Q: Are
there really that many differences between a
commercial real estate deal and buying a house?
A: While many of
the concepts are the same, there can be huge
differences between commercial and residential real
estate. Commercial real estate transactions can be
far more diverse and wide-ranging than selling
homes. Any real estate deal has its share of risks,
and problems can arise that you could never possibly
foresee. In general, however, the risk and potential
liability exposure that you face on a commercial
real estate deal can be much greater than when you
buy a house. Look at it from this perspective: by
and large, we all have a pretty good idea of what
goes on in a typical family home, but can you say
the same thing about a piece of business property?
Depending on the nature of the business, commercial
property may have all kinds of liens and title
problems. There may be greater concerns about
hazardous materials or zoning issues. And there will
always be questions about the suitability of the
property�s location for your business needs.
Furthermore, in many instances, you are not
afforded the same consumer protections on a
commercial real estate deal that may be available
when you purchase a residence. In some states, for
example, residential homebuyers are given greater
protections against abusive lending practices than
are business owners. Likewise, there are mandatory
disclosures required in residential real estate
matters that may or may not be required in a
commercial transaction.
Q: What
are some of the common pitfalls involving a real
estate business deal?
A: Regardless of
whether you�re buying a home or a piece of
investment property, there will always be risks
involved. Your goal should be to lessen these risks
as much as you can. Examples of potential problems
that oftentimes lead to legal disputes include:
- Defects in title
- Debt service and lender requirements
- Mechanics liens
- Zoning and land use problems
- Market fluctuations
- Hazardous waste and environmental
contamination
Real property interests are usually conveyed by a
deed. In order to track how property changes
hands, every state has a public record system where
real property deeds are recorded, becoming a part of
the public record system for everyone to see. In
theory, this is a great system for keeping track of
who owns what, but deeds are sometimes not recorded.
Sometimes people sell or transfer partial interests
in property. Lenders make loans against properties
and record mortgages or deeds of trust that become
liens that are of public record. Easements given to
cross over or use property may or may not be of
record. A judgment against a person can be recorded
and become a lien against any real property that
person owns, even without his consent. All these
things can become a lien against title. You may not
be buying everything you though you were buying,
because someone else may have a prior claim that you
did not know about.
If you are borrowing money to acquire a piece of
real property, the lender is no doubt going to want
security for the loan. While a personal guarantee
may work if your net worth is substantial, a lender
will usually want a mortgage or deed of trust
against the property. This will give the lender the
right to foreclose if you fail to comply with the
terms and conditions of the loan. Beyond the
repayment requirements, these terms and conditions
can give rise to other concerns that could become a
problem. For example, some lenders prohibit
borrowers from taking out more loans on their
property, which could stop you from getting more
financing that your business may need down the road.
Oftentimes, a commercial loan will also require
that a business maintain a certain net equity.
Pre-payment penalties are also common on real
property loans. Also, many lenders on a big
commercial real estate deal require that their legal
fees and costs be paid by the borrower(s).
In a business context, contractors who do work on
real property have a process called a mechanics
lien that they can use to make sure that they
get paid. This is a statutory lien that contractors,
laborers and material men place on property when
they've performed work or furnished materials in the
erection or repair of a building or an improvement.
They must generally give advance notice that they
are going to file the lien, and must then take
action to enforce the lien within strict timelines
if they aren't paid. Ultimately a mechanic�s lien
could be used to foreclose on property, so it can be
a very powerful tool for a contractor, a laborer or
a material man.
A big concern for a business is to make sure not
only that property used in the business is properly
zoned, but also that the zoning of nearby or
adjacent properties is not going to be a problem.
Believe it or not, many people fail in new
businesses because they don't investigate the land
use and zoning issues carefully enough. And even if
you do your homework, issues can come up down the
road if governmental agencies or neighbors try to
change the zoning on your property to limit your use
of it.
If you are in the real estate business, changes
in property values and other market fluctuations can
have a profound effect on your operations. Rents can
go up or down; tenancy rates can increase and
decrease. Changing property values and market
fluctuations can also affect any other type of
business that owns property. With retail space, for
example, a company that owns rather than leases a
store location may decide to change locations to
follow their customer base, only to find out that
they can't afford to move because of property values
having dropped to the point that their business
premises can't be sold at the price they need. (In
contrast, a lease may provide more flexibility
because, at the end of the term, the business could
simply pack up and move without having to worry
about selling the premises.)
The biggest potential concerns to owning business
property, though, are hazardous waste or
environmental cleanup problems. Property owners are
the ones who have primary responsibility for fixing
such problems, even if the current property owner
did not cause them. These problems may not be
obvious or apparent to the naked eye, and could
arise from anything ranging from an underground
storage tank to an old garbage dump. If you're in
the chain of title to contaminated property (meaning
that a some point you held an ownership interest in
that property), you're potentially responsible for
paying for the clean up. The costs for an
environmental cleanup operation can run into the
millions of dollars.
