Why is it necessary to have a separate real estate purchase contract, when escrow instructions usually seem to be enough?
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 could involve leasing out office space, owning an apartment complex or selling real property along with and as part of the sale of a business. It might be industrial or agricultural property. It could even involve residential properties like apartment complexes or rental houses being held for business or income-producing purposes. It can even involve working with the government. Unless the property is a residence where the homeowner is living, you’re probably dealing with commercial real estate.
Are there really that many differences between a commercial real estate deal and buying a house?
- A:While many of the concepts are the same, there can be huge differences between commercial and residential real estate. Commercial real estate transactions can be far more diverse and wide-ranging than selling homes. Any real estate deal has its share of risks, and problems can arise that you could never possibly foresee. In general, however, the risk and potential liability exposure that you face on a commercial real estate deal can be much greater than when you buy a house. Look at it from this perspective: by and large, we all have a pretty good idea of what goes on in a typical family home, but can you say the same thing about a piece of business property? Depending on the nature of the business, commercial property may have all kinds of liens and title problems. There may be greater concerns about hazardous materials or zoning issues. Also, there will always be questions about the suitability of the property’s location for your business needs. Furthermore, in many instances, you aren’t afforded the same consumer protections on a commercial real estate deal that may be available when you purchase a residence. In some states, for example, residential homebuyers are given greater protections against abusive lending practices than are business owners. Likewise, there are mandatory disclosures required in residential real estate matters that may or may not be required in a commercial transaction.
What are some of the common pitfalls involving a real estate business deal?
- A:Regardless of whether you’re buying a home or a piece of investment property, there will always be risks involved. Your goal should be to lessen these risks as much as you can. Examples of potential problems that oftentimes lead to legal disputes include:
- Defects in title
- Debt service and lender requirements
- Mechanics liens
- Zoning and land use problems
- Market fluctuations
- Hazardous waste and environmental contamination
Real property interests are usually conveyed by a deed. In order to track how property changes hands, every state has a public record system where real property deeds are recorded, becoming a part of the public record system for everyone to see. In theory, this is a great system for keeping track of who owns what, but deeds are sometimes not recorded. Sometimes people sell or transfer 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 of record. A judgment against a person can be recorded and become a lien against any real property that person owns, even without his consent. All these things can become a lien against title. You may not be buying everything you though you were buying, because someone else may have a prior claim that you didn’t know about.
If you’re borrowing money to acquire a piece of real property, the lender is no doubt going to want security 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. 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 that could become a problem. For example, some lenders prohibit borrowers from taking out more loans on their property, which could stop you from getting more financing that your business may need down the road.
Often times, a commercial loan will also require that a business maintain a certain “net equity.” Pre-payment penalties are also common on real property loans. Also, many lenders on a big commercial real estate deal require that their legal fees and costs be paid by the borrower(s).
In a business context, contractors who do work on real property have a process called a “mechanics lien” that they can use 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 for a contractor, a laborer or a materialman.
A big concern for a business is to make sure not only that property used in the business is properly zoned, but also that the zoning of nearby or adjacent properties is not going to be a problem. 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.
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 their customer base, only to find out that they can’t afford to move because of property values having dropped to the point that their business premises can’t be sold at the price they need. (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.)The biggest potential concerns to owning business property, though, are hazardous waste or environmental cleanup problems. Property owners are the ones who 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 an 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 clean up. The costs for an environmental cleanup operation can run into the millions of dollars.
Should I hire a real estate broker or a real estate lawyer?
- A:The goal of every seller is to maximize profits, and every prospective buyer wants to get property as cheaply as possible. Having to pay a real estate commission or other professional fees as part of a real estate deal only works at odds with these goals. Consequently, many business people who are sophisticated when it comes to negotiating real estate deals may feel comfortable with doing a lot of the work themselves on commercial real estate deals. However, even sophisticated business people will still rely on professional advice when comes down to actually closing a deal, as the potential pitfalls can be so significant. The bottom line is that you should 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 why you should 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 (for example, office space, retail space, industrial warehouse space, apartment complexes, agricultural land). Even if you’re just leasing property, a real estate broker may be invaluable. If he or she is good, an 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 you trying to negotiate the deal yourself. (Wouldn’t you love to have an agent representing your interests when you go buy a new car? It would help you to avoid high-pressure sales tactics, prevent you from making rash decisions and make it easier for you to say “no.” The same considerations apply here.)
