The problem of due diligence periods in real estate contracts

The problem of due diligence periods in real estate contracts

When a commercial property owner wants to negotiate a sale, the buyer often has a general idea of ​​what they are willing to pay. This idea usually reflects limited investigation and analysis, because more thorough investigation and analysis costs more than a potential buyer is willing to spend without knowing that the property is under contract.

With the exception of seller-friendly markets, both parties usually address the buyer’s concerns by signing a contract of sale but also give the buyer a due diligence period – 30 to 90 days – to further investigate the property. At that time, the buyer can carefully review the leases, check for any physical problems, look for environmental issues, and convince themselves that their plans for the property make financial sense. Above all, the due diligence period gives the buyer time to find the money – debt and equity – needed to acquire the property.

A few days before the due diligence period ends, the seller often receives a phone call from the broker regarding the transaction. At best, the broker will announce that the buyer needs to extend the period of due diligence to check for some issues that need more time, and are often environmentally related. In the worst case, the broker will declare that the buyer’s due diligence investigations revealed that the buyer’s estimate of the property’s value was too high, and that the transaction was meaningless without the price cut.

Either way, the seller faces a dilemma. Other potential buyers who may have been in the picture earlier in the process have all gone on to other things. At this point, they might have all lost interest. If the seller and his broker return to any of these buyers, they may view the property as damaged goods. If a seller pulls the property off the market, he may have to wait several months – or years – before going to the market again. As a result of all this, sellers usually accommodate buyers to some extent.

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Allow more easy time. The seller may try to limit what should happen at that time. For example, if a buyer needs more time to investigate a pile of unidentified items in a property’s backyard, the parties may agree that the extension of the due diligence period is only relevant to that investigation. As long as the cost of solving any problem is less than the agreed maximum, the buyer must close.

On the other hand, the buyer’s demand for a price adjustment leads to more shock to the seller. Can the seller get some benefit in exchange for the price adjustment? The seller may try to speed up closing, or ask the buyer to waive some contingencies or increase the deposit. In theory, the seller might claim the right to receive future payments if the property exceeds certain agreed performance standards. But in practice, buyers will not agree to such actions. If any buyer agrees to such measures, they will be difficult to negotiate, and even more difficult to implement and enforce.

The seller can protect himself from some of these risks by charging the buyer a non-refundable option fee to take the property off the market during the due diligence period. This fee would give the buyer control of the property while it conducts its investigations. It will also compensate the seller if the buyer decides not to proceed. Although this path makes a lot of sense, sellers can usually only get the option fee in very seller-friendly markets.

As another possibility, the contract may give the buyer a period of due diligence but allow the buyer to terminate only if the buyer identifies real problems with the property beyond a certain specified threshold. This approach may intimidate buyers because they usually rely on having full electives as a result of the due diligence period.

Perhaps sellers can protect themselves, at least a little, by not pretending that the due diligence period will end and the buyer will either go ahead or go away. Alternatively, the contract could be based on the possibility of extension. For example, the contract may state that if the buyer wants more time, he must pay an unrestricted extension fee for the purchase price. The buyer will of course prefer to only increase the deposit while keeping this increase in the escrow account to be applied to the purchase price. Even if the contract explicitly requires an extension fee if the buyer wants more time, the buyer may ask for a free extension, but this has a bad flavor because it is different from what both parties agreed on.

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If the seller has other buyers waiting in the wings, this can provide an attractive mechanism to prevent buyers from taking great advantage of due diligence periods. To this end, the seller may wish to make clear his right to negotiate with other potential buyers and even sign stand-by contracts with them. The seller will want to avoid agreeing to exclusivity with any buyer – a reasonable situation given that a buyer with a generous due diligence period does not have a strong commitment to the transaction either.

As the best strategy, of course, the seller should try to determine when to sell it during a seller-friendly market. Unfortunately, today’s commercial real estate markets are not seller friendly. It looks like this situation will escalate in the short term. Sellers should either wait for a better day somewhere down the road – but not all sellers have a long-term view – or find another way to mitigate the impact of generous due diligence periods in contracts.

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