Commercial real estate purchasers should verify that the real estate’s zoning permits the real estate to be used as the buyer intends.

Likewise, the commercial buyer should review certificates of occupancy and confirm that permits were issued for the initial construction and renovations. Home purchasers who plan to use their home for a business or a short-term rental should confirm that the zoning allows this. Individuals purchasing a home that has undergone renovation or upgrades should confirm that required permits were obtained. If a previous owner did not obtain all required permits, the buyer may have to pay to bring the property into compliance after the closing.

Sometimes, owners change the use of a commercial property without changing its zoning. More often, the zoning changes and the property’s use is “grandfathered” so it can continue after the zoning change. If the commercial property is operating under “grandfathered” zoning, the buyer should evaluate its ability to make changes to the property or rebuild after a casualty.

Insurance History

Commercial real estate buyers should have their insurance advisor review the insurance loss runs for the property. The buyer likely will “inherit” the property’s claims history. A history of excessive claims may result in higher-than-average insurance costs for the buyer. Rarely, a seller’s claim history might prevent buyer from getting insurance altogether.

Although most home purchasers don’t investigate a property’s insurance history, properties with particular risks (i.e. properties in a hurricane zone) might find insurance claim information useful in evaluating future risk.

Both home and commercial buyers should obtain insurance quotes during the due diligence period so there are no surprises after the closing. All buyers also should inquire whether the property is in a flood zone, in which case flood insurance is advisable.

Environmental Assessment

Commercial real estate buyers should order a Phase I Environmental Site Assessment (Phase I). The Phase I should reveal if there any “recognized environmental conditions” at the real estate.

Home purchasers rarely order Phase Is. However, all buyers should order inspections for mold, lead, asbestos, and radon as appropriate for the age and location of the property.

Many environmental concerns are not a “red light” for acquiring the real estate. Yet, they can cause increased maintenance and renovation costs for the buyer. Serious environmental concerns may make it difficult for the buyer to get a mortgage loan or to sell the real estate.

Wood-Boring Insect Inspection

Every real estate purchaser should obtain an inspection for termites, carpenter ants, and other wood-boring insects, and the seller should remediate any infestation before closing. A history of wood-boring insects doesn’t mean the buyer should buy the real estate. It does mean the buyer should be on the lookout for future infestations and may want to have regular preventive treatment for the insects.

Financial Analysis

Commercial real estate buyers should review every lease and confirm that the lease terms are consistent with the financial records. Also, buyers should compare the leases, financial records, and if possible, bank records, to confirm that rental revenue numbers are stated consistently.

Buyers also should walk through every rental unit and confirm that the tenants on the leases are actually occupying their units. For office, industrial, and retail properties, the buyer should get tenant estoppel certificates from major tenants, verifying their lease terms.

Buyers should read every service contract, and tax and utility bills, and verify that they match the financial records. Contract and personnel expenses should be evaluated against local industry norms. For instance, if payroll is lower than expected, the owner might be performing services for which the buyer would have to pay after closing or employees might be receiving reduced rent as part of their compensation. If maintenance expenses are lower than expected for a property of that type and age, the seller might not be maintaining the property

Americans with Disabilities Act Audit

Most commercial properties built or renovated after 1991 must comply with the Americans with Disabilities Act (ADA). If the property is not in compliance, the buyer should require that the seller correct any potential violations. Individual residents need not comply with the ADA.

Which Inspections Does the Property Need?

Just as every development section in sonata allegro form is different, every real estate property is unique. Depending upon its location or history, or the inspection results or buyer’s plans, additional inspections might be appropriate.

However, buyers need not go it alone. Mortgage lenders invest in a property alongside the buyer, and usually provide 70-80% of the closing funds. Lender inspection requirements benefit both the lender and the buyer. Plus, buyers can and should enlist experienced real estate attorneys, real estate brokers, and other professionals to help them determine whether additional inspections are advisable.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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