Keep in mind, too, that real estate agents work on similar deals all the time, so presumably know what they are doing. Their knowledge and contacts can well be worth the cost of a commission. They can also help you with the paperwork, to make sure you don’t do something stupid when submitting an offer.
If you’re a buyer, it may really make no sense not to hire a broker when it would usually be at no extra cost to you. The seller usually pays the commission in most real estate deals. Most real estate agents agree to split the commissions on listed properties, though, so an agent has a real incentive to be involved in a deal even if he or she is not the listing agent. But a buyer can simply chose to work with the seller’s agent to close a deal. The seller’s agent usually won’t object if a written consent is signed. (Incredibly, this happens all the time and it only makes sense from the standpoint of the seller’s agent, who then gets to keep the whole commission!)
A multiple-listing arrangement is a “you scratch my back, I’ll scratch yours” sharing mechanism for real estate agents. They are mutually beneficial to buyers and sellers, as well, since the multiple listing of all properties on the market will inevitably help to bring buyers and sellers together. One of the conditions to an agent participating in such an arrangement is that commissions are shared when more than one agent is involved in a transaction.
Any reputable real estate agent would be more than happy to explain the process at greater length. The agent should also be willing to work with you as long as you understand that he or she would have to look to the seller’s agent for payment of a commission, if any is to be paid. This helps protect the buyer in the rare instances where there is no seller’s agent (for instance, a “property for sale by owner”) where the seller’s agent does not participate in a multiple-listing arrangement.You shouldn’t hire a broker just because he or she is a relative, or because he or she is your best friend’s spouse. Instead, hire the best person you can find who has expertise in representing parties on real estate sales in the segment of the market where you are looking. Ask lots of people who they would recommend and why. Ask disinterested parties who are more likely to give you an informed answer (for example, escrow agents, lenders, contractors, real estate attorneys, and people who have recently bought or sold commercial property). Look in the newspaper advertisements to see who have been the highest producers in your segment of the real estate market. When somebody’s name comes up more than a few times, that person would be someone who you would want to contact.
If I hire a real estate broker, why do I need to hire a lawyer?
- A:The benefit of competent legal advice on a real estate deal stands on its own. There are so many things that can go wrong on a real estate deal that you may very well end up kicking yourself mightily if you don’t hire an attorney to help you with the transaction. You may even end up hiring a lawyer on a lawsuit, which could end up be a lot more expensive. Real estate agents 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 or otherwise breaching your listing agreement). Aso, listing agreements will clearly state that real estate agents are not providing legal advice. So real estate agents are typically not going to worry about the “what if’s” of the legal details and are inclined to do whatever they can to push a deal to closure. This is not the case with an attorney working on an hourly basis, who’s going to get paid one way or the other. An attorney will be in a better position to provide you with essential legal advice and to do so with more impartiality than may be the case with your real estate agent.
Is an escrow always necessary?
Strictly speaking, no. Unless the parties contractually agree to it as part of their deal, there’s seldom a legal requirement that there be an escrow. Inevitably, though, an escrow is almost always 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.
How do I find out if I am getting good title?
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 something that is almost universally done by title insurance companies. These companies have developed tools that they use to track public records and other resources to develop extensive databases on title to real property. They’re able to prepare title reports on property that are used to determine the status of title on real property transactions, and that are used as a basis for issuing title insurance.
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’ll 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 during which to act on the preliminary title report. So it’s 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.
