One of the items you’ll notice listed in the proforma when researching potential commercial real estate investments are closing costs. Today, we’ll break down what is included in those closing costs and what purpose they serve in a commercial real estate transaction.
One part of the closing process that you may have heard before if you own your home is the term escrow. If you put funds in escrow, they are being held by a neutral third party until either the deal closes, or one or both parties pull out of the deal. Because commercial real estate transactions typically involve quite a large sum and are more complex than a residential transaction, the access to these funds is tightly controlled.
Escrow is typically used to hold option money while the potential buyer performs their due diligence. Option money is often paid when a letter of intent to purchase the property is accepted by the seller from the potential buyer. It is used to prove to the seller that the buyer is serious about the potential deal, and to protect the buyer from the property owner selling the land to someone else while the buyer is still performing due diligence.
Sometimes, CRE purchasers will use the same title agent they use to do a title search on the property as the escrow agent. This isn’t a legal requirement, but one of convenience as the agent is typically familiar with the details of the deal and has no financial interest in the success or the failure of the deal. Typically escrow agents won’t have any responsibility for verification of any part of the deal other than only releasing funds when instructed from both the buyer and the seller. Instructions to release the funds are almost always required to be in writing.
The due diligence process is very important to the buyer, as there are fewer state and federal laws that protect buyers and sellers of commercial real estate. Because of this, the due diligence process can take several months to conclude.
CRE Buyer’s Due Diligence Items:
- Purchase of sale agreement has been properly executed
- Title search
- Title insurance policy
- Recent (within 6 months) survey report
- Recent environmental report
- Copies of any leases associated with the property
- Due diligence deadline
- Confirmation of zoning compliance
CRE Seller's Checklist:
- Purchase of sale agreement has been properly executed
- Buyer has delivered down payment to escrow agent
- The escrow agent has deposited the money in a segregated interest-bearing account
- Filed any responses to objections to the title and/or survey report
- Execution of assignment and assumption of leases by the buyer
Most of the items in the CRE buyer’s due diligence checklist are also included in the closing documents when the sale is completed. For example, the title commitment, survey, and environmental reports, deeds, lease/tenant information, zoning requirements or any other document those involved deem necessary to get the deal closed.
One of the first items that need to be completed during the due diligence period is a title search. A title agent will research the history of the property and make a list of any encumbrances, liens, or variances attached to the property. An example of a variance on the property is an adjoining property having permission to utilize a road or driveway on your property to access theirs. As a buyer, any objections you may have to anything found on the title commitment report must be brought up with the seller to be resolved so the transaction can continue.
Survey and Environmental Reports
Once the buyer has received the title commitment, the next step is to pass this information on to a surveyor and an environmental engineer. The surveyor will map out the property including any variations in elevation and outlining the encumbrances, liens, or variances outlined in the title commitment.
An environmental engineer will go out to the property and drill several holes six to eight feet down and test the soil for any contaminants. Because liability for environmental problems can be so severe, the parties will usually require a separate report and document to deal with the current understanding of environmental issues such as a known wetland or known ground or water pollution.
The buyer will want some statement from the seller stating the property is otherwise free from issues and the seller will want to try and avoid making such a statement. A document detailing the final agreement of the parties as to both the nature of any environmental issues and future liability for later discovered issues will be part of most commercial real estate closings.
Like in residential transactions, part of the closing documents will be some form of a deed, typically a quitclaim deed, but sometimes a special warranty deed is used. Either document, once recorded, officially transfers ownership of the property from buyer to seller.
Also, Federal laws such as the Patriot Act, also require that a non-foreign entity affidavit be executed with the deed.
A commercial real estate closing will include information on any leases/tenants attached to the property and an assignment and assumption of leases document. This document explains that the benefits of any lease transfers from the seller to the buyer. It also transfers future liability for breaches of the lease from seller to buyer and details responsibility for lease breaches prior to the sale. This document also notifies tenants of the change in ownership.
Buyers should require proof that the property is correctly zoned for its current use and for the buyer’s intended use. As part of the closing documents, the parties will want a report that proves a zoning and building jacket search have been conducted and that there are no known zoning issues. Depending on the jurisdiction, this report may include letters from the local municipalities, endorsements to the title of the property, or a detailed report from the title company.
The commercial real estate closing process can be involved and complicated. And, because there is less federal regulation of the process, the parties involved in the transaction have greater freedom to structure the deal and the closing documents to their liking. However, along with this freedom comes the responsibility for both sides to perform more due diligence. This article gave a broad overview of the commercial real estate closing process, but as always, it’s best to consult a competent real estate attorney to discuss a specific situation.
Disclaimer: This information is provided for informational purposes only, and should not be viewed or construed as investment advice.