The Problem With Due Diligence Periods In Real Estate Contracts

When a commercial property owner wants to negotiate a sale, the buyer often has a rough idea of ​​what they are willing to pay. This idea usually reflects limited investigation and analysis as a more comprehensive investigation and analysis will cost more than the potential buyer is willing to spend without knowing the property is under contract.

Except in a very seller-friendly market, the parties will usually address the buyer’s concerns by signing a bill of sale, but also giving the buyer a due diligence period – 30 to 90 days – in which to examine the property further. During this time, the buyer can carefully review the leases, check for any physical issues, check for environmental issues, and be satisfied that their plans for the property make financial sense. Most importantly, the due diligence period gives the buyer time to raise the money – both debt and equity – needed to purchase the property.

A few days before a due diligence period expires, the seller often receives a call from the broker about the deal. At best, the agent will announce that the buyer needs an extension of the due diligence period to review some issues that require more time, often environmental related. In the worst case, the agent announces that the buyer’s due diligence investigations have determined that the buyer overestimated the property’s value and the deal without a discount makes no sense.

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In either case, the seller faces a dilemma. The other potential buyers who may have been in the picture earlier in the process have turned to all other things. At this point, everyone has probably lost interest. When the seller and their agent return to one of these buyers, they may perceive the property as damaged merchandise. If the seller takes the property off the market, it may have to wait many months – or years – before it comes back on the market. As a result, sellers usually accommodate buyers to some extent.

Giving more time is easy. A seller might try to specify what needs to happen during this time. For example, if the buyer needs more time to examine a pile of unidentified materials in the backyard of the property, the parties can agree that the extension of due diligence applies to that examination only. As long as the cost of solving a problem falls below an agreed ceiling, the buyer must close.

A buyer’s request for a price adjustment, on the other hand, creates more trauma for the seller. Can the seller gain some advantage in exchange for the price adjustment? The seller might try to expedite the deal or the buyer might waive some eventualities or increase the down payment. In theory, the seller could claim a right to future payments if the property exceeds an agreed performance standard. In practice, however, buyers will not agree to such measures. If a buyer agrees to such measures, they will be difficult to negotiate and even more difficult to apply and enforce.

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A seller could protect against some of these risks by charging the buyer a non-refundable option fee for withdrawing the property from the market during the due diligence period. This fee would give the buyer control of the property while they carry out their investigations. It would also indemnify the seller if the buyer decides not to proceed. While this route makes a lot of sense, sellers can usually only get option fees in very seller-friendly markets.

As another possibility, a contract could give the buyer a due diligence period, but only allow the buyer to terminate if the buyer identifies genuine problems with the property that exceed a certain defined threshold. This approach would scare buyers who usually expect to be completely optional as a result of a due diligence period.

Sellers can perhaps protect themselves at least a little bit by not pretending that the due diligence period is about to end and the buyer is either going or going. Instead, the contract could provide for the possibility of an extension. For example, the contract might state that if the buyer wants more time, they must pay a renewal fee that is not counted towards the purchase price. The buyer would, of course, prefer to simply increase the down payment and have that increase applied in escrow to the purchase price. Even if the contract specifically asks for a renewal fee, if the buyer wants more time, the buyer can still apply for a free renewal, but that smacks badly because it differs from what the parties agreed to.

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If the seller has other buyers waiting in the wings, this can provide an attractive mechanism to prevent buyers from over-exploiting due diligence deadlines. To that end, the seller may want to make it very clear that they have the right to negotiate with other potential buyers and even sign replacement contracts with them. The seller will want to avoid agreeing on exclusivity with a buyer – a reasonable position considering that a buyer with a generous due diligence period is also not firmly committed to the transaction.

Of course, the best strategy a seller should try is to time his sale to take place during a seller-friendly market. Unfortunately, today’s commercial real estate markets are not very seller friendly. This situation is likely to escalate in the short term. Sellers must either wait for a better day in the future — but not all sellers have a long-term perspective — or find another way to mitigate the impact of generous due diligence periods in contracts.

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