Over the years, I have observed investor clients develop and hone their own unique style of doing things when it comes buying retail investment property and performing critical due diligence. Whatever the approach, I have found that successful investors consistently implement their due diligence process to ensure that what initially seems like an attractive opportunity, doesn’t become a chronic headache.
Below are six tips to help avoid traps for the unwary when it comes to purchasing retail investment property, such as strip centers, shopping centers, multi-tenant and single-tenant investment properties.
TIP #1: Title Review. Carefully review the title commitment and the underlying exception documents referenced in the commitment as soon as possible. Why? A thorough title review can reveal hidden costs, restrictions and obligations that may significantly affect your ownership rights. Documents that are recorded against the property may bind future owners. Ignoring these documents may lead to sleepless nights after closing. Successful investors tend to take a very proactive approach to understanding these documents and directly addressing potential issues.
Many recorded documents contain restrictive covenants or impose obligations on the owner. Certain agreements involve neighboring property owners, such as reciprocal easement agreements (REAs), access easements, and encroachment agreements. Other agreements involve local municipalities or utility companies, such as utility easements, license agreements, and maintenance agreements. Many of these agreements prohibit the placement of structures on certain portions of the property and impose ongoing obligations on the property owner.
A review of the covenants, conditions and restrictions (CC&Rs) is important, especially those containing use restrictions, building restrictions, parking restrictions, access agreements, operating covenants, maintenance obligations, and other restrictions and obligations that may affect your ownership interests.
An ALTA survey may be needed to fully evaluate title since the location of certain items (e.g., easements and encroachments) may be critical. An ALTA survey can also reveal boundary line issues. If a current ALTA survey is not available, this should be addressed sooner rather than later since surveys require lead time to prepare. Confirm that your purchase agreement allows ample time for survey and title review.
If there are onerous restrictive covenants governing the permitted or prohibited uses of the property, keep in mind that if an existing tenant defaults and vacates the premises, you may find yourself in the unenviable position of seeking a replacement tenant from an extremely limited pool of potential replacement tenants.
Finally, keep in mind that title issues may significantly affect your ability to sell the property down the road. An experienced transactional commercial real estate attorney can assist you in evaluating title and survey matters.
TIP #2: CAM Obligations. An important component of the due diligence process is a review of the applicable common area maintenance (CAM) charges, and the mechanism used for allocating these costs. Be wary of unusual charges and for exceptions made for other parties that may result in you being responsible for a disproportionate share of costs.
In the purchase agreement, it is a good idea to request continued access to the seller’s books and records for a specified period after closing. This may be important for clarifying CAM obligations and possible audits. The purchase agreement should also require the parties to reconcile applicable charges, if necessary, post-closing. The seller should remain responsible for any overcharging of CAM, taxes, and other charges that are paid by tenants during seller’s ownership of the property, together with audit costs (if applicable). Make sure that this provision survives the close of escrow.
TIP #3: Lease review. A careful review of each lease is critical. Be sure to obtain all related documents and correspondence, including lease addenda, assignments, amendments, guaranties, options to extend, and previously delivered notices or other pertinent correspondence.
Review each lease to make sure that the rent and other key business terms match what is stated in the marketing materials.
Be especially vigilant with respect to rent concessions and tenant improvement allowances.
Look for the existence of any co-tenancy requirements that, if violated, would allow the tenant to reduce rent payments or stop paying rent altogether.
Make sure that you are comfortable with the maintenance provisions. A well-drafted lease will describe meaningful standards to which the premises must be maintained.
Keep in mind that tenants may have been granted purchase rights or options, such as a right of first offer or a right of first refusal, which would need to be addressed.
Carefully review the assignment and subletting provisions of each lease. Ideally, if the tenant assigns the lease, the tenant will not be released from its obligations under the lease, except in very limited circumstances.
Finally, each lease should be carefully reviewed to determine what kind of early termination rights or rent abatement rights a tenant may have under its lease.
To the extent feasible, obtain estoppel certificates for leases, REAs, and other critical documents. In drafting the estoppels, focus on points of ambiguity, concern or exposure, and tailor the estoppel certificate accordingly. Keep in mind that each lease may also contain language governing the issuance of an estoppel certificate by the tenant which should be followed. Some leases may have a form estoppel certificate attached and grant the tenant a certain amount of time to provide an estoppel upon request.
Tip # 4. NNN Leases. If you are purchasing a so-called triple net investment property, confirm whether there is language expressly making it a true triple net lease. In a true triple net lease, the tenant should, among other things, be made responsible for all aspects of the repairs and maintenance to the building. Watch out for provisions making the landlord responsible for structural repairs, or foundation or roof repairs.
Also, check the lease to determine whether the tenant has the obligation to pay the property taxes directly to the applicable government entity, or whether you will be required to do so and to seek reimbursement from the tenant.
Confirm that adequate insurance coverage is required under the lease by conferring with an insurance broker or advisor, and verify that the tenant pays the insurance company directly. Also, make sure that the landlord is named as an additional insured under the policy.
You may wish to verify that if there is casualty damage or destruction to the building, then the tenant will be obligated to rebuild the premises at its own cost and expense, and that the tenant has no termination right in such event.
TIP # 5. Investment Property within a Larger Shopping Center. If a lease is signed by the developer of the shopping center of which your property is a part, the lease may require the developer/landlord to fulfill certain obligations with respect to the entire shopping center. It is important to identify and modify these provisions to ensure that the owner of the larger shopping center will remain responsible for satisfying those obligations (rather than you as the owner of a single parcel).
TIP #6. Zoning. Analyze the property’s zoning requirements, and determine whether there is any non-compliance or non-conforming use. If the property is benefiting from any “grandfathered” protection, determine what restrictions will apply to any future alteration, expansion, or reconstruction.
In conclusion, developing an effective due diligence process is an ongoing endeavor. If done consistently and conscientiously, however, it will serve you well as you continue your real estate journey.
This article provides general information about California law only and is not a substitute for legal advice. The views expressed herein may vary depending on the context. We encourage you to consult with a licensed attorney before taking any action that may affect your legal rights.