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 that there’s good and marketable title to the property being insured. However, this never means that title insurance guarantees perfect title. As with all insurance, there are a number of different types of policies and endorsements. There are also many exceptions to title, which all tie back into information in the preliminary title report. These include specific exceptions listed on the property to be insured, as well as standard exceptions.
One standard exception, for example, is that the insurance will only be provided for exceptions to title that are reflected by the public records. Unless a special endorsement is obtained (which costs more money), there’s no obligation on the insurance company to insure against defects in title that would have been apparent from surveying or otherwise physically inspecting the property.
There are also different types of policies. For example, it’s customary in most states for a seller to pay for standard coverage for the buyer that insures that the deed from the seller is conveying 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 mechanic’s liens, the buyer can purchase an owner’s policy. If a loan is involved, a lender’s policy can be issued that specifically insures the lender against title defects.
It’s 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.
Are there different types of deeds, and why should I care?
- A:The type of deed can make a big 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 that the seller has good title to the interest being conveyed. All states have something like a quitclaim deed where a party is only signing over 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. While this may amount to fraud on the part of the seller, who wants to have to sue someone to try to enforce your rights? Also, you may not even have a good case if, for example, you accepted a quit claim deed that says that you got only whatever interest the other party had, which may have been nothing. You can see the need to get competent legal advice.
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, and especially so in a commercial context. If you take title as an individual, you may be exposing yourself to potential liability exposure that you might want to try to avoid or at least minimize. You take title through a business corporation, but doing this could be disaster from a tax standpoint point. Sometimes, there may be other alternatives such as forming a limited liability company that you would own and control that, in turn, could lease the property to your business entity.
If joint ownership is involved, you should clearly understand the differences between taking title as joint tenants, as tenants in common, as a partnership or 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.
It short, there are no universal rules of thumb with respect to how to take title. It’s always advisable to seek professional advice, including your lawyer and CPA, to assist you in making a smart decision.
Why is it necessary to have a separate real estate purchase contract, when escrow instructions usually seem to be enough?
Amazingly enough, it’s perhaps all too common for parties to close a commercial deal without having a formal real estate purchase contract in place. They can 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 and they can proceed to close the deal. But it can become painfully clear that relying solely on escrow instructions is never the best way to do a deal. Among the things 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 pretty hard 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. A dispute is more likely to arise if problems come up with respect to a party’s performance.
- The escrow instructions aren’t going to cover any side deals the parties contemplated handling outside of escrow.
- The escrow holder isn’t going to provide any legal or tax advice to cover 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.
What should be in a real estate purchase contract?
- A:Real estate purchase contracts can be extraordinarily simple but usually end up being very complex and lengthy documents, in order to try to address all the “what if’s” that are typically involved in a commercial real estate transaction. Points that would typically be covered include:
- Recitals (background facts as to why the parties are doing the deal)
- Description of the property
- 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
- Zoning and land use issues
- Rights to inspection
- 1031 exchange provisions, if applicable
- Liability insurance requirements
- Indemnification and hold harmless provisions
- Remedies if a party breaches
- Rights to amend and modify
- Term and termination
- Rights to assignment or delegation of rights
- Attorneys’ fees and costs
- Arbitration rights, if any
- Governing laws
- Other standard provisions
In many instances, it’s possible to use standard form documents prepared by realtor associations that help to facilitate the drafting process. At a minimum, these standard form agreements can serve as effective checklists of issues you may want to address.
Does “as is” mean “as is”?
- A:As between the parties, it may be. Even here, though, there may be laws that preclude a seller from completely passing the buck on certain issues such as environmental clean up and hazardous waste. Also, the law sometimes requires mandatory disclosure of defective conditions or other problems with property.
If I am 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 certain situations where only makes sense to get one (such as when you’re buying a service station or a manufacturing business). Otherwise, though, the chance of there being any problem may seem remote and it may be tempting to pass on doing an expensive assessment. But 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 it doesn’t actually involve any boring 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.
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 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 his or her 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 it, 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 easy for a seller to run afoul with them. It’s always advisable to have competent legal counsel involved in the transaction.