“IT AIN’T ROCKET SCIENCE” BUT. . . You DO Need To Know What You're Doing

Albert Einstein: “Everything should be made as simple as possible,
but not simpler.”

R. Kymn Harp: D² = I + Fη

[Due diligence = Insight + Focused Investigation]


I’m a big fan of Albert Einstein. He’s one of my intellectual heroes. He could see and understand what others could barely imagine. His greatest gift, I believe, was his ability to find answers to questions others didn’t even know existed.

Real estate due diligence requires insight as well. To find the answers, you must know the questions.

Of course, I’m no Albert Einstein but, then, real estate due diligence is not inter-galactic science.

The term itself is confusing. “Due diligence” is used grammatically like it’s a thing or a process. “We need to complete our due diligence”; or “Let me review your due diligence”; or “due diligence is expensive”. I admit, I use it the same way.

In fact, however, “due diligence” is a standard of conduct. Due diligence refers to the degree of diligence we should exercise to investigate and analyze all important issues facing a particular transaction. That is to say, the degree of diligence that is “due” under the circumstances.

This definition has two important components:

1. a focus on “important issues”; and

2. the degree of diligence appropriate under the circumstances of the
particular transaction.

The art of the deal, so to speak, is in understanding what is “important” and what degree of investigation is due.

Failure to accurately identify these two threshold considerations will lead to one of two outcomes. The due diligence investigation will either be: (1) incomplete – and therefore ineffective to discover and resolve the important transaction risks it is intended to protect against; or (2) overly broad – in which case it will be more time consuming and expensive than it needs to be. Either way, its value is diminished.

Due diligence can be expensive. We need to avoid making it more expensive than necessary.

So, how do we make sure we get full value for our due diligence dollars? By making sure we know the right questions to ask, and then answering them.

This requires two preliminary sets of questions:

First: What is the vision for this property? Why is it being acquired, and how will it be used?

Second: What is necessary to be known in order to confirm the vision can be fulfilled?


To be sure, we must know the first to answer the second. It is in answering the second that due diligence must be exercised.

For guidance, ask for a copy of my article: “Due Diligence Checklists for Commercial Real Estate Transactions”.

For commercial real estate, there are four areas of concern:

1. Market Demand
2. Access
3. Use
4. Finances

Once the vision is clear, addressing these four areas of concern will determine whether that vision can be fulfilled. Within these four areas of concern we will find all the questions that need to be asked and answered to determine the feasibility of any commercial real estate transaction or project. How straightforward is that?

So what do these areas of concern entail? In simple terms, they can be summarized by a description of the inquiry they present.

1. Market Demand

“Market demand” asks this question: Is the proposed project needed or wanted by target consumers in the geographic area within which the property is located?

Market demand is the most fundamental of the four aspects of commercial real estate. If there is no market demand, the transaction or project should not go forward. If you are developing, financing or investing in a real estate project, make sure there is market demand for what is being offered. If you are a strategic owner intending to occupy and use the property yourself, market demand may be satisfied by your own business needs. If you are investing on speculation, be sure you know the demand of your intended market.

Determining market demand seldom involves a legal question. No attorney time is necessary. [See? I’m saving you money already.]

2. Access

“Access” asks this question: Assuming adequate market demand to justify the proposed transaction or project, can target consumers seeking the goods or services to be offered at or from the property get to it with ease? This aspect includes evaluation of:

a. existing or proposed highways, streets, and drives that will serve the site;
b. availability of in-and-out curb cuts for consumers and for delivery trucks and vans;
c. vehicular traffic flow to, from, and within the project site;
d. volume and convenience of pedestrian traffic;
e. ability of the project to accommodate the needs of the disabled in a manner compliant with Title III of the Americans with Disabilities Act (ADA), 42 U.S.C. §12181, et seq.;
f. adequacy of available parking (which, for business reasons, may need to be greater than the minimum required for zoning);
g. availability of public transportation; and
h. all other factors that may affect the flow of consumers and users to and from the site.

3. Use

“Use” asks this question: Can the property be used as intended? This aspect includes an inquiry into:

a. applicable zoning and private land use controls;
b. availability of utilities;
c. site topography;
d. quality of soil compaction to enable improvement using cost-effective methods of construction;
e. evaluation of the environmental condition of the property to determine whether environmental impediments exist that would prevent use of the property as intended absent remediation, institutional controls or environmental impact mitigation; and
f. all other factors that may prevent the site from being used as intended.


4. Finances

“Finances” asks these questions: (a) Can funds be obtained to acquire, construct, and operate the project? and (b) Will the investor receive an adequate return on investment to justify proceeding with the transaction or project?

To answer these questions we must know the a actual effective cost of acquisition or development and the net operating income and capital recovery expected to be generated by the project.

We must determine whether costly environmental remediation or institutional controls will be required; the amount of applicable user fees; environmental impact mitigation costs, if any; real estate taxes; special assessments; tenant allowance or build-out requirements; and all other factors having an economic impact.

Although finances are primarily a business concern, certain aspects of project finance do fall within the realm of legal due diligence. Thus the reference to one-half of the Finances concern being within the realm of attorney conducted due diligence.

~ Documentation of equity investments and project loans, as well as hybrids such as mezzanine financing, demand the attention of legal counsel.

~ If the property is leased, an evaluation of the amount, velocity and durability of the revenue stream and any financial commitments of the owner/landlord are often considered by counsel.

