Negotiating commercial real estate purchase and sale agreements

Due diligence period

A due diligence period gives the purchaser the right to investigate various aspects of the property and the seller, and to terminate the purchase and sale agreement and receive a refund of its deposit if it finds any matters unsatisfactory. This is typically negotiated between the seller and the purchaser.

The scope and timing of the due diligence period can vary greatly depending on the nature of the real property, the structure of the transaction, and the negotiating leverage of the parties involved.

A purchaser's due diligence investigation typically falls into several different categories, including the review of:

• Title and survey matters
• Leases, management agreements, and service contracts
• Environmental and engineering matters
• Use and zoning compliance

A purchaser should generally expect that the broader the scope of the due diligence review and the more due diligence materials the seller is required to produce, the fewer representations the seller is inclined to give. 

While the term of the due diligence period is typically included in the LOI, many details are often left to be negotiated in the purchase and sale agreement such as:

• The amount of insurance purchaser must provide to cover its actions on the property
• The notice mechanics for purchaser's election to continue or terminate the contract at the end of the period
• Any due diligence extension rights

Representations and warranties

Representations and warranties in commercial real estate transactions are typically heavily negotiated and each party's negotiating position often governs the outcome. The primary role of representations and warranties is to set out the facts the parties relied on in agreeing to enter into the transaction. 

These facts serve as a baseline, allowing each party to make claims against the other if the actual facts represented and warranted turn out to be different than those stated in the purchase and sale agreement. Representations and warranties in commercial real estate purchase and sale agreements typically cover:

• The seller's formation and authority
• Leases
• Environmental matters
• Management and other service contracts
• Litigation, liens, and judgments

Representations and warranties are equally important to both purchasers and sellers because the parties often use the representations and warranties in a purchase and sale agreement as a risk allocation device to:

• Apportion exposure to potential losses and shift risk from one party to another
• Create a direct claim against the maker if representations are inaccurate or warranties are breached
• Serve as a basis for each party's indemnification obligations

The purchaser is typically interested in representations and warranties of the seller that uncover information about the seller or the property, relate to topics that may cost the purchaser money, or expose the purchaser to unwanted or unanticipated liability.

Sellers, on the other hand, attempt to limit representations and warranties that relate to topics that may expose the seller to unwanted liability, or require the seller to take some type of action or incur an expense before the closing. 

The seller typically must remake its representations on the closing date so the purchaser can confirm no material changes have occurred between contract signing and closing. Defining material for this purpose is often a heavily negotiated point.

Other significant negotiating points related to representations and warranties include the survival period and remedies for a misrepresentation, including floors and caps on seller's liability.

Covenants

Unlike representations and warranties, which are generally limited to a particular section of a purchase and sale agreement, covenants and rights appear throughout the agreement. Covenants relating to the use and operation of the property during the contract period are of importance to both parties and heavily negotiated. 

Typical seller covenants include: 

• Rights of the seller to enter into new leases and contracts
• Seller's obligations for maintenance and repairs
• Maintaining insurance for the property at the same levels as existed on the contract date

Closing conditions

The purchaser should pay close attention to its closing conditions, or the conditions precedent to the purchaser’s obligation to purchase the property, for two primary reasons:

1. The closing conditions represent the purchaser’s last chance to retain its deposit after the due diligence period expires.
2. If the purchaser wants to acquire the property but lacks a necessary piece of the acquisition puzzle (such as a third-party approval or financing source), it risks losing the purchase right—in addition to its deposit—if it cannot close by a date specified in the purchase and sale agreement.

The purchaser should require each contingency relating to its intended use of the property be included as a closing condition. Examples of these contingencies are zoning approvals for development properties, and third-party approvals, such as lender consent for a loan assumption and franchisor consent for a hotel property.

In addition to these contingency-related conditions, the most common conditions to the purchaser’s obligation to close are:

• The continued accuracy of the seller’s representations and warranties
• The seller’s execution and delivery of the closing documents
• The seller’s ability to deliver actual, physical possession of the property to the purchaser

The seller generally has fewer closing concerns and thus fewer conditions precedent to its obligation to close than the purchaser. If the purchaser comes to the closing with the purchase price, the seller is likely to close. Customary conditions to the seller’s obligation to close the transaction are:

• Purchaser’s funding of the purchase price (net of all credits and prorations as specified in the purchase and sale agreement)
• Continued accuracy of the purchaser’s representations and warranties
• Purchaser’s execution and delivery of the closing documents

Prorations and credits

When drafting the purchase and sale agreement, the parties should further detail how prorations and apportionments will be made between the parties. 

The purchase and sale agreement should provide:

• The date on which proration calculations are based. This is customarily the date before the closing date, such that the purchaser is treated as the owner of the property (for proration purposes) as of the closing date.
• Any specific revenue or expense items unique to the property that are to be prorated. These include any assessments due to a property owners’ association or government body.
• Procedures for calculating prorated amounts for unique revenue or expense items. This includes overnight room revenue for a hotel property or restaurant receipts, both of which are customarily split between the parties.
• The handling of any accounts receivable payable to the property owner. If the purchaser elects to purchase the accounts receivable, it often pays tiered percentages of the accounts receivable balance based on the age of the account (for example, 90% for all accounts receivable between 30 and 60 days old, and 50% for accounts receivable older than 60 days).

Commercial real estate purchase and sale agreements are complex documents, and the above points are only samples of the many key negotiations that occur between purchasers and sellers of commercial real property.