Due Diligence and Closing Process
10 Stages between the signing of the letter of intent and owning property
by Rainer N. Filthaut
1. After the letter of intent has been signed, the purchase contract is negotiated between buyer and seller. It is important to ensure that all of the clients/investors requirements are met by the contract. In addition, standard elements such as representation and warranties, default provisions, casualty, condemnation, due diligence reviews and assignability rights should be part of every contract. As for representation and warranties, the industry standards have changed in a way that the time a warrant stays in effect after the transfer of the property has decreased to six months compared to two to three years in the past. Therefore, it is the investors’ and their agents’ responsibility to use the due diligence period wisely and review the property closely and thoroughly. Also, closing documents as well as conveyance documents (bill of sale, warranty/grant deed, assignment of leases, and assignment of contracts) should be negotiated in advance and attached as exhibits to the purchase contract before the investor signs it.
2. When the contract is signed, the buyer has the responsibility to deposit refundable earnest money in escrow within a certain time. If the deposit is not made on time, the buyer defaults on the contract; therefore, it is important that the broker/agent of investor takes into consideration the time it will take the investor to transfer the funds. If cash is deposited a W-9 form and investment instructions need to be handed out. The deposit will be held in an escrow account for 40 to 50 days.
3. Next, the investor should allow a minimum of two to three weeks for third-party due diligence review. For the investor’s own safety, it is not recommended to use a seller’s existing third part review. There are two parts of a third party review: engineering and environmental. A third party engineering review checks for a building’s structural deficiencies or damages (such as roof, foundation, and so forth). This review is important for two reasons. First, it will allow the investor to better plan financially for upcoming costs or receive a credit from the seller to fix the problems. Second, it can help lower the purchase price if the seller did not disclose these deficiencies in the original contract. A third party environmental site assessment determines in phase I if there is any environmental risk associated with the property by researching the owner history of the property. The results of a phase I review determine if a phase II review is necessary.
4. Another review that should be done is a review of the property’s business and legal status to avoid lawsuits in the future. It is suggested that the buyer receives credit for deficiencies and problems found at the time of closing to avoid that the sellers dissolves or sells all of its assets and cannot be held liable anymore. The review includes five elements: lease reviews, tenant interviews, tenant estoppel certificates; service contracts and warranties, and title and survey.
Lease reviews: should uncover any discrepancies between the current and future income offered to the buyer and the current and future income that the tenants are legally obligated to provide. This will protect the buyer from unexpected costs or lower income and returns.
Tenant Interviews: can reveal if there are any repairs needed that the seller has neglected. Also, the buyer can get a feel for the stability of the rent roll and future income.
Tenant Estoppel Certificates: it is recommended that the buyer obtains signed estoppel certificates from all tenants. One should allow two to three weeks to complete this stage.
In the estoppel certificates the buyer states all the facts of the lease and by signing the tenant accepts these facts. The following should be included in an estoppel certificate:
There are no amendments or modifications to the lease that the buyer does not know about.
Economics of the lease (base rent, base years, expense stops and so forth)
Term/dates of the lease
Amount of security deposit
Future options to renew or terminate the lease or option to purchase the property
Any know defaults of landlord or tenant under the lease
Outstanding improvement allowances due to tenant
Service Contracts and Warranties: Service contracts include contracts to provide services such as janitorial, building security, landscaping, fire alarm monitoring, and trash removal. Buyer needs to ensure that these contracts are transferable to new owner and that the vendors provide good service and charge market rates. In addition, the buyer needs to ensure that warranties and guarantees are transferable to the new owner. This often requires fees and specific transfer procedures. The buyer should attach all service contracts and warranties/guarantees that it intends to keep and transfer to its name as an exhibit.
Title and Survey: In this review it is very important to determine the following:
Records of any liens against the property that need to be discharged or released by the seller on or before closing
Existence of easements or encroachments
Zoning violations related to height, use, parking etc.
Any violations under covenants, conditions and restrictions
Match of legal description in the title report and that on the survey
5. An acquiring entity has to be formed by a legal compliance department. Also, the buyer has to ensure that the new entity is legally allowed to transact business in the state in which the property is located. In addition, the buyer has to prove its existence and authority by providing the title company with the organizational documents.
6. New owner entity needs to set up necessary bank accounts. Some local requirements include the following: set up an interest-bearing account for the security deposit separate from a property account; set up a lockbox account for tenants’ rental payments separate from a property account.
7. A tedious and work-intense stage is to collect financial information to calculate prorations and make adjustments to existing utility bills. Buyer should collect the following data for the month of closing: copies of current tenant billings, schedule of prepaid rents, most recent tax bills for property, schedule of actual collected rental income, schedule of unpaid leases and tenant improvement costs (ensure you break down what part is assumed by seller and buyer), aged receivables, schedule of
security deposits, schedule of unpaid assessment and association fees or dues and copies of most recent invoices, and a schedule of service expenses due showing which contracts have been prepaid and which are unpaid at time of closing. When transferring utilities on the day of closing, deposits need to be paid and the meters should be read on the day of closing.
8. Next, arrangements have to be made to deposit the purchase proceeds in escrow. After prorations and adjustments are known, the exact amount of purchase proceeds that is required for closing can be determined by the following formula:
Purchase proceeds needed for closing = Purchase price
+ closing costs
+ acquisitions or capital reserves
+ advisory fees
+ closing costs contingency
+/- prorations and adjustments
- buyer’s initial deposit
These funds have to be put into escrow the day before closing to ensure that sufficient funds are available to operate the property upon closing and to force the buyer/investor to keep an eye on possible time restraints when liquidating or transferring funds.
9. It is equally important to coordinate the execution of all closing documents. This entails a six step process: the documents need to be produced, checked for accuracy, complete with all relevant exhibits, signed by all parties, notarized, and delivered into escrow a day prior to closing. One should allow two weeks for the coordination of closing documents.
Finally, the closing statement has to be reviewed and approved by both buyer and seller. Generally, a lawyers/escrow holder who needs to approve the exact amount of net proceeds that will be passed on to the buyer produces it. The buyer needs to confirm receipt of net proceeds into its bank account.