~ Certainly, if public money is sought to reduce the net cost of development, legal counsel is required.

[For more information on obtaining government money for your project, particularly if it has environmental concerns, ask for a copy of my free booklet: “BROWNFIELD DEVELOPMENT: PUBLIC MONEY FOR PRIVATE DEVELOPMENT”.


Other Due Diligence Concerns

The four areas of concern described above pertain to the “real estate” aspects of the transaction. If you are dealing with commercial real estate, your due diligence must focus on these issues.

Every capital transaction has other due diligence concerns as well. These other concerns are beyond the scope of this article, but may include issues pertaining to entity structure, authority of the parties, income and capital gains taxation and tax deferments, securities, and the overall structure of the transaction, to name just a few.

Commercial real estate due diligence is not rocket science but . . .
. . . it certainly helps if you know what you’re looking for.

TURNING BROWNFIELDS GREEN - Government Money For You

We've all seen it. That perfect corner location, vacant industrial building or urban site that just seems to sits empty year after year. "Environmental problem", we hear. "Costs too much to cleanup." "They can't give that site away."

Perhaps.

What if the site were clean? Would it be a good development site then? What if, instead of environmental cleanup costs coming out of your pocket, you could get the government to pay them? What if, additionally, you could get income tax deductions or, better yet, transferable income tax credits for cleaning up the site?

Government funds may not be available in every case but, when government funds are available, commercial real estate projects not otherwise feasible can be made profitable. For developers, profitable is good.

Revitalization of brownfields is an urgent concern in many communities. When the local community benefits, public money may be available. In fact, in many cases public money is available. You just have to know how to ask for it.

When it comes right down to it, all commercial real estate development involves four primary areas of concern: (i) market demand; (ii) access; (iii) use and (iv) finances. These four aspects are the primary focus of every development project.

The issue of brownfield site development implicates the “use” and “finances” aspects of commercial real estate development.

The presence of certain hazardous substances, pollutants, or contaminants may impair the ability of a site to be used as intended by a developer absent remediation to remove environmentally offensive substances or, where applicable, installation of suitable institutional controls to limit their exposure.

Developers often don't know the difference between a polychlorinated byfenyl and a polynuclear aromatic hydrocarbon or any other regulated substance that may contaminate a potential development site.

What they do know is that the presence of these substances in quantities requiring cleanup or installation of institutional controls adds costs to real estate projects that would not be incurred if these substances were not present. From a developer’s standpoint, these costs are “extras”. Environmental cleanup and installation of institutional controls add to the cost of site development but do not add to its value.

Real estate development is driven by economics. The science and regulatory scheme for dealing with environmental contamination is left to environmental attorneys, engineers and others. Developers need to know how much it will cost, how long it will take and how the developer is going to recover the added expense.

In many cases, a viable source for recovering brownfield cleanup costs is government money.

The sources of government funds for brownfield redevelopment are varied. They fall into the broad category of what commercial real estate developers refer to as “entitlements”. While there are a few actual “entitlements” available to brownfield site developers, such as favorable tax treatment for brownfield site clean up costs, the greatest opportunities to obtain government funds for brownfield site development are through use of government “incentive” programs.

The main point to understand about government development incentives is that they are designed and intended primarily to benefit local government, not developers. This is not to say that they don't benefit developers. It is just to point out that benefiting developers is not their primary aim.

Understanding this distinction is critical when searching for government money to benefit private development. The way to obtain government money for private development is for the private developer to align its development plans with the needs of the public, as determined by local government.

I am not suggesting that all development decisions should be turned over to local public officials, but a developer seeking public money should certainly try to design the project to give them what they want. Presumably, local public officials are in touch with the needs of local citizens. If they are willing to pay to fulfill those needs, why not accommodate them?

If there is no public objective sought to be achieved by local government through development of a particular project, there will be no public money available for the project. Once again, availability of government funds for private development is an “incentive”, not a right. Developers are “entitled” to seek “incentives” and, if the developer fulfills the incentive’s objective, it will be "entitled" to receive the benefits of the incentive program, but when it comes to receiving public money, use of the term “entitlement” is often overoptimistic.

Use of public funds must primarily benefit the public. It is up to the developer to make sure its development plans coincide with the public good so that what benefits the public can benefit the developer as well.

Fortunately, it is possible for municipalities to offer development incentives in a way that can benefit the public, the project and the developer while not really costing local government a dime. In some cases State and Federal cleanup grants are available that may used to benefit the project. In other cases, user taxes in the form of business district sales tax rebates or sales tax and real estate tax increment financing can be used. If the right set of circumstances is present, transferable income tax credits may be available to the developer to market and sell to raise private development capital.

In smaller communities, it may be necessary to educate local officials as to the programs available to help them provide economic incentives for needed development.

Once public officials become convinced their public constituency will benefit from a project, and can be shown how to receive those benefits with little or no out-of-pocket costs to local government, the stage is set. At this point, a development financing scenario that uses public funds for private development can be structured to the mutual benefit of the community at large and the private developer. Thus is born the so-called “public-private partnership”. It is not so much a partnership in fact, as it is a mutual benefit compact. It is a relationship that sets up the proverbial “win-win” scenario where both the public sector and private sector benefit from private development through use of public funds.

