Due diligence for the distress deal: how little can you afford?

Prudent buyers of commercial property typically expect all of their acquisitions to come with nicely wrapped boxes of due diligence, with all "I’s" dotted and "T’s" crossed. Purchasers of distressed assets, however, rarely have that luxury. Because sellers of distressed assets often place great value on the ability to close quickly and because the existing diligence files on distressed assets are often old, sparse or non-existent, the distressed asset buyer often faces the prospect of having to purchase an asset with little confirmatory due diligence and few (if any) seller assurances as to underlying asset quality. However, a buyer must do at least some minimal due diligence in order to justify the negotiated purchase price being paid for the asset.

This article will review five important categories of due diligence typically obtained by buyers in commercial real estate transactions: title, survey, environmental, lease/contract, and legal compliance due diligence. It will then discuss the differences between the "lender grade" versions of this due diligence commonly obtained in non-distress transactions and less robust but still viable alternatives to that "lender grade" level of due diligence for consideration by distressed asset buyers.

1. TITLE DILIGENCE

Lender Grade: A New Title Insurance Commitment from a National Title Insurer. This will confirm both the current record owner of the property and exceptions that affect title to the property, such as easements, restrictive covenants, other recorded third party rights to use the property, and outstanding mortgages or liens.

Viable Alternatives:

• Title Search or Abstract. If performed by a competent title examiner, an up-to-date title search or abstract may be almost as good for due diligence purposes as a new title commitment. A title commitment will be based on such a search or abstract anyway, so with a title search/abstract, the buyer simply omits the final step of having the title company issue a formal commitment to issue a title policy. Of course, by foregoing obtaining a new title commitment and policy, the buyer gives up having the "full faith and credit" of a national title insurer standing behind the title policy if there is a title problem.
• Review of Online Tax Records. This is a quick way to confirm the likely ownership and configuration of the subject property. Armed with a street address or tax parcel number, a buyer can verify property ownership as shown in the tax records as well as obtain a rough plat of the property’s boundaries (by tax parcel). Buyers must remember that this sort of search is only as accurate as the tax records, and those records will not reveal title encumbrances like easements and unreleased mortgages. However, to quickly and inexpensively confirm the probable ownership and configuration of a particular tract, this approach can be very useful.
• Online Records and Searches. An online search of real estate records can be an easy and quick way to obtain copies of vesting deeds and mortgages for a particular property as well as other documents for which a buyer already has recording information (e.g., through references on deeds, old title policies or old surveys). However, this approach is only as reliable as the online records and the person doing the searching. Moreover, it may be difficult to locate easements, restrictive covenants and other potentially important documents unless the searcher already has recording information for those kinds of documents.
• Review of Vesting Deed or Other Recorded Documents in Hand. Such a review can confirm certain basic title facts. For example, review of a recorded warranty deed can confirm the probable ownership of the property and also reveal important information about title exceptions as of the date of that deed. However, there is no guaranty that the grantor in the deed actually owned the property it purported to convey. Perhaps more importantly, review of a prior deed provides no information about what has happened to the property since the date of the deed. Relying on copies of prior recorded documents, without performing additional title diligence, therefore presents significant risk.
• Review of Title Policies, "Marked Up" Title Commitments, or Pro Forma Policies from Prior Deals. With two important exceptions, these can be almost as helpful as a current title commitment. The first exception is that title insurance documents from prior deals provide contractual assurances of title only for the named insured; they do not allow a new buyer to bring a title claim under them. Secondly, they speak as of the dates that they were issued, and therefore they will not reflect any changes to the title since those dates--such as a subsequent conveyance or mortgaging of the property. Therefore, it would be important to combine a review of a prior title policy with an online search to determine if a deed or mortgage has been recorded since the policy’s issuance date.

