Why is it necessary to have a separate real estate purchase contract, when escrow instructions usually seem to be enough?
Q: What exactly is commercial real estate?
A: Broadly defined, the term “commercial real estate” can be used to refer to any dealing with real property in a business context. It might involve leasing office space, building a new office tower, or selling real property as part of the sale of a business. It could be industrial property (e.g., a factory) or agricultural property (e.g., a farm). It might even involve residential properties like apartment complexes or rental houses being held for business or income-producing purposes. Unless the property is a residence where the homeowner, renter, or subletter is living, you're likely dealing with commercial real estate.
Q: Are there really that many differences between a commercial real estate deal and buying a residential house?
A: While many of the concepts are the same, there can be significant differences between the commercial and residential real estate markets. Generally, it is far more common for commercial property to be leased, rather than sold. It isn’t uncommon for commercial space to be owned by large real estate holding companies, particularly in urban areas. These entities will often enter into long-term leases with various businesses. The lease periods can be lengthy, often three, five, or ten years.
This stands in sharp contrast to the residential market, where outright sales are more common. Residential real estate also offers significant leasing and renting opportunities for the consumer, but typically for one-year terms.
Certain types of commercial transactions can have additional legal implications, particularly with regards to zoning and land use. For example, if you are hoping to buy or lease a commercial building in which to manufacture chemical products, you’ll need to consult with an attorney to verify that you file the proper public permits and that the location is properly zoned for such activity. These sorts of issues are less common for residential buyers, who generally plan to use the home for the purpose for which it was intended: a residence.
Commercial buyers and lessors generally are not afforded the same consumer protections as residential buyers and sellers. Commercial entities are generally considered to be sophisticated parties, usually represented by counsel. States typically have legislation designed to afford special protection to homeowners and renters. Many cities and states also have specialized housing courts, known to be “tenant friendly.” Commercial buyers and lessors have no such favorable forum; disputes will typically wind up in a commercial or federal court.
Q: What are some of the common pitfalls in a commercial real estate business deal?
A: When buying, selling, renting or leasing a piece of commercial real estate, there are always risks involved. Your goal should be to minimize these as much as possible. Examples of potential problems that often lead to legal disputes include:
Defects in title: Real property interests are usually conveyed by a deed. In order to track how property changes hands, every state (indeed, most every individual county) has a public record system where real property deeds are recorded, becoming a part of the public record. In theory, this is a great system for keeping track of who owns what parcels of land, but deeds are sometimes not recorded, or have facial defects regarding the scope of land that they cover. Sometimes people confuse matters by selling or transferring 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 made part of the public record. A judgment against a person can be recorded and become a lien against any real property that person owns, even without the person's consent. All these things can become a lien against title. You may not be buying everything you thought you were buying, because someone else may have a prior claim that you didn't know about.
Debt service and lender requirements: If you’re borrowing money to acquire a piece of real property, the lender is no doubt going to want security (collateral) 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 itself. 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. For example, some lenders prohibit borrowers from taking out more loans on their property, which could stop you from getting the very financing that your business may need in order to succeed.
Mechanics liens: Contractors who do work on real property can use a “mechanics lien” to make sure that they get paid. This is a statutory lien that contractors, laborers, and materialmen 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’re 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, and dangerous for the property owner who's in a dispute with a contractor about whether the work was properly done in the first place.
Zoning and land use restrictions: A significant concern for a business is to make sure not only that its property is properly zoned for the uses it will make of it, but also that the zoning of nearby or adjacent properties is not going to create conflicts. Believe it or not, many people fail in new businesses because they don't investigate the land use and zoning issues carefully enough. 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.
Market fluctuations: If you're 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 its customer base, only to find out that it can't afford to move because property values have dropped to the point that the business premises can't be sold at the price needed. (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.)
Hazardous waste and environmental contamination: One of the biggest potential concerns to owning business property is hazardous waste or environmental cleanup issues. Property owners have primary responsibility for fixing such problems, even if the current property owner didn't cause them. These problems may not be obvious or apparent to the naked eye, and could arise from anything ranging from a leaking 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 cleanup. The costs for an environmental cleanup operation can run into the millions of dollars.
Q: Should I hire a real estate broker?
A: Generally speaking, the goal of every seller is to maximize profits, while the goal of every buyer is to minimize costs. Having to pay a real estate commission or other professional fees as part of a real estate deal can work against these goals. Consequently, many business people who are sophisticated when it comes to negotiating real estate deals may feel comfortable with doing much of the work themselves. However, even sophisticated business people should rely on professional advice when it comes time to close a deal, as the potential pitfalls can be significant.
You should, nevertheless, 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 to 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 (such as office space, retail space, industrial warehouse space, apartment complexes, agricultural land, and so forth).
Even if you’re just leasing property, a real estate broker may be invaluable. A good 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 your trying to negotiate yourself. Keep in mind, too, that real estate agents work on similar deals all the time. Their knowledge and contacts can be well worth the cost of a commission. They can also help with the paperwork, to make sure you don't do something stupid.
Hire the best person you can find, who has expertise in representing parties on particular type of real estate transaction at hand. Ask disinterested parties who are more likely to give you an informed answer (escrow agents, lenders, contractors, real estate attorneys, and people who have recently bought or sold commercial property).
Q: If I hire a real estate broker, why do I need to hire a lawyer?
A: A real estate broker is a licensed professional who is hired to negotiate the purchase and sale of real estate for a commission or fee. However, a broker is typically not an attorney. Many listings will clearly state that real estate agents are not providing legal advice. Real estate brokers 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). Therefore, brokers are typically not going to worry about the “what if’s” of the legal details and may do whatever they can to push a deal to closure.