Brownfield development incentives, like all government development incentives, are designed and intended to induce developers to build the type of development within a community that local government believes is needed. Development incentives are bargaining chips, so to speak. They are the currency in trade to “purchase” the kinds of development local government seeks.

This concept is the foundation for obtaining public money for private development.

To receive public funds for a private project, a developer will need to demonstrate that (i) the project benefits the public good (the "Public Purpose Test") and, (ii) “but for” the commitment of public funds, the project will not go forward – at least not in a way that achieves the maximum benefit to the public sought by local public officials (the "But For Test").

As fundamental as the Public Purpose Test and the But For Test are as predicates to receiving public money for private development, they are not as difficult to satisfy as one might imagine.

The benefits to local government obtained by offering incentives to developers to clean up and redevelop brownfield sites are numerous. They are recognized to include revitalization of blighted and decaying areas, decreased pollution, increased jobs, expanded retail choices for local residents, relief of the tax burden on local residents, increased value in the tax base enabling increased spending on city services and education, improving the quality of life for all residents through creation of public amenities such as parks and open space and creating a more satisfying living environment.

Courts have widely accepted that use of public funds to promote economic development is a legitimate public purpose, even if the public funds inure to the benefit of private developers.

Real estate development is an intensely local undertaking. Competition exists within and between local communities to attract development. Commercial real estate development, particularly retail development, can be a great benefit to local governments because it enhances the real estate tax base and increases sales tax revenue. Real estate tax revenue and sales tax revenue are the two primary sources of revenue available to local governments to pay for governmental services.

For real estate development to go forward, however, the project must make economic sense to the developer. Environmental clean up costs and other excess costs of developing brownfields can adversely impact the economics of any commercial project.

If $1,000,000 in extra cost is incurred to investigate, clean up and prepare a brownfield site to build a 200,000 square foot shopping center, but the same 200,000 square foot project could be built across the street on a “clean” site without these costs, the brownfield developer will be at a competitive disadvantage to another developer who develops the clean site. If the going rental rate for retail space is $40 per square foot in the geographic area in which the two sites are located, it is not likely that prospective tenants will be willing to pay more rental per square foot simply because the brownfield site developer paid more to develop its project. As a consequence, the brownfield site developer’s return on investment will be less, because – all else being equal – it has $1,000,000 more invested in the project than the developer of the clean site across the street.

This fundamental financial reality becomes particularly significant when the street separating the two sites is a city or village boundary, with one site in one municipality and the other in another municipality. This is especially true if, in fact, market demand will support development of only one of the two sites with the hypothetical 200,000 square foot shopping center, so that competition exists between the two municipalities to get the project built within its municipal boundaries.

Why would a municipality care if the site is built within its boundaries instead of the one next door? Because municipalities rely primarily upon real estate tax revenue and sales tax revenue to pay the costs of running the municipality and to pay for vital municipal services like police protection, fire protection, street maintenance, snow removal, and the like. If the project is built within the municipality it will enjoy the benefit of increased real estate taxes and increased sales taxes the project brings with it. If it is built across the street in another municipality, it will not.

Even when inter-municipal competition for tax dollars is not at stake, development of brownfield sites is desirable to municipalities because it can change the character of the property from a blighted, unhealthy eyesore to a productive tax generating enterprise. This can increase the taxable value of not only the brownfield site but surrounding properties as well, and create jobs and serve as a catalyst for urban renewal.

The key point here is that there is a recognized public interest in returning brownfield sites to productive use. Understanding this can open the door to receiving public money for private development. Public money can make the difference between going ahead with a project or giving it a pass.

When considering a brownfield project, know what sources of public funds are available and how to make the case to receive them.


Thanks for listening.

Kymn

Due Diligence: What is it?

"Due Diligence" is among the most often used and seldom understood terms in commercial real estate. It is bandied about like it is a "thing" or, sometimes, a "destination". It is neither.

Due Diligence is a "process". The process of investigating and discovering all material facts and information important to the project at hand. It is the process of answering in the affirmative questions that must be answered "yes" and answering in the negative questions that must be answered "no". It is the research, discovery or confirmation of all that is necessary to make a commercial real estate project or transaction a success.

Note that the term is "Due Diligence", NOT "do" Diligence. It is the exercise of such degree of diligence appropriate to the circumstance. Not every avenue of inquiry is relevant to every transaction.

The "secret" to cost-effective Due Diligence is tailoring the inquiry to the specific objectives of the party for whom the investigation is being conducted.

There are, in general, four "types" of parties active in conducting Due Diligence. They are: (i) the "Strategic Buyer" (which may include a long term lessee); (ii) the "Financial Buyer"; (iii) the "Developer"; and (iv) the "Lender". The transaction objective of each of these parties is different from the objectives of the others – although there is certainly some overlap.

General Objectives:

(i) The "Strategic Buyer" is acquiring the property for its own use and must verify that the property is suitable for that intended use.

(ii) The "Financial Buyer" is acquiring the property for the expected return on investment, and is primarily concerned with verifying the amount, velocity and durability of the revenue stream.

(iii) The "Developer" is seeking to add value by changing the character or use of the property – usually with a short-term to intermediate-term exit strategy. The Developer must focus on whether the planned change in character or use can be accomplished within budget.

(iv) The "Lender" is seeking to establish two basic lending criteria:

(1) "Ability to Repay" – The ability of the property to generate sufficient revenue to repay the loan on a timely basis; and

(2) "Sufficiency of Collateral" – The "quick" disposal value of the collateral, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.

