Basic Aspects of Purchase and Sale Agreements for Commercial Real Estate, Commercial Lender, 3rd Quarter 2000 and Central Realty Investors, August 2002

August 2002

by Nadav Ravid

“The best way to be boring is to leave nothing out.”— Voltaire

If Voltaire was correct, then purchase and sale agreements should be very boring.  A good contract for the sale of real estate should not only cover the general “business” aspects of a transaction, but also the “legal” aspects, such as title and environmental liabilities.  This article examines the most important issues that parties to a Contract should consider when selling and purchasing real estate.

FINANCING.  Generally, a seller (Seller) of commercial real estate will require that the buyer (Buyer) pay the purchase price at the closing without regard to whether or not the Buyer will be successful in obtaining a loan on the property to finance the purchase price.  Therefore, without a financing contingency, if the Buyer is unable to fund the loan, then the Buyer is in breach of the Contract.  If the Buyer, however, is successful in negotiating a financing contingency in the Contract, then the terms of such a provision should be clearly defined in the Contract.  For example, the Contract should specify the minimum interest rate for the loan and the term for repayment, upon which terms the Buyer must accept from a lender or be in breach of the Contract.  Otherwise, the Buyer would have the right to terminate the Contract under the basis that the Buyer could not obtain a loan satisfactory to the Buyer, even if the Buyer was able to obtain a loan at “market rates.”

DEPOSIT.  Typically, deposits equal approximately three percent of the purchase price of the property.  The main issue concerning deposits is whether or not they are refundable to the Buyer at any time if the Contract is terminated.  Sellers try to negotiate the Buyer’s deposit to be nonrefundable immediately upon deposit while Buyers try to negotiate for the deposit to remain refundable until the closing of the transaction.  Generally, Contracts will contain provisions somewhere in the middle, requiring that the Buyers’ deposit become nonrefundable after expiration of the time for Buyer’s due diligence investigation of the property.  This compromise gives the Buyer a “free look” at the property to determine whether or not the Buyer wants to proceed with purchasing the property.  In some cases, Sellers limit this free look by specifically limiting the grounds upon which the Buyer may terminate the contract even during the due diligence period.  For example, a Contract may permit the Buyer the right to terminate the Contract based on the Buyer’s reasonable disapproval of the physical condition of the property provide that such disapproval is only reasonable if the condition of the property cannot be repaired without the buyer spending more than, for example, $100,000.  Otherwise, the Buyer has to proceed with the purchase of the property or lose the deposit.

Unless a Buyer is certain that he will proceed with the purchase of the property, the Buyer will likely not continue beyond the date the deposit goes “hard” and becomes nonrefundable so as not to lose the deposit.  Therefore, the date that the deposit becomes nonrefundable is often the demarcation line establishing whether or not the transaction will close.

LIQUIDATED DAMAGES: Specified Performance.  The deposit amount is usually tied into the liquidated damages provision to the Contract such that if the Buyer commits a breach of the Contract, i.e., terminates the Contract without cause, then the Seller may keep the deposit as liquidated damages for Buyer’s breach of the Contract.  Liquidated damages are generally not applicable to Seller breaches, however, since if the Seller is in breach of the Contract, the Buyer will likely want to pursue an action for specific performance against the Seller.  A successful action for specific performance would force the Seller to sell the property to the Buyer, which action a Buyer may want to pursue under the theory that the real estate property is unique and Buyer’s damages cannot be measured by monetary damages.

DUE DILIGENCE.  The due diligence period is the time period in which the Buyer is given an opportunity to study the property to determine whether or not the assumptions and the factors relied upon by the Buyer in valuing of the property are substantiated by the property records.  Due diligence may cover many different aspects related to the property.  Generally, the diligence includes reviewing title, preparing a survey, conducting physical inspections and soil tests, conducting environmental studies, reviewing the applicable laws affecting the property such as zoning, permits, ADA requirements, and reviewing the property’s leases.

Sophisticated Buyers will typically not proceed with purchasing a property unless the Buyers have fully reviewed all of the property’s records and conducted all necessary studies of the property to confirm that there does not exist any potential “land mines”.  Therefore, this time period is crucial for a successful transaction.

Before entering into the Contract, one of the Seller’s biggest concerns is that the Buyer will tie up the property by entering into the Contract without seriously intending on purchasing the property.  By doing this, the Buyer’s actions will result in lost time and the Seller losing out on other potential buyers who stay away because such potential buyers do not have the time to wait until the property becomes available on the market.  Another consequence is that potential buyers may stay away even after the property becomes available because they may suspect that the reason the original Buyer did not purchase the property is because the property is overvalued or has something wrong with it.  From the Buyer’s perspective, however, the Buyer wants to ensure that the property’s value is supported by the property’s records.  Therefore, the Buyer will need to carefully study various aspects of the property.  As a result, Buyers try to negotiate as much time as possible for the due diligence period, while Sellers try to limit such time periods.

