Due Diligence in Real Estate Transactions.

A three-part article.

Due diligence has always been part of real estate transactions. Purchasers of, and lenders secured by, real property have always needed to send someone out to "check under the hood" of the property they were planning to acquire or to use as collateral for loans. But just as increased use of complex technologies, such as on-board computers, have made it more complicated to check out a used car thoroughly, increasing use of complex legal technologies, such as securitized lending, and increasingly complex regulations governing real property have made the process of checking out interests in real estate more complex, and due diligence has assumed greater importance in many transactions.

By doing "due diligence" - investigating all aspects of an interest in real property on behalf of a client that plans to take an interest in it - a lawyer can sniff out and often resolve certain practical and legal problems that might otherwise create significant difficulties after the transaction closes. Many of these risks are not intuitively obvious, and can create very large practical difficulties for a buyer or lender if a careful review of all aspects of a parcel of real property is not accomplished before a transaction closes, when all parties are most inclined to work together to resolve such issues. The need for due diligence arises in several circumstances: in a purchase of real property, in a purchase of the assets or stock of a company that has significant real estate holdings, and in loans secured by real property.

PART ONE: OVERVIEW OF DUE DILIGENCE PROCESS

1. What is due diligence, and when is it done?

"Due diligence" means an appropriate investigation into all aspects of a parcel of real property to be conveyed to the purchaser or lender. What amount of diligence is "due" depends upon the circumstances, including the risks created by the prior use of the property, the monetary value of the transaction, and the budget available.

In a simple purchase of real property, a buyer will typically make an offer for a given piece of real property at a set price, but the offer will be contingent upon the buyer's (and it's lawyer's) review and investigation of every aspect of the property. Usually, the buyer will demonstrate that it is serious about buying the property by making a "good faith" deposit of a certain amount of money into escrow, which amount will be applied to the purchase price if the sale closes. That deposit will usually be returned to the buyer if the buyer terminates the transaction before a certain date, which is often referred to as the date the money "goes hard." The period until the money goes hard is often referred to as the "due diligence period," the "inspection period," or the "review period." Most often, a due diligence review of the property takes place during that time.

When an acquiring company seeks to acquire another company, and the target company has significant real property assets, a prudent buyer will usually ask its counsel to perform a due diligence review of the real estate owned by the target company. In this circumstance, due diligence is often conducted in a different manner: often the lawyers have much less time. For example, if the target company is "in play", meaning that several different possible acquiring companies are making offers to buy the target company, the acquiring company's counsel must perform a quick and thorough review of the target company's records to determine what, if any, legal issues create problems for the target company and whether they affect the value of the target company.

A lender seeking to make a loan secured by real property will usually have its staff and its lawyer review the status of the real property collateral during the time after the lender accepts the borrower's application for a loan and prior to funding the loan. Although real estate collateral is often part of a credit package, it is increasingly the sole security offered for a loan. In order to access the securitization markets, lenders are also asked to make representations to their secondary market about the quality of the collateral, with serious consequences if the statements are wrong. Limited recourse loans, appraisal requirements, and third-party servicing arrangements all force lenders to carefully investigate and document all aspects of the real estate collateral they plan to encumber. A lender's review is similar to that made by a buyer of real estate, which reflects that the lender may have to "buy" the property through foreclosure if the borrower defaults on its loan.

2. Keeping track of the information obtained about the property.

Regardless of the type of transaction, if time allows, most experienced lawyers put together some sort of checklist to keep track of all of the information they need to gather before closing a transaction. This checklist is usually circulated to the client, and often to the other parties. One of the most effective ways to keep track of the information gleaned about a property - as well as what issues still need to be addressed - is to make a combined closing/diligence checklist. At a minimum, such a checklist should include the names, addresses, phone numbers and other contact information about each of the parties to the agreement, their lawyers, the title insurance company and the escrow company. Items that are to be delivered by the seller or borrower at or before the closing, such as a title report, survey, specific information about the property, escrow instructions, certificates from governmental authorities and evidence of appropriate corporate or partnership action and authority need to be included. Items to be delivered by the purchaser or lender, such as any initial and additional deposits, escrow instructions, and evidence of appropriate corporate or partnership action and authority should also be included.

The contents of such a checklist vary by type of transaction. In a loan, for example, a checklist would typically include an approved loan application, payment of an underwriting fee, confirmation that taxes have been paid, evidence of insurance, evidence of zoning suitable for the use to be made of the property, confirmation that title is otherwise unencumbered, confirmation that all easements and other interests in the property …