Due Diligence in Commercial Real Estate Transactions

In commercial real estate transactions, “due diligence” refers to the investigation and analysis of real estate by a prospective buyer or tenant. The scope of due diligence varies from one transaction to another, depending on the location, history, existing improvements, proposed alterations, and intended use of the property. The scope of due diligence also depends on the knowledge, experience, and strategy of the buyer or tenant and its attorney and consultants.

Due diligence in commercial real estate transactions typically involves a wide range of complex matters, such as title review, survey, environmental assessment, physical inspection, review of leases, contracts and records, analysis of zoning and land use regulations, and obtaining governmental approvals.

The due diligence process should be one of the first considerations of a prospective buyer or tenant. It is prudent to consider due diligence requirements and timelines before entering into negotiations, in order to establish reasonable expectations in preliminary discussions and in the letter of intent. In addition, it is important to plan and manage the due diligence process for orderly and timely completion.

In some cases, due diligence begins before a purchase agreement or lease is signed. A prospective buyer or tenant must make a business decision whether to invest time and money performing due diligence before entering into a contract to purchase or lease the property.

On one hand, early due diligence may reveal that the property is not suitable, in which case the time and expense of negotiating a purchase agreement or lease can be avoided.

On the other hand, if the property is not under contract, there is a risk that the seller or landlord may receive a better offer and enter into a contract with a third party instead. This risk may be addressed by including a legally binding non-solicitation clause (a/k/a “no-shop” clause) in the letter of intent. However, there remains a risk that the parties may not reach agreement regarding the terms of a purchase agreement or lease, in which case the expense of early due diligence will be a sunk cost.

The purchase agreement or lease should include a detailed framework for due diligence. The key issues for a prospective buyer or tenant include: (i) which due diligence activities shall, or may, be performed, (ii) which party is responsible for performance, (iii) which party is responsible for the costs, (iv) the timeline for completion, and (v) the rights and obligations of the parties if the buyer or tenant is not satisfied with the findings. The key due diligence issues for a seller or landlord include the foregoing, and also may include issues such as (vi) liability for personal injury or property damage, (vii) insurance requirements, (viii) indemnification, (ix) restoration of the property to its prior condition, (x) interference with business operations, (xi) communication with tenants or employees, (xii) notice prior to entering the property, (xiii) a right to accompany the prospective buyer, tenant, or its agents, and (xiv) confidentiality.

Typically, commercial real estate purchase agreements establish one due diligence period in which the buyer may perform any and all due diligence that is desired by the buyer, subject to any specific exceptions, conditions, or limitations. In some cases, the due diligence period is divided into two parts: an initial inspection period, followed by a governmental approval period. This structure is particularly useful for real estate development projects in which the buyer or tenant would prefer to determine if the land is suitable before incurring expenses related to governmental approvals and entitlements.

The duration of due diligence periods for commercial real estate purchase and sale transactions typically ranges from 30 days to 120 days or more. If the due diligence period is divided into two parts, the initial inspection period and the governmental approval period each may last for 30 days to 120 days or more. The actual duration of the inspection period(s) is negotiated for each transaction based on the circumstances and the bargaining position of the parties.

The duration of due diligence periods for commercial leases varies greatly, depending on the circumstances. For example, the due diligence period for a ground lease typically is similar to the due diligence period for a purchase and sale transaction. In contrast, the due diligence period for a suite in an existing office or retail complex may be covered by the letter of intent and may expire or be waived prior to signing the lease.

Please Note: The information in this article is provided solely as general information and not as legal advice. Receipt of this information or its use does not establish an attorney-client relationship. Readers are urged to speak with a qualified attorney when making decisions regarding a specific legal issue.  For questions about any issue regarding commercial real estate transactions, please feel free to contact the author.