Generally, Sellers provide Buyers with 30-60 days to conduct all of the due diligence.  Sellers sometimes provide Buyers with options to extend the due diligence period provided the Buyer pays a nonrefundable extension fee.  In many cases, 30-60 days is a short time to thoroughly study a property.  Therefore, Buyers often insist that Sellers provide Buyers all of the necessary property records available to Sellers immediately prior to the commencement of the due diligence period.  In some Contracts, Buyers are able to extend the due diligence period because the Sellers failed to provide the Buyers with the required property records.  Therefore, it is important for Sellers to provide in the Contract the methods and time-frames for delivering the property records to the Buyer.  For example, the Contract should specify the documents that the Seller will provide (or has provided) to the Buyer and have the Buyer acknowledge receipt of such documents.

TITLE.  The Buyer purchases the property subject to any other rights existing prior to the Buyer’s purchase.  There are at least three general ways for the Buyer to be deemed to be aware of prior rights: If the Seller or any other party actually notified the Buyer; If a physical inspection of the property would disclose such prior right; or a review of the public records in the local county.

The Contract should require the Seller to disclose any known prior right and provide the Buyer with forceful remedies in the event the Seller fails to disclose all such matters.  The Buyer should also review the property’s title report, which contains the public records to determine whether or not there exist any encumbrances that will adversely affect the value of the property.  In addition to reviewing the title report, the Buyer should conduct a physical inspection of the property and obtain a survey of the property, which plots all encumbrances on the property.

Most properties contain some encumbrances, such as a utility easement or an oil and gas lease.  The Buyer must determine whether or not such encumbrances will adversely affect the Buyer’s intended use of the property.  For example, if the buyer intends to construct an addition to an existing building, but such addition will interfere with an easement, then the Buyer should not purchase the property since the easement holder may be entitled to preclude the buyer from constructing such addition.  Sometimes encumbrances remain despite the fact that the easement holder will likely never enforce such easement.  In these cases, title companies provide Buyers with the option of purchasing an endorsement to the policy that will ensure the Buyers against any losses incurred as a result of the enforcement of the easement.

PHYSICAL INSPECTION AND SOIL TESTS.  The Buyer should conduct a physical inspection of the structural integrity of the improvements and geologic soil tests of the property to ensure that the property’s structure and soil are satisfactory Sellers often justifiably require a lot of control over any inspection or tests conducted on their property, including requiring that prior to any such tests or inspections, the Buyer provide Seller with adequate insurance to protect the Seller against any damage caused by Buyer on the property and any injury to anyone resulting from such tests or inspections.  The Seller will want to detail in the Contract the level of control required by the Seller and the Seller’s insurance requirements.  The Buyer will want to ensure in the Contract that the Seller provides the Buyer adequate access to the property for Buyer’s inspections and tests.

COMPLIANCE WITH LAWS.  The Buyer should ensure that the property contains all the necessary permits and licenses and that the Buyer’s intended use of the property complies with the applicable zoning requirements.  The Buyer should also determine that the property’s improvements, if any, are in compliance with all laws.

Two important areas of law with which it may be costly to comply are the American with Disabilities Act and environmental laws.  Therefore, the Buyer will want the Contract to clearly provide that any violations of such laws shall be paid by the Seller; however, Sellers will often respond that the sale of the Property is “As-Is” and that any costs associated with the condition of the property should be borne by the Buyer.

ENVIRONMENTAL STUDIES.  If a property is contaminated with hazardous materials then not only will the property value drop exponentially, but the property owner may be required to remediate the hazardous substances, regardless of whether or not the property owner caused the contamination.  It is not uncommon for remediation costs to exceed millions of dollars.  Therefore, sophisticated Buyers should thoroughly review all aspects of the property’s environmental status.  Typically, Buyers will conduct a Phase I report which will contain a review of all of the environmental property records.  If a Phase I report does not reveal any past environmental uses of the property or any other reason to suspect that the property may be contaminated with hazardous materials, then the Buyer’s environmental due diligence is usually satisfied.  If, however, the Phase I report reveals that there may have been some contamination of the property, then a Phase II may be required which entails physical testing of the property’s soil and ground water for hazardous substances.  As discussed above with respect to the physical inspection and soil tests of the property, the Contract should detail the issues of access, maintenance and insurance of the property.

LEASES AND ESTOPPELS.  The valuation of a property is often most closely connected to the rents that the property generates from the tenants.  Therefore, it is critical to review the leases to determine the reliability of the income stream.  For example, if the property contains many long-term leases with above-market rents, then the Buyer will want to review the leases to make certain that the Seller has not committed any acts that would permit the tenants to terminate the lease.  In contrast, if the leases are long-term and below-market, then the Buyer will want to review the leases to determine whether or not the tenants have committed any acts that would permit the buyer, as the new landlord, to terminate the leases.  Additionally, the Buyer will want to review the leases to determine whether or not there are any tenant rights to expand or reduce the premises, extend the term of the lease, or purchase the property.

To address such concerns, Buyers should require that Sellers provide estoppel certificates from all tenants certifying whether or not there are any defaults by either parties or related matters affecting the landlord’s and the tenants’ rights to the property.