Most investors of
commercial real estate understand the importance of “due diligence”; a term
often used to describe the process of investigating anything and everything
about the property to be purchased. Confirming
what property is being received, what condition it is in, what can or cannot be
done with the property, and what risks are inherent in its ownership are of
critical importance and warrant formal and extensive due diligence inspection
rights in the commercial contract. Title
commitments, surveys, environmental
audits, and building inspection reports are
the most often utilized tools found in a “diligence tool box.”
There is no need for diligence in
a residential transaction, is there? Don’t the broker forms all have inspection
rights already in their contract forms? It is not like we are dealing with
multi-million dollar properties, right?
We often hear questions like these, and unfortunately, most
often we hear them after the contract has been signed, when it is usually too
late to be intelligently preemptive. The
answers are: (1) yes, there is
need for diligence in residential transactions; (ii) yes, the broker forms all have inspection rights
already in their contract forms, but thee forms don’t go far enough; and (iii)
it doesn’t matter if the property being purchased is for $100,000 or $1,000,000;
most real estate issues/problems don’t discriminate based upon price. Actually,
buyers of lower priced properties often fare worse than buyer-investors of
higher priced real estate because they are less likely to be able to absorb a
loss, unwanted litigation or unbudgeted for expenses.
Simply put, diligence is needed in any real
estate transaction because the buyer is usually at a disadvantage. More often than not, the buyer has little
or no knowledge concerning the property, but must diligently investigate and
inspect it or risk understanding, all too well, the still
surviving doctrine of “caveat emptor” (let the buyer beware). Most broker forms, do indeed give the buyer
the right to perform inspections, but they are often limited to the following:
“General Home Inspection”; “Pest Inspection”; “Radon Inspection” and “Lead
Paint Inspection”. I have yet to see a
broker contract form that calls for a title commitment to search for title
issues such as liens and easements, or allows for a survey to check for
boundary lines and encroachments.
Additionally, with respect to the limited inspection rights
that are included within a broker contract, (i) sellers and brokers usually
push for tight inspection time frames (3-7 days), and (ii) the canned contract
language to deal with a problem is often muddled and more seller than buyer
friendly. For example, most broker forms only allow the buyer to terminate, if
a “latent, material defect is discovered that was not previously disclosed by
seller”. Of course, none of the adjectives are defined in the contract.
Moreover, buyer can only get its deposit back if buyer and seller agree and
sign a mutual release. Obviously, when issues arise between buyer and seller,
they seldom agree with each other.
What Due Diligence is recommended for Residential Transaction?
What Due Diligence is recommended for Residential Transaction?
I. "Pre-contract Diligence"
Talk to
neighbors. Find out, for example if they can hear the train from nearby tracks,
or commercial activity from the next door commercial property. Visit the
property after a hard rain to see if there are visible drainage issues. Observe
traffic patterns during rush hour vs. quiet, open-house Sundays. Surf the Net.
Crime statistics, sexual predator registries, County Auditor
“Pre-contract diligence” may not produce
information to discourage a purchaser. On the other hand, if it does, the time,
money and stress inherent in the real estate purchase/sale process can be
avoided early on. Of course, the purchaser may be happy with the results. While
that is “a good thing”, the diligence process, at this point should be
considered as just beginning, not ending.
II.
“Post Contract Diligence”
Every buyer should have the property they
are buying inspected to minimize the risk that they are also buying the
property’s problems. Whether or not using a broker form, the purchase agreement
should, at a minimum authorize physical inspections, allow for an adequate time
period for the inspections and provide remedies/contingencies to the buyer in
the event any of the inspection reports reveals defects (i.e. seller’s
obligation to cure defects; buyer’s right to cancel the purchase). One way to
get beyond the issues with the broker forms discussed above would be to define
“material defect” in terms of a dollar threshold to repair.
While a purchaser should certainly be
happy if its prospective property is free of physical defects, the buyer should
be equally concerned that title to the property is free of defects, or
“marketable”, and seek assurance of the same. You wouldn’t buy a car with a lien
against it, or if there was a question as to whether or not the seller owned
it. The same basic principle is involved when buying a house, except there
could be a lot more and different types of encumbrances/claims against the
title. For example, your neighbor might have a recorded right to use your
driveway to get to his/her house (also generally known as an “easement”).
Most contracts and forms will provide that
Seller is to provide buyer with a title insurance policy at closing, but many
of those forms state that the title will be subject to items of record, and
facts a survey would show. So, if a search of title shows the afore-mentioned
driveway easement of record, you get title to the property, but it is subject
to that easement. Moreover, if a survey later shows that your neighbor is also
using 10’
of your property, as its own, you could be in for costly litigation, after
closing to try and get that 10’
back. Can this be prevented? Easily. All you need to do is add to the contract, that in addition to the
physical inspections, you want a Title Commitment and Survey (and a right to
terminate if there are defects/encroachments). A “title commitment” is simply a
contract by the insurance company to enter into an insurance policy (contract)
with the buyer, whereby the title insurance company will guarantee good title,
subject to exceptions it finds upon a title search of the property. If your
title commitment or survey show problems such as easements and liens having
been filed against the property, better to know this sooner vs. later so you
can, if you need to, walk away, get your money back and find a property without
title/survey issues.
One
other way to ensure that you cover your diligence tracks, without having to
write in the margins of a form contract is to add an Addendum to the Contract, comparable to the following, sometimes referred to as a
“free look”:
“Buyer shall have a period of fifteen (15)
days (the “Due Diligence Period”) from the latest date the mutually signed
Agreement and this Addendum were signed by a party hereto (the “Effective
Date”) to inspect the Property and to perform such investigations, review of
title, survey, condominium documents (if applicable) and otherwise engage in
such inspections and investigations as desired by the Buyer. Seller
agrees to cooperate with Buyer to allow Buyer and its agents to enter the
Property for such inspections and investigations and to assist (without expense
to Seller) in obtaining information requested by Buyer. Should Buyer
determine that the Property is not suitable for any or no reason in Buyer’s
sole and absolute discretion, Buyer may terminate the Agreement by providing
written notice thereof to Seller no later than the last day of the Due
Diligence Period. Upon such termination, all earnest money deposits will
be promptly returned to Buyer (without further action of the parties), and the
parties will have no further obligations hereunder. Should Buyer fail to
timely terminate the Agreement as described above, Buyer shall no longer have
the right to terminate the Agreement under this provision. The
inspections set forth in this Addendum are in addition to, and not in lieu of,
the other inspections of Buyer under the Agreement, and in the event of
conflict (between any provisions of the Agreement and this Addendum concerning
timing, rights of the parties and otherwise re: inspections), this Addendum
shall control.
Do you have to
go through the above-mentioned diligence process when buying a house or condo?
Many buyers purchase property without doing any diligence, and have lived
happily ever after, right? The simple answers to the above questions are no,
and yes. However, if you are considering buying any real estate without a due
diligence process, to quote Clint Eastwood, in the movie Dirty Harry: “You’ve gotta
ask yourself one question: “Do I feel lucky? Well, do ya…” As lawyers, we
only see the unlucky ones after the sale.
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