Commercial Real Estate Q & A
What is commercial real estate?
The term usually refers to retail properties, office buildings, shopping centers,
hotels, warehouses, manufacturing facilities, apartment complexes - and vacant land that
has the potential for development for these types of buildings. In short, almost any kind
of real estate except single-family home and single-family lots can be regarded as
commercial real estate.
Do contracts for the sale or purchase of commercial real estate have to be in
writing?
Yes. A real estate agreement that consists only of an oral understanding and a
handshake will not be enforced by a court. An ancient law called the Statute of Fraud
requires that real estate sales contracts be in writing.
A contract does not have to very fancy to be valid. If it describes the property and
the price, it usually will be enforceable in court. Obviously, however, it is not a good
idea to rely on a bare-bones contract when you purchase commercial real estate. You need
much more detail.
If I am buying commercial real estate, what should go into my contract?
Since every real estate deal is different, you will need to get advice from lawyer on
how best to protect your interests in the contract. Typically, however, your contract
should address at least the following issues:
(1) An exact description of the property you are buying, including the land surrounding
the building.
(2) The purchase price and whether it is all due at closing or in installments.
(3) A list of any equipment or personal property that is included in your purchase.
(4) Any contingencies that must be met before you are obligated to complete the
purchase, for example, you can make the deal contingent on your ability to get a mortgage
loan.
(5) How property taxes and utility bill will be pro-rated (allocated) between you and
the seller.
(6) The type of title evidence or title insurance the seller must provide.
(7) The date for closing and delivery of possession.
(8) What legal recourse a party has if the other party defaults.
Your lawyer may advise you to include several other provisions as well.
What is an option?
It is a right a seller grants a buyer to buy real estate within a certain period of
time. For example, suppose you are interested in buying an office building but want more
time to investigate the cash flow and compare this building to others in your area. You
might offer to pay the owner an option fee to tie up the property. In return, the owner
might be willing to grant you the right to buy the building within a certain period (say,
six months) at a stated price. The owner would not be able to sell to anyone else in
meantime.
You could agree that all or part of the option fee would apply toward the purchase if
you decided to actually purchase the property. If you did not exercise your option, you
would forfeit your option fee.
What are contingencies?
Contingencies are escape hatches in a real estate contract. They let you walk away from
the deal without penalty if certain conditions are not met. You might, for example, sign a
contract to buy a building, but make your obligation to close contingent on things such as
the following:
(1) Your being able to get a mortgage loan of at least 75% of the purchase price.
(2) Your having a contractor inspect the condition of the building and your being
satisfied with the contractor's report.
(3) Your determination that the building can be renovated to your satisfaction.
(4) Your being satisfied with a report you will order concerning environmental hazards.
Your lawyer can help you put the right contingencies in the contract for your deal.
I am interested in buying a building but my intended use is not permitted under
the local zoning ordinance. What can I do?
You may be able to get the zoning changed or perhaps the local zoning board has
authority to grant you a variance or exception so that you can use the building the way
you would like to. See our section on "Zoning" for more information.
One way to proceed is to sign a sales contract, but include a clause that makes your
obligation to close contingent on your being able to change the zoning or getting
permission from the local zoning people for your intended use. Another possibility is to
get an option from the owner, and then investigate the possibility of a getting the zoning
the way you want it. If you get what you want during the option period, you can exercise
your option and buy the property.
I am looking at a small shopping center that I may want to buy. How do shopping
center leases work?
Quite commonly, the tenant pays a base rent - often tied to the amount of square feet
the store occupies. In addition, the lease may require the tenant to pay a certain
percentage of gross sales.
Shopping tenants often contribute a portion of the expenses of maintaining the common
areas of the shopping center and may also pay for part of the property taxes.
A building I am considering is occupied by several commercial tenants. If I buy
the building, can I evict them?
Generally not. If a tenant has a legally valid tenancy and is current on the rent and
all other lease obligations, the law usually lets the tenant remain in possession until
the end of the lease, regardless of who owns the building.Your best bet is to ask the
owner for the legal status of each tenant since your ownership of the building will be
subject to those leases. You may need a lawyer's help in evaluating how to deal with the
tenants.
What is title insurance and why do I need it?
Title insurance guarantees that you are receiving full legal ownership of the
commercial property that you are buying. If a lien later shows up or it turns out some
other property owner has the right to use your parking lot, you can sue the title
insurance company to recover any loss that you have suffered.
Having a title insurance policy takes much of the legal risk out of buying a building.
Usually the seller pays the insurance premium for this coverage but sometimes it is paid
by both parties or the buyer alone.