Separate legal advice from an experienced real estate attorney is typically well worth the additional cost. It's far more cost effective to hire a lawyer to get the deal done right than to wait until you're embroiled in an expensive lawsuit.
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 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: “Good title,” also referred to as “clear title,” means that the ownership interests in a particular piece of real property are clear and unclouded. Clear title is generally necessary before property is sold; otherwise, the buyer risks a third party emerging and claiming that the seller did not have full ownership of the parcel. In some states, there are lawyers who specialize in researching public records to determine the status of title to property. They'll issue opinions or reports as to the condition to title. In other states, the job of researching title to property has become almost universally done by title insurance companies. These companies have developed tools to track public records and other resources to create extensive databases on title to real property. They’re able to prepare title reports on property that show the status of title, which are used as a basis for issuing title insurance.
Q: What's 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's 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 in which to act on the preliminary title report. Thus, it is 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’s title insurance and why is it necessary?
A: Title insurance is nothing more than an insurance policy that provides assurance to interested parties (including the lender) that there is good and marketable title to the real property being insured. However, title insurance does not guarantee perfect title. As with all insurance, there are a number of different types of policies and endorsements. There are also many exceptions to title in the typical policy, which all tie back into information found in the preliminary title report.
One standard exception, for example, is that the insurance will be provided only for exceptions to title that are reflected by the public records. Unless a special endorsement is obtained (which costs more money), the insurance company has no obligation to insure against defects in title that would have been apparent from surveying or otherwise physically inspecting the property.
It is customary in most states for a commercial property seller to pay for standard coverage for the buyer that insures that the deed from the seller conveys the 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 mechanics liens, the buyer can purchase an owners' 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 used to convey title can make a significant 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 stating that the seller has good title to the interest being conveyed. All states have something like a quitclaim deed, where a party is signing over only 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, particularly when you accept a quitclaim deed. Buyers should be careful to seek legal advice regarding the type of deed they are accepting, and should also invest in title searches and title insurance for good measure.
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, especially in the commercial context. If you take title as an individual, you may be exposing yourself to potential liability that you might want to avoid or at least minimize. You could also take title through a business (most likely a corporation or limited liability company). This would limit your potential liability.
If joint ownership is involved, you should clearly understand the differences between taking title as joint tenants, as tenants in common, as a partnership, and 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. Read more on Nolo’s FAQs on taking ownership of property as tenants in common or joint tenants.
It’s always advisable to seek professional advice, including your lawyer and CPA, to assist you in making a smart decision regarding taking title.
Q: Why is it necessary to have a separate real estate purchase contract, when escrow instructions usually seem to be enough?
A: Amazingly, it’s all too common for parties to close a commercial deal without first drafting and signing a formal real estate purchase contract. The parties might 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, stating how much money will be paid into escrow and when title will transfer. Then the parties can proceed to close the deal.
However, having a full purchase contract in place is usually a better strategy, even if the initial legal fees are higher. Among the factors 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 probably going to be difficult 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. And many real estate disputes arise with respect to one party’s performance (or lack thereof).
- The escrow instructions aren’t going to cover any side deals the parties may have contemplated handling outside of escrow.
- The escrow holder isn’t going to provide any legal or tax advice concerning 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.
- Escrow instructions won’t include a comprehensive dispute-resolution provision directing the buyer and seller to mediation or arbitration instead of a lawsuit.
Q: What provisions or language should be in a real estate purchase contract?
A: There's a reason that real estate purchase contracts usually end up being complex and lengthy documents. Buyers and sellers try to address all the “what if’s” that might arise in a commercial real estate transaction. While there is no comprehensive list of these potential topics, common elements include:
- names and addresses of the parties
- recitals (background facts as to why the parties are entering into the transaction)
- description of the property (specific borders and coordinates).
- 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 (disclosure of known conditions or defects)
- relevant zoning and land use issues
- buyers’ right of inspection
- Internal Revenue Code Section 1031 exchange provisions, if applicable
- liability insurance requirements
- indemnification and hold harmless provisions
- remedies if a party breaches
- rights to amend and modify
- rights to assignment or delegation of rights
- attorneys’ fees and costs (for example, “Seller must pay buyers’ attorneys’ fees in the event that seller breaches”)
- dispute resolution provision (for example, “All disputes shall be submitted to binding arbitration”), and
- governing laws (for example, “The law of New Jersey shall govern”).
It's often possible to use standard form documents prepared by state Realtor associations to facilitate the drafting process. At a minimum, these standard form agreements can serve as effective checklists of issues you may want to address. Nevertheless, every commercial real estate transaction is unique, and the safer course is to hire a professional to prepare a customized purchase contract.
Q: Does “as is” really mean “as is”?
A: “As is” essentially means that the seller is offering a piece of real property with no warranties as to its quality. Buyers can assume that the property has some issues that the seller expects to factor into the initial purchase price without facing further negotiation or demands for repairs. Sellers trying to evade liability by selling their home “as is” should be careful, however. Many states have legislation to preclude a seller from completely passing the buck on certain issues such as environmental cleanup, hazardous waste disposal, or dealing with other dangerous known conditions. The law sometimes requires mandatory disclosure of defective conditions or problems with property, a legal norm common to other types of sales contracts. For example, a seller would likely be found liable if it sold a commercial property to a buyer and failed to disclose its knowledge that the foundation was buckling.
Q: In 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 situations where it definitely makes sense to get one (such as when you’re buying a service station or a manufacturing business). If the chance of finding any problem seems remote, should you skip an expensive assessment? 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 doesn’t actually involve excavation 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’s 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’s 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 a like-kind property. It’s 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 its 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 handles this, 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 always advisable to have competent legal counsel involved in the transaction.