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Real estate due diligence represents a “standard of conduct”, and “is the degree of diligence necessary to resolve all important issues facing a transaction” (Harp, 2011). Due diligence is typically divided into two subcategories, “property” due diligence and “transaction” due diligence (Harp, 2011). Property due diligence is focused on the real and personal property which is the subject of the transaction (Harp, 2011). Property due diligence is concerned with market demand; access issues (highways and streets leading to property, handicap access, adequacy of parking, etc.); use factors (zoning, availability of utilities, environmental factors or other legal impediments); and financial factors (probable costs for the development, net operating income, environmental impact costs, detailed examination of leases and rent rolls, current deferred maintenance status, etc.) (Harp, 2011).
Transaction due diligence is focused on addressing those material issues necessary for the transaction to proceed to closing (Harp, 2011). Transaction due diligence may be further broken down into two components which include acquisition due diligence (conducted on behalf of both the purchaser and seller to better understand each party and their agreement) and financing due diligence (conducted by the borrower to understand the aspects of the loan) (Harp, 2011). There is overlap between the acquisition and financing sub-parts of due diligence. However, they ultimately “must be analyzed separately and synchronized for simultaneous closing” (Harp, 2011).
The transaction which I chose to review concerns Ms. Hanny Lerner, who was under contract to purchase an industrial building in conjunction with the SBA 504 lending program (Lerner, 2013). Under this program, Ms. Lerner was committing a 10% down payment, while the remainder was financed by the bank (50%) and the SBA (40%) (Lerner, 2013). The first problem occurred with transaction / financing due diligence whereby there were significant delays obtaining financing (beyond the 60 day mortgage contingency in the purchase agreement). Ms. Lerner acknowledges that if a mortgage broker had been used (who had experience and relationships with large banks), the time required to obtain financing would have likely been shorter (Lerner, 2013).
Secondly, once the 60 day mortgage contingency had been exceeded, the seller requested, and Ms. Lerner agreed to convert the purchase agreement from a “mortgage contingent” contract to a “time is of essence” (TOE) contract (Lerner, 2013). A TOE contract may work fine for an all-cash deal, but presents problems for a loan contingent on SBA approval. Ultimately, an additional 30 day extension was required due to delays in loan approval (Lerner, 2013).
The third aspect of due diligence failure occurred with property due diligence, specifically the lack of a clause for environmental issues in the purchase agreement. The bank ordered a Phase 1 environmental assessment which revealed two underground storage tanks with no evidence of proper removal or abandonment (Lerner, 2013). A Phase 2 assessment was then conducted to excavate the ground underneath the property and properly abandon the tanks (Lerner, 2013). Costs for this work were borne by Ms. Lerner due to the lack of environmental clause in the purchase agreement (Lerner, 2013).
Finally, Ms. Lerner owned an apartment building which was to be used as collateral by the bank and the SBA for the new property loan (Lerner, 2013). Due to a dispute with a former partner, a “lis pendens” was placed on the apartment building prior to closing (Lerner, 2013). At that point and with the lis pendens attached, both the bank and the SBA pulled the financing commitment (Lerner, 2013).
In summary, there are a multitude of factors to consider when conducting due diligence. Developing a checklist and understanding the inter-relationships and potential pitfalls of different aspects of property and transaction due diligence are crucial for success of the deal.
Harp, K. R. (2011, July/August 2011). Give them their due. Probate & Property, 25, Issue 4.
Lerner, H. (2013). How to get screwed when buying real estate. Retrieved from http://www.forbes.com/sites/hannylerner/2013/12/31/how-not-to-get-screwed-when-buying-real-estate/
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