Q: Should
I hire a real estate broker or a real estate lawyer?
A: The goal of
every seller is to maximize profits, and every
prospective buyer wants to get property as cheaply
as possible. Having to pay a real estate commission
or other professional fees as part of a real estate
deal only works at odds with these goals.
Consequently, many business people who are
sophisticated when it comes to negotiating real
estate deals may feel comfortable with doing a lot
of the work themselves on commercial real estate
deals. However, even sophisticated business people
will still rely on professional advice when comes
down to actually closing a deal, as the potential
pitfalls can be so significant. The bottom line is
that you should seriously consider hiring real
estate professionals, and professional fees should
be factored in as a cost to doing any commercial
real estate deal.
There are many reasons why you should hire your
own real estate broker (or an agent who may work for
a broker). The broker or agent should have specific
expertise in commercial real estate, and
particularly in the area where you need it (for
example, office space, retail space, industrial
warehouse space, apartment complexes, agricultural
land). Even if you're just leasing property, a real
estate broker may be invaluable. If he or she is
good, an agent will go out and find property for
you. The agent will also serve as an arm's-length
intermediary to negotiate on your behalf, which can
be much more effective than you trying to negotiate
the deal yourself. (Wouldn't you love to have an
agent representing your interests when you go buy a
new car? It would help you to avoid high-pressure
sales tactics, prevent you from making rash
decisions and make it easier for you to say no. The
same considerations apply here.)
Keep in mind, too, that real estate agents work
on similar deals all the time, so presumably know
what they are doing. Their knowledge and contacts
can well be worth the cost of a commission. They can
also help you with the paperwork, to make sure you
don't do something stupid when submitting an offer.
If you are a buyer, it may really make no sense
not to hire a broker when it would usually be at no
extra cost to you. The seller usually pays the
commission in most real estate deals. Most real
estate agents agree to split the commissions on
listed properties, though, so an agent has a real
incentive to be involved in a deal even if he or she
is not the listing agent. But a buyer can simply
chose to work with the seller's agent to close a
deal. The seller's agent usually won't object if a
written consent is signed. (Incredibly, this happens
all the time and it only makes sense from the
standpoint of the seller's agent, who then gets to
keep the whole commission!)
A multiple-listing arrangement is a you
scratch my back, I'll scratch yours sharing
mechanism for real estate agents. They are mutually
beneficial to buyers and sellers, as well, since the
multiple listing of all properties on the market
will inevitably help to bring buyers and sellers
together. One of the conditions to an agent
participating in such an arrangement is that
commissions are shared when more than one agent is
involved in a transaction.
Any reputable real estate agent would be more
than happy to explain the process at greater length.
The agent should also be willing to work with you as
long as you understand that he or she would have to
look to the seller's agent for payment of a
commission, if any is to be paid. This helps protect
the buyer in the rare instances where there is no
seller's agent (for instance, a property for sale by
owner) where the seller's agent does not participate
in a multiple-listing arrangement.
You shouldn't hire a broker just because he or
she is a relative, or because he or she is your best
friend's spouse. Instead, hire the best person you
can find who has expertise in representing parties
on real estate sales in the segment of the market
where you are looking. Ask lots of people who they
would recommend and why. Ask disinterested parties
who are more likely to give you an informed answer
(for example, escrow agents, lenders, contractors,
real estate attorneys, and people who have recently
bought or sold commercial property). Look in the
newspaper advertisements to see who have been the
highest producers in your segment of the real estate
market. When somebody's name comes up more than a
few times, that person would be someone who you
would want to contact.
Q: If
I hire a real estate broker, why do I need to hire a
lawyer?
A: The benefit of
competent legal advice on a real estate deal stands
on its own. There are so many things that can go
wrong on a real estate deal that you may very well
end up kicking yourself mightily if you don't hire
an attorney to help you with the transaction. You
may even end up hiring a lawyer on a lawsuit, which
could end up be a lot more expensive. Real estate
agents don't usually get paid unless the deal closes
(or unless you somehow become obligated to pay a
commission by, for example, backing out of a deal or
otherwise breaching your listing agreement). And
listing agreements will clearly state that real
estate agents are not providing legal advice. So
real estate agents are typically not going to worry
about the 'what if''s' of the legal details and are
inclined to do whatever they can to push a deal to
closure. This is not the case with an attorney
working on an hourly basis, who is going to get paid
one way or the other. An attorney will be in a
better position to provide you with essential legal
advice and to do so with more impartiality than may
be the case with your real estate agent.
