Reducing Risk and Improving Returns Through Due Diligence

Posted about 2 years ago. Applies to California, 1 helpful vote

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Due Diligence. Comprehensive due diligence before leasing or purchasing real estate reduces the buyer/lessee’s risk by ensuring the real estate meets their needs and fleshing out any issues. Think of due diligence as a pie chart: if no due diligence is conducted, your transaction is all risk. As you conduct more thorough due diligence and add categories of investigation, you add “pieces" to your pie chart that reduce the size of the risk segment. In addition, due diligence can reduce the expense of the transaction if you uncover defects that your seller/lessor is willing to pay to have corrected or credit to the purchase price. However, the amount of due diligence that a party can conduct is limited by time and money. In a seller’s market, the buyer may have to act quickly to secure a good property in the face of many competitors. In a distressed sale, the seller may not have sufficient information on the property. In some cases, the buyer/lessee may not have funds to pay third party providers to assist with its due diligence.

While many sellers/lessors resist allowing due diligence (especially prior to a formal written purchase agreement) revealing a property’s “warts" early can eliminate a buyer that isn’t willing to accept the property so the seller can move on to a more compatible buyer. In addition, a seller that presents well organized and complete information can give a potential buyer confidence in the property and put them at ease and in some cases, sell the property at a premium. Notwithstanding, any information provided by the seller should be without representation or warranty of any kind. In some cases, sellers refuse to represent or warrant that they even own the property and require the buyer to rely on title insurance. While that may seem to be an extreme position, for a seller that conducts a high volume of transactions, giving reps and warranties can create growing liability over time.

Risk means money; either lost or earned. From a basic standpoint, failure to uncover a transaction’s risks (such as unknown property defects or expenses) costs money later to correct the problem. For a more sophisticated buyer, risk is an opportunity to make money by acquiring properties with “hair on them." Real estate is priced to account for the risk associated with a type of property or transaction, such as an REO or foreclosure that is priced below market value due to unknown condition of the property. A sophisticated buyer that conducts thorough due diligence can weed out properties that are value priced without the associated problems or can determine with a degree of certainty problems that need to be corrected.

Starting early saves money. Due diligence should begin as soon as the property is identified and before you are contractually bound to purchase or lease the property. Finding “deal killer" issues early prevents you from expending funds on a property that doesn’t suit your needs. In some instances, a seller or lessor will allow you to conduct certain due diligence activities before the parties sign a lease or purchase agreement, but a pre-diligence agreement should be entered to protect the seller from problems (liability indemnification and non-disclosure) associated with the buyer’s due diligence activities. In purchase agreements and some leases, the due diligence time period gives the buyer/tenant a "free look" at the property and the right to terminate the agreement for any reason if its needs aren't met. The danger to a seller/lessor is that a potential buyer may encumber the property with mechanics liens from third party consultants, incur liability for damage or injury occurring on the property, or uncover a defect (or alleged defect) in the property. In one instance, a property owner received a due diligence rejection letter from a potential buyer alleging the property had black mold. The buyer ended up purchasing a property owned by the same person that conducted the property inspection. The owner’s mold specialist determined the “mold" was smudge marks caused by a washing machine hose. Unfortunately, the property owner was left with a letter in its records that caused a potential disclosure issue to future buyers.

What should or must a seller disclose? In California, sellers have a common law duty to disclose facts that materially affect the value or desirability of the property, that are known to or accessible only to the seller and that seller knows are not known to, or within the reach of the diligent attention and observation of the buyer. Even if a seller uses an “as-is" clause, the seller can be liable (through fraud or misrepresentation) if it conceals material defects not otherwise known or observable to the buyer. Basically, an “as-is" provision does not excuse a seller from disclosing hidden material facts known to the seller and failure to disclose such matters constitutes fraud. In addition, a buyer can’t waive disclosure requirements imposed by statute.

“Material" facts are those that have a significant and measurable effect on the property’s value or desirability. Facts that have been deemed material in the past include: improvements constructed on fill, flooding, prior landslides, structural defects, such as roof leaks, termite infestations, building code violations, improvements constructed without permits, zoning violations, existence of easements. In addition, non physical conditions have been found to be material, such as noisy neighbors, murders on the property, zoning violations, and nearby commercial developments. Regarding corrected conditions, courts have not always held that correction of a condition precludes disclosure. Cases have turned upon whether such condition can be “reliably repaired" and have in fact been so repaired. For example, replacement and testing of rusted gas lines or sprinklers are repairs that can be relied upon and need not be disclosed. However, repairs of conditions that have a history of persistence despite subsequent repair (such as a hillside the continually slides), or if the repair may not be reliable, require disclosure.

Due diligence checklists. A good method of performing due diligence is to make a check list of criteria that the property must meet to serve the needs of the transaction. If the acquisition will be financed, the purchaser should check with its lender to determine its due diligence requirements. Depending upon the size and type of transaction, due diligence checklists can be several pages long and contain hundreds of items. Such items may include area/location map, area demographics, copy of existing owner's title policy, project/center CC&R's, acceptable commitment to issue title insurance to the buyer with copies of all exceptions to title, copy of seller’s vesting deed, zoning regulations, discussions with local planning and building officials, building permits, insurance certificates, copy of a real estate tax statement for each parcel, seller's corporate resolution or partnership agreement authorizing the transaction, parcel map or subdivision plat, site improvement and utility plans, geotechnical report, phase I environmental site assessment report with reliance letter and provider's E&O insurance certificate, project pro forma/operating profit & loss statement, construction contract with itemized budget (if recent construction), final as-built plans and specifications, architect's verification of built-to-plans, ADA Access Compliance, ALTA/ACSM as-built survey certified to the buyer, MAI appraisal (including land valuation) and reliance letter, permanent certificate of occupancy, property condition survey, guarantees and warranties, and lease assignments and tenant's estoppel certificate.

Developing comprehensive and disciplined due diligence processes can add value to an organization by reducing risk, both long and short term, reducing acquisition costs, and providing better returns on invested capital by making wise investment decisions.

Additional Resources

Robert Casey, real estate and business attorney

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