To be effective, Due Diligence must be exercised from the initial contemplation of a project through its conclusion, and beyond. It never really ends. Unfortunately, for some, it never really begins.

PERFECT SELLER! - Commercial Real Estate Transactions

Commercial real estate Sellers are funny people. Not "ha ha" funny, but funny in the sense that they sometimes have an odd way of looking at things.

This is not an indictment against any unique class of people. Lets face it, sooner or later virtually all commercial real estate Buyers become commercial real estate Sellers. It is simply a recognition of an odd twist that occurs in the mindset of many commercial real estate investors when the tables are turned and they become Sellers instead of Buyers.

Generally, once a Seller has made the decision to "sell", most Sellers want to move ahead with as little pain and delay as possible. Right?

What typically happens? The Seller finds a commercial real estate broker and lists the property. Once the Seller receives a letter of intent or contract offer, the Seller contacts its attorney to prepare or review the contract. The contract is virtually always subject to a "due diligence review" period during which the Buyer is to investigate the property to determine whether it satisfies Buyer's use or investment criteria. The contract invariably includes a variety of "Seller deliveries": a title commitment; copies of documents of record; ALTA survey; a rent roll; copies of leases; service contracts; etc. etc. etc.

So, what does the typical Seller do?

Often, the Seller waits until the contract is fully executed before ordering title, obtaining copies of documents of record, compiling leases, ordering a Survey, and gathering other required Seller deliveries.

Worse, many Seller's adopt the attitude that: "Buyer's financing and due diligence is Buyer's problem – leave me out of it."

While it is certainly true that Buyer's financing and due diligence is the responsibility of the Buyer, it is also true that much of the information a Buyer needs must be obtained from the Seller. If the Buyer is delayed or obstructed in obtaining necessary information it will be delayed in performing its due diligence review and unable to satisfy necessary conditions for financing. Even if the contract is "not contingent on financing", the practical reality – in most cases - is that if financing is not obtained the transaction will not Close. Failure to take reasonable steps to facilitate Buyer's due diligence and financing, then, ultimately becomes the "Seller's problem”.

What SHOULD a Seller do?

Sellers should become proactive instead of reactive.

Instead of waiting until a letter or intent is received or a contract is signed before compiling information a Buyer will almost certainly need, a Seller should compile the information a Buyer will need as soon as the Seller decides to sell.

How does Seller know what the Buyer will need? Interesting question. When the Seller was a Buyer, he/she knew exactly what a Buyer needed to evaluate the property, get financing, and Close. Still, even if amnesia has set in, what a Buyer needs is fairly predictable. [See my article "10 Things Every Buyer Needs to Close a Commercial Real Estate Loan" from August 2003/Updated February 2006.]

If you are a Seller and are, indeed, committed to selling your property, sooner or later you are going to be called upon to deliver at least the typical Seller deliveries. Sooner is better than later. It will speed up the due diligence process and enable the Buyer to determine at the earliest possible date whether there are obstacles to Closing.

Once gathered, the Seller Deliveries should be bound in a "Due Diligence Binder" for distribution to interested Buyers.

It will typically expedite the transaction if the Due Diligence Binder is delivered to the Buyer when the Buyer is first seriously considering purchase of a property – even before the purchase contract is drafted. If, in fact, conditions do exist that prevent a Buyer from proceeding to Closing, it is in Seller’s interest to find out now rather than later so the property can be kept on the market and made available to a Buyer who may be in a position to proceed.

Certainly, Seller may require a prospective Buyer to sign a Confidentiality, Non-Use and Non-Disclosure Agreement as a condition to receiving the Due Diligence Binder if the Seller feels this is desirable.

If the documents are voluminous (such as if the property is a large shopping center, office building or mixed use development with many tenants), an alternative is the establishment of a so-called "war room" where copies of all the documents are maintained and can be made readily available for inspection by prospective Buyers. Even then, all title related documents should be compiled in a Due Diligence Binder for ready review by Buyer’s attorney.

What should the Due Diligence Binder or war room include? At a minimum, it should include the following:

1. Current Commitment for Title Insurance

2. Copies of all documents of record referred to in the Commitment for Title Insurance which will remain on Schedule B of the Commitment of Title Insurance after Closing (i.e. easements, restrictions, covenants, etc.)

3. Current real estate tax bill(s)

4. A current ALTA Survey showing all improvements as currently exist, ideally including items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from Table A of the Optional Survey Requirements for ALTA Surveys.

5. If the property is income producing, operating statements for the past 3 years, a Rent Roll and copies of all leases, licenses and concessions. [Don't forget about cell-tower leases and billboard or sign leases, and parking leases.]

6. A schedule of any personal property to be included.

7. If the property is an out-lot or otherwise part of a larger whole and is required to participate in payment of common area maintenance (CAM) charges, copies of invoices and CAM charge breakdowns for at least the past 2 years.

8. Service contracts (for elevator, fire/sprinkler maintenance, scavenger, snow removal and landscaping, security, etc.).

9. Any available environmental site assessment reports (Phase I and Phase 2) and, certainly, any NFR letters or governmental notices relating to environmental issues.

10. Blueprints, building plans, site plans, schematics, soil compaction test reports, structural reports, roof warranties and other information relating to existing improvements.