2. SURVEY

Lender Grade: A New ALTA Survey. A new survey will show the boundary lines of the subject property, the location of any buildings or other improvements constructed on the property, and the location of easements, set back lines and utilities affecting the property. It can sometimes be very difficult to confirm that property descriptions contained in deeds or other title documents actually "match up" with what actually exists on the ground without a good survey to help verify that. A survey is also necessary to identify certain problems such as encroachments on or from neighboring tracts, encroachments on utility easement areas or no build/set back areas, or the locations of certain easements. Also, if the surveyor makes a mistake in preparing the survey, the surveyor (or its E&O insurance carrier) may be legally responsible for damages sustained by parties legally entitled to rely on the survey.

Viable Alternatives:

• Recorded Plats, Site Plans, Etc. Recorded plats, site plans or similar drawings for the subject property may be helpful. Recorded easements will often include site plans which show the location of the easement on the subject property. Some of these, such as a plat or site plan that is part of a formal planned development, may rise to the level of a boundary survey of the subject property. They may also show the proposed location of required improvements, set back lines and other physical aspects of the property. They usually are not prepared on an "as built" basis, however, and thus often do not show the actual constructed location of improvements or encroachments.
• Tax Maps and Online Mapping Tools. Tax maps, Google Maps and similar mapping tools can confirm basic property location and configuration and the location of buildings and improvements on the property, including those that may pose problems such as potentially encroaching fences. However, such resources typically will not show easement locations or encroachments and may not be current.
• Prior Title Policies. A prior title policy for the property may reference survey exceptions indicated by a survey obtained at the time that prior policy was issued, revealing any survey problems that existed as of the date of prior title policy. The prior title policy may also include endorsements that provide additional comfort on survey issues. Such endorsements could include, for example, a contiguity endorsement (multiple parcels are contiguous to each other), same as survey endorsement (the property described in the vesting deed/title policy is the same property described in a specifically referenced survey), or an endorsement insuring access to the subject property via a particular ingress/egress easement.
• Existing Surveys. Depending on its age, an existing survey can be almost as good as a new one, particularly if the buyer can also obtain a reliance letter from the surveyor. The buyer can obtain an even higher degree of survey comfort if a creditworthy owner/seller of the property will provide a "no change affidavit" attesting to the fact that there has been no change at the property (e.g., no new construction of any kind) since that existing survey was prepared. Simply calling the surveyor who prepared a prior survey may yield useful information about survey matters affecting the property.
• Site Visits. Personal site visits may be helpful in verifying that what actually exists on the ground matches up with what the buyer believes it is acquiring, at least in general terms. Such a visit may also reveal obvious problems that merit further investigation (e.g., such as a fence from an adjacent property that clearly seems to encroach on the subject property).

3. ENVIRONMENTAL DUE DILIGENCE

Lender Grade: A New "Clean" Phase One Environmental Report. In order to avail itself of the "innocent purchaser defense" under the federal (and many state) environmental laws, a prospective buyer must conduct "all appropriate inquiry" into the property, which is typically accomplished by obtaining a current phase one environmental site assessment. The "innocent purchaser defense" may allow a buyer to avoid certain kinds of environmental liability for environmental conditions that pre-date the buyer’s purchase of the property that are not identified as potential risks in the phase one report or, if so identified, are ruled out as a result of a phase two investigation. The phase one can also be used as part of establishing the federal "bona fide purchaser defense," which unlike the innocent purchaser defense can provide the buyer with liability protection against the historical environmental conditions that are discovered through the phase one exercise.

Viable Alternatives:

