Do Your Homework to Capitalize on the Real Estate Boom

After eight years of decline, real estate is making a sustained recovery. Good due diligence will help keep you in the money.

Preceding the 2007 credit market crash, we experienced a real estate bubble marked by a period of exorbitant real estate values. Commercial, industrial and residential real estate then saw unprecedented declines. Following the Lehman Brothers bankruptcy, new construction and development screeched to a halt. Seven years later, the commercial and residential real estate markets have improved. For example, New York City and the surrounding areas started seeing a surge in sales in the final quarter of 2013 – a trend that is expected to continue.

In the summer of 2013, an SGR client received an unsolicited offer of $20 million to purchase a retail condominium unit on the Upper East Side. The client chose not to sell at that time and in more recent months, has received additional unsolicited offers ranging from $25-35 million. After consultation with Neal Dorman, a partner in SGR’s New York office, as well as local real estate experts, the client determined that, with retail rentals on the Upper East Side being at or near record highs, even those unsolicited offers may be below market. The client is now considering actively marketing the property to determine its true value.

Last fall, Anne Pitter and Eliot Zuckerman, partners in the Real Estate Practice of SGR’s New York office, represented a client in the sale of a commercial property in a “hot” New York City neighborhood. A letter of intent was signed at the end of September 2013 for $42.5 million. Although the initial offer did not result in an executed contract, the client received multiple written offers thereafter. A contract was signed in mid-November for $50 million. The purchase price jumped $7.5 million in less than eight weeks!

New York City’s residential real estate market is equally robust. Notwithstanding that construction and development have picked up, there is still insufficient inventory to meet demand, resulting in a decreased average number of days a property is on the market and increased prices. Areas once considered on the “fringe” – Williamsburg or Gowanus in Brooklyn; Long Island City and Astoria in Queens – are now in high demand. Several clients seeking to purchase residential property in New York City and the surrounding suburbs have lost multiple properties in bidding wars, sometimes before the property was even publicly listed.

So, with prices high and inventory low, how can investors get the most out of this real estate market?

DOING YOUR HOMEWORK

As evidenced by the anecdotal experiences discussed above, it’s hard to know the true value of real estate in a rising market. Buyers don’t want to overspend and sellers are concerned about leaving value on the table by selling too quickly. Whether commercial or residential, doing your due diligence is of key importance.

The importance of due diligence

Generally speaking, when acquiring real estate, the buyer gathers information before making an offer on the property. Primarily, the buyer uses this information to decide whether the property is a good investment and to determine the value of the property. Particularly with commercial real estate, the contract of sale will allow the buyer a specified period of time to conduct more thorough due diligence before the contract becomes binding on the parties (although the tighter the market, the shorter the due diligence period a seller is likely to allow).

If a contract does not contain a due diligence period, the buyer should complete the due diligence process before a binding contract is executed. In certain instances, a buyer may decide to terminate the contract or otherwise abandon the transaction after performing due diligence, but more commonly, a buyer uses the information to negotiate contractual protections (such as indemnification for enumerated liabilities) or to adjust the purchase price. In addition to confirming the seller has good title to the property, a due diligence inquiry should establish the following key information about the property.

Ascertain the value of the property: Review comparable sales, understanding that in a rising real estate market, the purchase price of neighboring properties last month may not represent the value now.

Understand the liabilities and risks: With commercial properties, learn more about the management and day-to-day operations of the property. Who are your tenants? What lease obligations are you inheriting? What contracts come with the acquisition of the property?

Identify impediments to the transaction: These could include required consents or any restrictions on transfer. For example, the sale of a cooperative unit will require the consent of the Board of Directors. If the seller is a trust or an estate, additional consents are likely required.

DUE DILIGENCE MATERIALS: WHAT TO REVIEW AND WHAT TO LOOK FOR

Title Report: The title report or title commitment is a report compiled by a title insurance or abstract company. It provides essential documents and information  about the property, including how title is currently held and what exceptions or encumbrances are of record (for example, an existing mortgage). The title report delineates the steps necessary to clear title issues to ensure that, to the extent possible, a buyer purchases the property free and clear of any liens or encumbrances. While the entire report should be reviewed, there are certain components of special importance.

Deed: How is title currently held by the seller? All persons or entities with an interest in the property need to consent to the conveyance of the property and sign the deed or otherwise authorize its execution.

Mortgage Chain: What mortgages encumber the property? Depending on the terms of the existing loan, a buyer may consider assuming the seller’s mortgage (a more common practice with commercial real estate, but something residential purchasers may want to discuss with their attorneys, particularly if there is a sizable mortgage on the property). More commonly, a buyer will want the mortgage paid off or assigned to the buyer’s lender. 

Certificate of Occupancy: What are the legally permitted uses of the property? Is it being used in accordance with those permitted uses? Can it legally be used as intended by the buyer?

Violations, Liens and Judgments: What liens and judgments will the seller need to have removed or satisfied in order to deliver clear title? What violations are listed against the property and what fines are associated with those violations? Commercial buyers often agree to take a property subject to violations, but will often require a credit against the purchase price in the amount of the monetary fines. The buyer will then have to remedy what gave rise to the violation and have the violation removed of record.

Restrictive Covenants: Are there any restrictions on what a buyer can do with the property? A buyer will take the property subject to the restrictive covenants because the covenants are said to “run with the land.” Common covenants include utility easements (e.g., allowing a telephone company to run wires above the property) or access easements (e.g., allowing a neighboring property owner to use a portion of the property as a means of ingress and egress).

Real Property Survey: Does the seller own what the buyer thinks he or she is buying? A recent survey will depict the location of all improvements relative to a property’s boundaries and the location of any restrictive covenant encumbering the property. Were required permits and sign-offs obtained for all of the improvements appearing on the survey?

DUE DILIGENCE: OTHER THIRD-PARTY REPORTS TO REVIEW

Thorough due diligence may also require input from consultants and review of their specialized reports.

Environmental Site Assessment

Does the property have potential environmental issues? This report will enumerate potential or existing environmental contamination liabilities, such as underground fuel tanks, asbestos or lead paint. The report should address issues with the underlying land as well as physical improvements to the property. If a site is considered contaminated, a more detailed investigation involving chemical analysis for hazardous substances should be performed.

Engineer’s Report: Are the improvements on the property structurally sound? Are the building systems in compliance with local codes? Are they sufficient for the buyer’s intended use? All major building systems, such as plumbing, heating and electrical as well as the structure itself, should be inspected by an expert.

Zoning Report: Zoning laws, which are constantly changing, dictate how a property can be constructed, remodeled or used for business. A buyer will want to confirm that the property is currently in compliance with applicable zoning ordinances with respect to usage, parking, setbacks, height, density and coverage requirements, and that the intended operation of the property and any construction that the buyer intends to perform will be permitted under applicable zoning laws.

Summary: Due diligence is an important part of every real estate transaction regardless of the state of the market. In a rising market, with real estate values difficult, if not impossible, to nail down, it becomes even more imperative.