I have heard the term 'build-out.' What does it mean?
Every business has its own jargon and the commercial real estate business is no
exception. Many office and retail buildings start out with tenant spaces consisting of
little more than four walls and a door. The idea is that the spaces will be finished to
meet the specific needs of each tenant.
The process of finishing this raw space is known as the "build-out." There
can be extensive negotiations between the building owner (landlord) and the tenant over:
(1) What improvements will be made?
(2) Who will pay for these improvements?
(3) Who will be in charge of getting the work done?
(4) What will the tenant be permitted (or required) to remove at the end of the lease?
What is a 'work letter'?
It's a letter signed by a commercial landlord and a commercial tenant dealing with all
the issues pertaining to the build-out of the tenant's space.
Sometimes it is a separate letter. Others times it is simply an exhibit attached to the
lease.
What kinds of insurance should I buy for my commercial building?
Property damage insurance will help protect your investment if your building is damaged
or destroyed by fire or other causes. Public liability coverage will protect you if
someone is hurt in the building and sues you.
But also consider rent interruption insurance to make sure you do not lose rental
income while you are repairing damage caused by a fire or tornado.
What are 'pro-rations'?
Often there are taxes and utility bills that cover periods both before and after the
closing. These expenses need to be allocated between buyer and seller. In the real estate
industry, these allocations are called "pro-rations."
To avoid problems at closing over the details of these pro-rations, you should describe
the mechanics in the sales contract.
What does 'escrow' mean?
It's simply an arrangement where a third party - such as a title insurance company or a
lawyer - holds money or documents and distributes them according to instructions from both
parties.
In a commercial real estate transaction, for example, the escrow agent may obtain funds
and documents from the buyer, the seller, and the commercial lender. When everything is
ready, the escrow agents make sure the money and papers wind up in the right hands. Escrow
agents make transactions flow smoothly and reliably.
What are fixtures?
They are the parts of the building that are permanently in place and which cannot be
removed without damage to the building. The plumbing system is an example. Usually,
fixtures are included when you buy a building.On the other hand, items that are not
attached or are easily removed are considered to be personal property. Office equipment is
an example. Usually, personal property is not included when you buy a building, unless
specifically listed in the sales contract.Some items (like a window air conditioner) might
fall into either category. To avoid disputes, it is a good idea to specify in the sales
contract how such items are to be dealt with.
How should I take legal title to commercial property?
You can, of course, take title in your own name. But you may want to consider forming a
corporation or limited liability company (LLC) and putting the legal title in the name of
the business entity. This requires more paperwork and a bit more expense, but you limit
your personal liability if someone gets hurt on your property.By limiting personal
liability, you decrease the risk that you could lose your other assets such as your home
and personal bank accounts if there is a big verdict in favor of an injured person.
Your lawyer can help you decide if putting your commercial real estate into a separate
legal entity is the best thing for you
Can a deal go ahead even if there is a defect in the legal title?
Yes, the buyer is always free to accept the risk of a title defect, but should first
consult with a lawyer to make sure the risk is minimal. There often are ways to reduce the
risk to manageable proportions. For example, the title insurance may be willing to insure
over the risk if appropriate affidavits are signed or if money is placed in escrow to
cover the risk. In some cases, the seller may be willing to put money in escrow so there
are funds on hand to pay off a construction lien if the lien holder goes to court during
the statutory period and wins.
Or if there is a boundary line dispute, you as the buyer may decide to buy the property
anyway if only a small piece of the property is involved in the dispute. Your reasoning
may be that even if you lose the disputed area, the remaining land that you are buying is
well worth what you are paying.
Similarly, if there is some problem with the building itself - say, a defective heating
and air conditioning system - and the seller is not willing to fix it, you may decide that
you are getting such a good deal on the building that you will proceed with the purchase
despite the defect.
What is 'eminient domain'?
It is another word for condemnation - the right of the government to take private
property for a public purpose, for example, to make way for a road. The Constitution
requires the government to pay you fair compensation if it takes your property.
What is a 'nuisance'?
Legally speaking, it is some condition on your property or some use of your property
that interferes with a neighboring owner's ability to enjoy their property. For example,
if dense smoke or loud noises are emitted from your property, a neighboring owner can
claim it is a nuisance.A judge may require you to stop creating the nuisance and to
compensate the other owner for any losses.
I have a contract to purchase a building. What if the seller refuses to close?
If you have done everything required of you in the sales contract, you can go to court
and seek "specific performance" - a judge's order requiring the seller to
transfer the property to you.