Q: Is
an escrow always necessary?
A: Strictly
speaking, no. Unless the parties contractually agree
to it as part of their deal, there is seldom a legal
requirement that there be an escrow. Inevitably,
though, an escrow is almost always a good idea. The
escrow company ends up being an intermediary and a
facilitator to the transaction. They can also handle
most of the details and the paperwork, including
escrow instructions, title reports, title insurance,
recording deeds and other instruments, and
disbursing funds.
Q: How
do I find out if I am getting good title?
A: In some states,
there are lawyers who specialize in researching
public records to determine the status of title to
property. They will issues opinions or reports as to
the condition to title. In other states, the job of
researching title to property has become something
that is almost universally done by title insurance
companies. These companies have developed tools that
they use to track public records and other resources
to develop extensive databases on title to real
property. They�re able to prepare title reports on
property that are used to determine the status of
title on real property transactions, and that are
used as a basis for issuing title insurance.
Q: What is
a preliminary title report and how much attention
should I pay to it?
A: A preliminary
title report is a document prepared on real property
once an escrow is opened, but prior to closing. It
provides all kinds of information about the property
that is essential for a buyer to see, such as how
title is currently held and what kind of exceptions
to title are currently of record (for example,
easements, liens and encumbrances). The preliminary
title report then becomes the final title report, on
which title insurance is based. In addition to
specific exceptions to title that will be listed on
a title report, it will also list standard
exclusions from coverage.
In virtually every real estate transaction, the
buyer has the right to approve or object to the
preliminary title report and back out of the deal
unless the seller can provide clean title by
eliminating certain exceptions to title prior to
closing. But a buyer will only have a short period
of time during which to act on the preliminary title
report. So it's extremely important for a buyer to
carefully review a preliminary title report
immediately and to take appropriate action if there
are any unacceptable exceptions to title.
Q: What is
title insurance and why is it necessary?
A: Title insurance is
nothing more than an insurance policy that provides
assurance to interested parties that there is good
and marketable title to the property being insured.
However, this never means that title insurance
guarantees perfect title. As with all insurance,
there are a number of different types of policies
and endorsements. There are also many exceptions to
title, which all tie back into information in the
preliminary title report. These include specific
exceptions listed on the property to be insured, as
well as standard exceptions.
One standard exception, for example, is that the
insurance will only be provided for exceptions to
title that are reflected by the public records.
Unless a special endorsement is obtained (which
costs more money), there is no obligation on the
insurance company to insure against defects in title
that would have been apparent from surveying or
otherwise physically inspecting the property.
There are also different types of policies. For
example, it's customary in most states for a seller
to pay for standard coverage for the buyer that
insures that the deed from the seller is conveying
title that it purports to convey, subject to
exceptions in the title report. If a buyer wants
additional protection against third party claims
such as mechanic's liens, the buyer can purchase an
owner's policy. If a loan is involved, a lender's
policy can be issued that specifically insures the
lender against title defects.
It is not always necessary to get title
insurance. In a transaction between related parties,
for example, they may decide not to pay for it and
take the risk of transferring property interests
without purchasing title insurance. In a typical
arm's-length deal, though, it almost always makes
sense to purchase title insurance. If a commercial
loan is involved, the lender will require title
insurance to protect its interest.
Q: Are
there different types of deeds, and why should I
care?
A: The type of deed can
make a big difference. In some states, the typical
conveyance is a grant deed, which basically
says the seller has an interest in the property and
that it is being conveyed to the buyer, but not
necessarily with any representations or warranties
as to title. Other states have warranty deeds
that go a step further to provide a warranty that
the seller has good title to the interest being
conveyed. All states have something like a
quitclaim deed where a party is only signing
over whatever interest that party has in the
property, if any.
The bottom line is that you could take a deed
from someone that means nothing. While this may
amount to fraud on the part of the seller, who wants
to have to sue someone to try to enforce your
rights? And you may not even have a good case if,
for example, you accepted a quit claim deed that
says that you got only whatever interest the other
party had, which may have been nothing. You can see
the need to get competent legal advice.
Q: Does it
make any difference how I take title to commercial
real property?
A: There are many
issues that can arise with respect to how you take
title to property, and especially so in a commercial
context. If you take title as an individual, you may
be exposing yourself to potential liability exposure
that you might want to try to avoid or at least
minimize. You take title through a business
corporation, but doing this could be disaster from a
tax standpoint point. Sometimes, there may be other
alternatives such as forming a limited liability
company that you would own and control that, in
turn, could lease the property to your business
entity.
If joint ownership is involved, you should
clearly understand the differences between taking
title as joint tenants, as tenants in common, as a
partnership, or as community property. You should
also clearly understand your rights versus the
rights of your co-owners. Each and all of these
types of ownership have significant ownership
implications and rights of survivorship.