• Existing Environmental Reports. Existing environmental reports may provide helpful information and comfort on environmental issues if a current phase one is not available. These older reports will of course not address any issues that arise after the report date, which means that the older the report is, the less useful it is for these purposes. Also, if the report is mistaken, only the parties to whom it is addressed would typically be able to make a claim against the environmental consultant, unless a new buyer obtains a reliance letter from the consultant (discussed below). Most importantly, an existing phase one that is more than 180 days old will not allow a new buyer to utilize the "innocent purchaser" defense discussed above.
• Reliance Letter. It may be possible (for a fee) to obtain a reliance letter from the environmental consultant that prepared an existing environmental assessment. The reliance letter may allow the party in whose favor the reliance letter runs to bring a claim against the consultant if the consultant’s report is mistaken, subject to any liability limitations and disclaimers in the consultant’s contract. Furthermore, if the phase one is less than 180 days old, the reliance letter, together with a user questionnaire from the buyer submitted to the consultant, may satisfy the buyer’s all appropriate inquiry requirements for the innocent purchaser defense.
• Review of Historical Users and Walking the Property. A review of historical users and uses of the property (and surrounding property) may provide a buyer with comfort that past uses of such property do not entail significant environmental risks. Simply walking the property may also provide useful visual clues (such as the presence of tanks, staining or obvious dumping) regarding the need for additional environmental diligence.

4. LEASE AND CONTRACT DILIGENCE

Lender Grade: Complete Lease/Contract Review and Current "Clean" Estoppels from Tenants and Other Contract Parties. Ideally, a buyer would obtain and review copies of all leases and other contracts affecting the property, and such copies would be certified by the seller to be true, correct and complete. The buyer would then buttress that by obtaining current estoppel certificates from all tenants and other contract parties confirming that there are no defaults and addressing other typical estoppel matters.

Viable Alternatives for Distressed Assets: There is no real substitute for reviewing copies of the leases and contracts that affect the property. Obtaining estoppels to backstop that lease/contract review will not always be possible as a result of time constraints or a tenant failure to cooperate. In those circumstances, as a second best alternative, the buyer may consider accepting substitute estoppels from the property’s seller that cover the same kinds of things that would be found in a typical estoppel, if the seller is willing to provide these and has the creditworthiness to back them up. Meeting with property managers or onsite tenant representatives can help flush out whether any tenant has a dispute with the landlord. If leases (or memoranda of leases) have been recorded, reviewing those recorded instruments may also be helpful in confirming the terms of important leases, in lieu of (or in addition to) obtaining tenant estoppels as to such leases.

5. LEGAL COMPLIANCE DILIGENCE

Lender Grade: Updated Zoning and Legal Compliance Report from a National Firm. The gold standard for this item would typically include a current property zoning report or opinion from a qualified law firm or recognized company specializing in providing such reports, perhaps coupled with a zoning endorsement to the buyer’s title policy. The buyer could also obtain an architect’s or engineer’s certificate as to the property’s compliance with building codes. It can, however, be time consuming and quite expensive to obtain this kind of evidence of legal compliance.

Viable Alternatives: It will often be possible, at nominal cost, to obtain a zoning compliance letter from local code enforcement officials. Although such letters can take time to obtain and may vary widely in terms of their scope and usefulness, they will almost certainly be much better than nothing. A review of the local zoning ordinances by the buyer or its counsel can obviously be helpful. Obtaining copies of existing certificates of occupancy should provide some comfort that, at least as to the space covered by the CO and as of the date of CO issuance, the property met local code requirements. The existing property owner or its lender may also have obtained zoning conformance reports or title policy zoning endorsements in the past, and, if available, these should also provide some assurance that as of their issuance dates, the property was compliance. Of course, the older those materials are, the less useful they are, and the new buyer will not be legally entitled to rely upon them without obtaining a reliance letter (or comparable document) from the issuer of those materials.

CONCLUSION

If current due diligence is unavailable, a buyer should use as many of the suggested alternatives discussed above as possible, recognizing that as more alternatives are used, the likelihood of obtaining accurate and complete results is enhanced. A buyer should appropriately weight all evidence based on all relevant factors (e.g., date of the due diligence, whether an item of due diligence was drafted or reviewed by an attorney known to be thorough, etc.). A distressed asset buyer who must make quick due diligence decisions should approach its task as a puzzle. There is no "one size fits all" solution to the due diligence puzzle. Each situation and property is unique, and each buyer’s risk tolerance is different. Accordingly, each buyer must determine what level of diligence it must perform in order to be comfortable in closing the purchase of a particular distressed asset.