To the extent practical, a Seller should compile all information in its possession or control that Seller would reasonably want to see if it were a Buyer conducting its own due diligence review to decide whether to purchase the property. [Ask for a copy of my January 2006 article: Due Diligence Checklists for Commercial Real Estate Transactions].

If you are a REALLY bold Seller, you might even consider preparing and including with the Due Diligence Binder a bare-boned but workable form of Purchase Agreement you would be willing to accept if tendered with an acceptable purchase price from a qualified Buyer.

Of course, to be a “PERFECT SELLER”, you need to understand the issues presented by the Due Diligence Binder’s contents, especially as they relate to access, use and financing, and be prepared to work with the Buyer to resolve problematic issues to get the transaction to Closing.


SELLER RESISTANCE:

Sellers are sometimes reluctant to voluntarily offer this information up front. Why? There are four common reasons.

1. Some Sellers think they should not volunteer anything. That maybe the Buyer will forget to ask for that “one document” that reveals a defect, thereby enabling the Seller to "get away with" selling the property without addressing the issue.

If this is the thinking, it is naïve and short sighted. What is more likely to happen is that the Buyer will discover the defect during its due diligence investigation and will either terminate the transaction or demand a significant price concession under the threat of contract termination.

On the other hand, it has been my experience that if the defect is disclosed at the outset, when the Buyer is enthusiastically formulating the project concept, resolution of the issue may be factored into the Buyers' development plan and never again become a major transaction issue.

2 Another reason I hear is that the Seller does not wish to prematurely spend the money to put the due diligence materials together “in case transaction falls apart”. The Seller is concerned with “wasting money”.

My response to this is two-fold: i) If the Seller is committed to Selling the property, the expenditure is not wasted even if the current transaction fails because most of the information will be useful when the next Buyer comes along; and ii) the benefit of facilitating Buyer's due diligence and accelerating Closing will often far exceed the carrying cost of compiling this information in advance. Besides, the sooner you can get to Closing, the more likely the transaction is to close.

3. A variation of the "money" theme is the notion that once a Buyer spends large amounts of money performing due diligence the Buyer becomes committed to the deal and is more likely to Close. This may occasionally be true, but experience shows that most Buyers will walk away rather than throw good money away chasing a bad deal. The result is that the property may then need to go back on the market to start from square one. If this happens more than once, the property may gain an reputation as a "problem property", thereby depressing its value in the marketplace.

4. The best reason I hear (usually from other lawyers) is that volunteering this information risks exposing Seller to liability on a theory of Seller implicitly warranting the accuracy of the contents of the Due Diligence Binder.

My response is that it only takes a little bit of creative draftsmanship to mitigate this risk. Further, preparing and offering a well-constructed Due Diligence Binder documents Seller’s deliveries and positions the Seller to avoid most contractual warranties, thereby reducing Seller’s exposure to liability.

WHAT ARE THE ADVANTAGES TO SELLER?

If you are a Seller of Commercial or Industrial Real Estate and conscientiously follow the recommendations outlined above, your transaction will proceed more smoothly and quickly, the likelihood of Closing will increase, and you will save money by avoiding the need to renegotiate issues that should have been addressed at the outset of the transaction.

To be sure, other issues will arise. They always do. But your chances of proceeding to Closing on-time and on-budget will greatly increase if you make the effort to be as close to a Perfect Seller as possible.

Thank you for listening,

R. Kymn Harp


PS. If you are a commercial real estate broker, I encourage you to discuss with your Seller the strategy outlined in this article the moment the property is listed for sale. Send your Seller a copy of this article if you wish. I assure you, if your Seller follows the advice in this article, everyone will benefit.

Kymn

UNCOMMON VIEW - Mixed Use - Commercial Real Estate Development

A story I heard growing up:

When my grandfather was 10 years old he found a penny. With that penny he bought a pencil. He sharpened that pencil then sold it for two cents. He took that two cents and bought two more pencils, sharpened them and sold them for four cents. He reinvested his four cents in four more pencils, sharpened them and sold them for eight cents. Then, again, he bought eight more pencils, sharpened them and sold them for sixteen cents. This went on until my grandfather had amassed $10.24. That’s when my great Aunt Sophie died and left us her portfolio of shopping centers, office buildings and rental homes. Our family has been in the real estate business ever since.

The story isn’t true, but it taught four valuable lessons: 1) Sweat equity is a powerful tool; 2) If you reinvest your earnings, wealth can grow geometrically; 3) The BIG money is in real estate; and 4) It would be nice to have a rich Aunt Sophie.

Like most families, we didn’t have a rich Aunt Sophie, so my parents focused on lessons 1, 2 and 3.

I mention this story as a backdrop. My life growing up was always about real estate.

In my article “Keys to Closing Commercial Real Estate Transactions”, I mentioned my father because he was, and is, a wiz when it comes to commercial real estate. It was through him that I came to represent commercial real estate developers.

What I didn’t mention was that my mother was active in the family real estate business as well. While my father focused on commercial land development, my mother focused on residential real estate. I should have known better than to mention one but not the other. This article could be sub-titled “Keys To Maintaining Harmony”.

What does maintaining harmony have to do with commercial real estate development? Stick with me on this, then decide.

My mother cared about “quality of life” issues. Comfortable homes. Neighborhood parks. Safe streets. Good schools. Museums and other cultural enhancements.