It short, there are no universal rules of thumb
with respect to how to take title. It's always
advisable to seek professional advice, including
your lawyer and CPA, to assist you in making a smart
decision.
Q: Why is
it necessary to have a separate real estate purchase
contract, when escrow instructions usually seem to
be enough?
A: Amazingly enough, it
is perhaps all too common for parties to close a
commercial deal without having a formal real estate
purchase contract in place. They can shake hands on
a deal, show up at an escrow company and tell an
escrow officer what they want to do. The escrow
officer can then draft instructions for the parties
to sign and they can proceed to close the deal. But
it can become painfully clear that relying solely on
escrow instructions is never the best way to do a
deal. Among the things to take into account are:
- Escrow instructions are prepared primarily
for the benefit of the escrow holder and not any
of the parties to the transaction. They
typically contain language that tries to absolve
the escrow company of any liability. If
something goes wrong, it's pretty hard to hold
the escrow company responsible.
- Conditions that may excuse performance by
one party or the other aren�t likely to be
spelled out clearly. A dispute is more likely to
arise if problems come up with respect to a
party�s performance.
- The escrow instructions aren't going to
cover any side deals the parties contemplated
handling outside of escrow.
- The escrow holder isn't going to provide any
legal or tax advice to cover issues typically
addressed in a real estate purchase contract.
- Escrow instructions aren't going to contain
representations and warranties from the parties
that would typically be addressed in a real
estate purchase contract.
- Escrow instructions won't spell out the
consequences if someone breaks the deal.
Q: What
should be in a real estate purchase contract?
A: Real estate purchase
contracts can be extraordinarily simple but usually
end up being very complex and lengthy documents, in
order to try to address all the "what if's" that are
typically involved in a commercial real estate
transaction. Points that would typically be covered
include:
- Parties
- Recitals (background facts as to why the
parties are doing the deal)
- Description of the property
- Sales price and terms of payment
- Title and title insurance
- Closing date
- Escrow provisions
- Conditions to closing
- Representations and warranties
- Environmental and hazardous waste provisions
- Zoning and land use issues
- Rights to inspection
- 1031 exchange provisions, if applicable
- Liability insurance requirements
- Indemnification and hold harmless provisions
- Remedies if a party breaches
- Rights to amend and modify
- Term and termination
- Rights to assignment or delegation of rights
- Attorneys' fees and costs
- Arbitration rights, if any
- Governing laws
- Other standard provisions
In many instances, it's possible to use standard
form documents prepared by realtor associations that
help to facilitate the drafting process. At a
minimum, these standard form agreements can serve as
effective checklists of issues you may want to
address.
Q: Does as
is mean as is?
A: As between the
parties, it may be. Even here, though, there may be
laws that preclude a seller from completely passing
the buck on certain issues such as environmental
clean up and hazardous waste. And the law sometimes
requires mandatory disclosure of defective
conditions or other problems with property.
Q: If I am
buying real property for my business, do I need to
get an environmental site assessment?
A: Some lenders may
require an environmental site assessment, and there
are certain situations where only makes sense to get
one (such as when you are buying a service station
or a manufacturing business). Otherwise, though, the
chance of there being any problem may seem remote
and it may be tempting to pass on doing an expensive
assessment. But you're probably doing yourself a
disservice if you don't get one, as any problem that
arises could result in catastrophic liability
exposure for you even if you didn't cause the
problem.
There are also different types of environmental
site assessments. A Phase I, for example, generally
involves an inspection of the property and review of
various records, but it doesn't actually involve any
boring or drilling, or the testing of soil or water
samples. These activities are usually done during
the course of a Phase II assessment, which can be
quite expensive. It is usually an option for a buyer
to do a Phase I assessment and consider the results
and recommendations of that process before deciding
on whether to proceed further.
Q: What is
a 1031 exchange?
A: A 1031 exchange
refers to a method of deferring tax on the sale of
an interest in real property allowed under section
1031 of the Internal Revenue Code. In brief, it
allows a seller to defer tax on a gain that would
otherwise be realized on a sale of property if the
proceeds from the sale were reinvested in like-kind
property. It is quite common for a 1031 exchange to
be involved in some manner in a commercial real
estate transaction.
A seller must contractually arrange to convey his
or her interest in the property being sold in
exchange for receiving an interest in another piece
of commercial property. If cash is involved, an
escrow company or facilitator usually it, because
treatment under section 1031 won't be possible if
the proceeds are paid to the seller even for an
instant. In practice, however, the rules for a 1031
exchange can be quite complex and it is easy for a
seller to run afoul with them. It is always
advisable to have competent legal counsel involved
in the transaction.
