We have all heard the situation before – a developer trying to take advantage of declining property values finds a distressed project and believes the project could be turned around with an infusion of fresh capital. 

The developer, in an effort to make an offer more attractive than other bidders, agrees to limited due diligence rights in the purchase agreement. These limited due diligence rights may include an extremely short due diligence period or limited termination rights for specific conditions (such as environmental conditions costing more than a certain dollar amount to remediate). The downside to this limited due diligence approach is that a buyer might not find out what it is really acquiring until after the closing.

In the current economic climate, owners and developers must pick and choose their investments wisely, and a comprehensive analysis of a property is an indispensable element of any investment decision. A thorough due diligence process enables a buyer to develop a more complete picture of the physical, legal and financial conditions of a property and reduces the risk that the property will fail to meet the buyer’s expectations after the closing.

Zoning Analysis Essential

An essential and often overlooked component of due diligence is a zoning analysis for the targeted property. 

A buyer must verify that the property can legally be used for either its current or any anticipated use. For that reason, a buyer should confirm that the property complies with the applicable zoning regulations and any other permit conditions which may have been imposed in the past. A review of the municipal zoning and building files often reveals useful information, including the existence of any zoning or building code violations and any land use permits that have been issued for the property.

In addition, a buyer should request a certificate of zoning compliance from the local zoning enforcement officer or other evidence confirming that there are no zoning violations. If a buyer intends to change the use of the property, the buyer should also confirm that the new use is permitted in the zone in which the property is located. Otherwise, a buyer may discover after the fact that it cannot use the property for its intended purpose.

Similarly, a title search is necessary to identify any recorded use restrictions. A title search will also identify any mortgages or encumbrances which must be cleared so that the property can be conveyed with marketable title. If a recent survey is not available, a buyer should have the property surveyed or have an existing survey updated. A survey may disclose information which cannot be discerned from a title search, such as whether any improvements on adjacent properties encroach onto the targeted property. In addition, a survey will confirm the locations of easements and any underground pipes or utilities.

As part of its due diligence, a buyer should also inspect the physical condition of the property.

To the extent that a significant physical defect is discovered during the due diligence period, a buyer may use that information to negotiate a reduction in the purchase price to address the defect. If the defect is not discovered until after the closing, the buyer will likely face an uphill battle obtaining recourse against the seller.

In addition, a buyer should engage a licensed environmental professional to determine if there are any potential environmental liabilities associated with the property. If potential liabilities do exist, the buyer can negotiate a proper allocation of the liabilities between buyer and seller prior to the closing.

Of course, a buyer should not pass up an opportunity to review the financial aspects of a property. This review should include an analysis of any existing contracts (and any associated financial obligations) which will remain in place following the closing. Also, the buyer should obtain estoppels from any material tenants. With the above information in hand, the buyer can more accurately project the property’s expected cash flow following the closing.

Proper due diligence allows the buyer a unique opportunity to thoroughly investigate a property without a significant investment relative to the property’s purchase price. A buyer that foregoes this opportunity does so at its own peril and may find out after the closing that its expectations for the property vary greatly from reality. Only after a thorough due diligence process can a buyer truly assess if a property is a wise investment decision.

Thomas Regan and Mike Camilleri are partners and Jeff Matrullo is an associate in the real estate practice group at Brown Rudnick LLP in Hartford.