I remember watching my mother lay out walking paths around detention ponds in residential developments and looking through catalogs evaluating park benches and playground equipment for neighborhood parks. As a residential real estate investor, developer and broker, my mother focused on “living environments”. If families were going to live in her neighborhoods then the neighborhoods had to be “family friendly”.

As you might imagine, with my father focused on commercial development and my mother focused on residential quality of life issues, conversations around the dinner table were always interesting, and sometimes dicey.

On one side of the table, my father envisioned expansive commercial development for retail shopping centers, office buildings, restaurants, hotels, theaters, warehouse superstores, entertainment centers, nightclubs and more.

On the other side was my mother insisting upon neighborhoods with comfortable homes, safe streets, parks and other open areas, dry basements, clean air, clean water, and minimal noise and light pollution.

According to conventional wisdom – derived from public zoning board and plan commission hearings and community planning group meetings when commercial development is proposed near existing homes and neighborhoods – one might expect a clash of ideas turning into heated challenges and demands to forego development. Fortunately, our dinner table was nothing like most public hearings.

My mother and father each respected the vision of the other and understood the natural symbiotic relationship between residential and commercial development. Instead of complaining that one was trying to destroy the vision of the other, they anticipated each other’s legitimate development and environmental needs and sought reasonable accommodation when possible. Sometimes they couldn’t agree, but there was always a meaningful attempt to understand the viewpoint of the other, exchange ideas and come to a mutually respectful and workable plan.

My mother was a resourceful advocate. She made my father think about how commercial development would impact residential neighbors and plan ways to mitigate adverse consequences on families. Long before coming into their current vogue, I learned at our family dinner table the concept of “lifestyle commercial centers” and complementary residential/commercial mixed use developments.

The point for commercial developers and residential advocates is that they should each turn down the volume of their development debate and respectfully listen to what the other is saying. When the other has presented legitimate concerns or needs, those concerns and needs should be reasonably accommodated where possible. An idealistic dream? Perhaps. But I grew up watching it work.

To be sure, not all expressed concerns are legitimate and not all proposed accommodations are possible. In those cases, resolution must necessarily be left up to public plan commissions, zoning boards, and municipal trustees or aldermen to arbitrate and decide the debate. As guardians of the public welfare entrusted with promoting the best interests of the community at large, they must decide. In a fair and evenhanded political environment, your best bet for prevailing is to demonstrate that you have listened with respect and have made reasonable and conscientious efforts to promote public harmony rather than discord.

POINT: If you are a commercial real estate developer proposing a commercial development near existing residential neighborhoods, don’t pretend they don’t exist. Think about how they will be impacted and include in your development plan ways to mitigate any adverse consequences created by your development. Talk to your residential neighbors. Listen to what they have to say. They are not ALL crazy. Sometimes (often, actually) they have legitimate concerns about real problems. If you can include in your development plan a way to economically fix a problem they already have (such as flooding, blight, inadequate parking, lack of sufficient parks or playgrounds, poor traffic circulation, etc.), your chances of favorable governmental action to approve your development plan goes up.

Whether you are a commercial real estate developer or a neighborhood advocate, understand that, whether you like it or not, conditions change. Nothing stays the same. Obsolescence and blight are natural products of time. Redevelopment is coming. If not today, then someday.

* * *

Which brings me back to my point of promoting family harmony by making amends to my mother. You don’t necessarily have to read what follows. This is primarily for her.

My mother retired last year but says she still enjoys reading my newsletters and articles. Perhaps a mother’s love, but she always likes to read what I write about real estate and real estate development. She says her favorite is a poem I wrote about “real estate development” called The Great Pyramids Of Egypt Are In Disrepair. She thinks I should share it.

The poem was written in 1992. I have to admit, it never occurred to me that the poem was about “real estate development”. I can assure you, I was not consciously thinking about real estate development at the time I wrote it.

But my mother is a smart woman and I have learned my lesson. I am not going to lightly cross her again. So, in the interest of family harmony, here it is. I leave it to you to decide if it is about real estate development. If you don’t think so, please don’t tell my mother.


Thanks,
Kymn


THE GREAT PYRAMIDS OF EGYPT ARE IN DISREPAIR

We looked deep into each other’s eyes and said:
“Our Love will last forever”.

When I was two my parents built a new house
next door to the one we rented from my grandfather.
It was “ultra modern” with all the latest conveniences
A garbage disposer – dishwasher – central air –
central vac – wall-to-wall carpet – a private den –
We had a bird bath – and two hundred newly planted Scottish pines.

It’s a parking lot now –
The church next door needed it.
Business was good.

The church doors were padlocked last year.
God moved down the street to nicer quarters.

I saw a news clip recently.
The Great Pyramids of Egypt are in disrepair.
They may not last unless work starts soon.
Sometimes the damage can be too great.
Even mummies get so wrapped up in what
they are doing they can begin to unravel.

Yesterday a friend asked: “Whatever happened to that girl?”


* * *


The POINT (according to my mother):

Change happens.
What seems new and permanent today
Will be gone tomorrow.

No time stands still.
Real Estate projects are no exception.
Redevelopment is coming.

Thank you for listening.

R. Kymn Harp*


*HARP – Not just a beer.
The uncommon lawyer.

COMMERCIAL TRANSACTION CLOSING COSTS - Who Pays what?