As an alternative, you can sue for monetary damages. For example, if the contract has a
purchase price of $500,000 and you can show its fair market value is $550,000, the judge
may award you the $50,000 difference.
The seller is suggesting that we sign a letter of intent before we prepare a
contract. Is this a good idea?
Often it is. By signing a letter of intent - especially in a complex transaction - you
know earlier on that you and the seller agree on the major terms of the deal. Obviously,
it is better to know this before you put time and expense into preparing the contract
itself.
A word of caution, however: The letter of intent should state specifically that it is
not a binding agreement. Only the contract itself should be binding. The devil is in the
details; you want to be free to get out of the deal if, later, you and the seller cannot
reach agreement on the details of the contract.
What happens if there is damage to the property from fire, hail, flood or
windstorm during the term of the contract and before closing?
In most states, if your contract does not cover this subject, the risk of loss is on
the seller. In other words, if the building is damaged by fire before the closing, the
buyer can cancel the purchase unless the seller restores the building to its prior
condition.Since this is an important issue, it is best to cover it in the contract rather
than to rely on the prevailing law. You and the seller can tailor this term to meet your
own needs and wishes. In case of a legal dispute, a judge or arbitrator will make every
effort to carry out the intentions of the parties as stated in the contract.
What legal recourse does a buyer or seller have if the other party refuses to
close?
Typically, a sales contract drafted by a lawyer will spell out the remedies for
default. For example, if the buyer defaults, the contract may say that the seller can keep
the deposit as liquidated damages.
If there is nothing in the contract dealing with default, then in most states, if the
seller defaults, the buyer can go to court and seek an order of specific performance. This
order commands the seller - under penalty of being held in contempt of court - to transfer
the property to the buyer upon payment of the agreed purchase price. This is based on the
assumption that each piece of real estate is unique and that money alone may not
adequately compensate the buyer for loss of the desired property.
Alternatively, the buyer can sue for difference money damages: the difference between
the contract price and the fair market value of the property (assuming it is higher than
the contract price). The buyer may also be able to recover consequential damages such as
mortgage application fees and appraisal fees paid in reliance on the contract.
If the buyer defaults, the seller can sue for difference money damages as well. But
here, of course, it would be the difference between the contract price and the lower fair
market price. For example, suppose the contract calls for the buyer to pay $500,000 but
the fair market value of the property is only $450,000. The seller could try to get a
judgment awarding the $50,000 in lost profit. It is relatively uncommon for a court to
order a buyer to complete the purchase by paying the entire purchase price.
When is either party obligated to pay a broker's fee upon the sale of
commercial real estate?
First of all, for either party to owe a broker's fee (often called a commission), there
must be a written agreement (often called a listing agreement) signed by the party who is
to pay the fee. No agreement, no fee. The fee is usually stated as a percentage of the
sales price.
Assuming there is a written agreement, it alone will determine when the fee is owed.
Commonly, the fee agreement will provide that the seller will owe the broker's fee when
the property is sold to a person produced by the broker during the listing period - 90 day
or six months, for example. The fee agreement may also say that the seller owes the
broker's fee if the property is sold to anyone during the listing period, whether or not
the buyer was produced by the broker.
In some commercial real estate deals, the buyer and seller agree to split the broker's
fee.
Are there standard representations and warranties usually included in a
commercial real estate contract?
No. Representations and warranties are always a matter for negotiation. There are many
commercial real estate contracts that say, in effect: "The property is being sold 'as
is.' Seller makes no representations or warranties."
When a seller is making representations and warranties, the seller's lawyer may insist
on adding the cautionary words, " . . . to the best of seller's knowledge." That
way, the seller is not guaranteeing unknown facts or conditions.
If you are buying income-producing property, your lawyer may want the seller to
guarantee the accuracy of the rental income figures as well as the expenses the seller has
represented to you. You may also want the sales contract to include a statement that the
seller is aware of no hidden defects in the building - that is, defects that your
inspector is unlikely to discover.
Is it necessary to have a new survey when purchasing commercial real property?
There is no hard and fast rule. In general, it is always preferable to have a fresh
survey so you know exactly what you are buying. But if there has been a survey within the
past few years and you are convinced after looking at the property that nothing has
changed, your lawyer may tell you that you can safely avoid getting a new survey.
Also, be aware that if you are borrowing money from a commercial lender, the lender
will probably order a mini-survey (sometimes called a mortgage report). While this is not
as good as a full survey ordered for your benefit, your lawyer may conclude that it is
adequate for your needs. This is particularly true if, based on the lender's survey, the
title insurance company is willing to guarantee that there are no boundary line problems.
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