I was asked this morning how closing costs are typically divided between Buyers and Sellers in an Illinois Commercial/Industrial real estate transaction. This has come up before, so my response is posted below for others who may be interested:

* * * * *

In Illinois commercial/industrial real estate transactions, allocation of "closing costs" is always subject to negotiation, but as a general proposition "the customary practice" for "usual" closing cost items that come to mind is as follows:

SELLER PAYS for:

1. Title Policy with extended coverage (but Buyer pays for most other endorsements)

2. ALTA Survey (although if Seller has a fairly recent Survey and the improvements have not changed, often the Seller will provide what it has and the Buyer will be obligated to pay for updates).

3. UCC searches on any equipment or other personal property included in sale (if applicable)

4. State and County transfer taxes. (by State law)

5. All property use expenses applicable to periods PRIOR to Closing.

6. Seller's title clearance expenses (i.e. pay-off and release of mortgage and other liens)

[BASICALLY, the Seller pays to establish WHAT it owns.]

BUYER PAYS for:

1. All Environmental due diligence (although sometimes contract will provide for reimbursement of Phase 1 audit if undisclosed contamination is found that results in transaction being terminated).

2. Geo-technical studies (i.e. subsurface environmental, compaction, etc.)

3. All title endorsements other than extended coverage, and any lender's title insurance policy.

4. Municipal transfer taxes (unless provided otherwise by ordinance).

5. Special survey requirements (such as topographical contours, etc.)

6. All Property inspection expenses

7. All property use expenses applicable from and after Closing.

8. Buyer's financing expenses (including, without limitation, recording mortgage and assignment of rents, etc. and also cost of recording the Deed)

[BASICALLY, the Buyer pays for all matters related to its due diligence investigation to verify that once it owns the property it can be used in a way that is satisfactory to Buyer.]

SHARED EXPENSES:

1. Closing Escrow (except Buyer pays for lender's escrow)
2. "New York Style" closing fee

If you are concerned about some other specific cost or expense item, do not hesitate to contact me. As mentioned above, while this division is more or less "customary", in any given transaction the actual negotiated allocation may be different.

Kymn

KEYS TO CLOSING - Commercial Real Estate Transactions

Anyone who thinks Closing a commercial real estate transaction is a clean, easy, stress-free undertaking has never closed a commercial real estate transaction. Expect the unexpected, and be prepared to deal with it.

I may not be particularly good at warm and fuzzy small talk, and I may not charm your sox off with my charisma, but give me a complex commercial real estate transaction to close and I'll get it done.

I've been closing commercial real estate transactions for nearly 30 years. I grew up in the commercial real estate business.

My father was a "land guy". He assembled land, put in infrastructure and sold it for a profit. His mantra: "Buy by the acre, sell by the square foot." From an early age, he drilled into my head the need to "be a deal maker; not a deal breaker." This was always coupled with the admonition: "If the deal doesn't close, no one is happy." His theory was that attorneys sometimes "kill tough deals" simply because they don't want to be blamed if something goes wrong.

Over the years I learned that commercial real estate Closings require much more than mere casual attention. Even a typically complex commercial real estate Closing is a highly intense undertaking requiring disciplined and creative problem solving to adapt to ever changing circumstances. In many cases, only focused and persistent attention to every detail will result in a successful Closing. Commercial real estate Closings are, in a word, "messy".

A key point to understand is that commercial real estate Closings do not "just happen"; they are made to happen. There is a time-proven method for successfully Closing commercial real estate transactions. That method requires adherence to the four KEYS TO CLOSING outlined below:


KEYS TO CLOSING

1. HAVE A PLAN: This sounds obvious, but it is remarkable how many times no specific Plan for closing is developed. It is not a sufficient Plan to merely say: "I like a particular piece of property; I want to own it." That is not a Plan. That may be a goal, but that is not a Plan.

A Plan requires a clear and detailed vision of what, specifically, you want to accomplish, and how you intend to accomplish it. For instance, if the objective is to acquire a large warehouse/light manufacturing facility with the intent to convert it to a mixed use development with first floor retail, a multi-deck parking garage and upper level condominiums or apartments, the transaction Plan must include all the steps necessary to get from where you are today to where you need to be to fulfill your objective. If the intent, instead, is to demolish the building and build a strip shopping center, the Plan will require a different approach. If the intent is to simply continue to use the facility for warehousing and light manufacturing, a Plan is still required, but it may be substantially less complex.

In each case, developing the transaction Plan should begin when the transaction is first conceived and should focus on the requirements for successfully Closing upon conditions that will achieve the Plan objective. The Plan must guide contract negotiations, so that the Purchase Agreement reflects the Plan and the steps necessary for Closing and post-Closing use. If Plan implementation requires particular zoning requirements, or creation of easements, or termination of party wall rights, or confirmation of structural elements of the building, or availability of utilities, or availability of municipal entitlements, or environmental remediation and regulatory clearance, or other identifiable requirements, the Plan and the Purchase Agreement must address those issues and include those requirements as conditions to Closing.

If it is unclear at the time of negotiating and entering into the Purchase Agreement whether all necessary conditions exists, the Plan must include a suitable period to conduct a focused and diligent investigation of all issues material to fulfilling the Plan. Not only must the Plan include a period for investigation, the investigation must actually take place with all due diligence.

NOTE: The term is "Due Diligence"; not "do diligence". The amount of diligence required in conducting the investigation is the amount of diligence required under the circumstances of the transaction to answer in the affirmative all questions that must be answered "yes", and to answer in the negative all questions that must be answered "no". The transaction Plan will help focus attention on what these questions are. [Ask for a copy of my January, 2006 article: Due Diligence: Checklists for Commercial Real Estate Transactions.]

2. ASSESS AND UNDERSTAND THE ISSUES: Closely connected to the importance of having a Plan is the importance understanding all significant issues that may arise in implementing the Plan. Some issues may represent obstacles, while others represent opportunities. One of the greatest causes of transaction failure is a lack of understanding of the issues or how to resolve them in a way that furthers the Plan.

Various risk shifting techniques are available and useful to address and mitigate transaction risks. Among them is the use of title insurance with appropriate use of available commercial endorsements. In addressing potential risk shifting opportunities related to real estate title concerns, an understanding of the difference between a "real property law issue" and a "title insurance risk issue" is critical. Experienced commercial real estate counsel familiar with available commercial endorsements can often overcome what sometimes appear to be insurmountable title obstacles through creative draftsmanship and the assistance of a knowledgeable title underwriter.

Beyond title issues, there are numerous other transaction issues likely to arise as a commercial real estate transaction proceeds to Closing. With commercial real estate, negotiations seldom end with execution of the Purchase Agreement.

New and unexpected issues often arise on the path toward Closing that require creative problem-solving and further negotiation. Sometimes these issues arise as a result of facts learned during the buyer's due diligence investigation. Other times they arise because independent third-parties necessary to the transaction have interests adverse to, or at least different from, the interests of the seller, buyer or buyer's lender. When obstacles arise, tailor-made solutions are often required to accommodate the needs of all concerned parties so the transaction can proceed to Closing. To appropriately tailor a solution, you have to understand the issue and its impact on the legitimate needs of those affected.

3. RECOGNIZE AND OVERCOME THIRD PARTY INERTIA: A major source of frustration, delay and, sometimes, failure of commercial real estate transactions results from what I refer to as "third-party inertia". Recognize that the Closing deadlines important to transaction participants are often meaningless to unrelated third parties whose participation and cooperation is vital to moving the transaction forward. Chief among third-party dawdlers are governmental agencies, but the culprit may be any third party vendor or other third party not controlled by the buyer or seller. For them, the transaction is often "just another file" on their already cluttered desk.

Experienced commercial real estate counsel is often in the best position to recognize inordinate delay by third parties and can often cajole recalcitrant third parties into action with an appropriately timed telephone call. Often, experienced commercial real estate counsel will have developed relationships with necessary vendors and third parties through prior transactions, and can use those established relationships to expedite the transaction at hand. Most importantly, however, experienced commercial real estate counsel is able to recognize when undue delay is occurring and push for a timely a response when appropriate. Third party vendors are human (they claim) and typically respond to timely appeals for action. It is the old cliché in action: "The squeaky wheel gets the oil". Care must be taken, however, to tactfully apply pressure only when necessary and appropriate. Repeated requests or demands for action when inappropriate to the circumstance runs the risk of alienating a necessary party and adding to delay instead of eliminating it. Once again, human nature at work. Experienced commercial real estate counsel will often understand when to apply pressure and when to lay off.

4. PREPARE FOR THE CLOSING FRENZY: Like it or not, controlled chaos leading up to Closing is the norm rather than the exception for commercial real estate transactions. It occurs because of the necessity of relying on independent third parties, the necessity of providing certifications and showings dated in close proximity to Closing, and because new issues often arise at or near Closing as a consequence of facts and information discovered through the continual exercise of due diligence on the path toward Closing.

Whether dealing with third-party lessees, lenders, appraisers, local planning, zoning or taxing authorities, public or quasi-public utilities, project surveyors, environmental consultants, title insurance companies, adjoining property owners, insurance companies, structural engineers, state or local departments of transportation, or other necessary third-party vendors or participants, it will often be the case that you must wait for them to react within their own time-frame to enable the Closing to proceed. The transaction is seldom as important to them as it is to the buyer and seller.

To the casual observer, building-in additional lead-time to allow for stragglers and dawdlers to act may seem to be an appropriate solution. The practical reality, however, is that many tasks must be completed within a narrow window of time just prior to Closing.

As much as one may wish to eliminate the last minute rush in the days just before Closing, in many instances it is just not possible. Many documents and "showings", such as UCC searches, surveys, water department certifications, governmental notices, appraisals, property inspection reports, environmental site assessments, estoppel certificates, rent rolls, certificates of authority, and the like, must be dated near in time to the Closing, often within a few days or weeks of Closing. If prepared and dated too far in advance, they become stale and meaningless and must be redone, resulting in additional time and expense.

The reality is that commercial real estate Closings often involve big dollar amounts and evolving circumstances. Rather than complain and stress-out over the hectic pace of coordinating all Closing requirements and conditions as Closing approaches, you are wise to anticipate the fast paced frenzy leading up to Closing and should be prepared for it. As Closing approaches, commercial real estate counsel, real estate brokers and necessary representatives of the buyer and seller should remain available and ready to respond to changing demands and circumstances. This is not a time to go on vacation or to be on an out of town business trip. It is a time to remain focused and ready for action.

Recognizing that pre-Closing frenzy is the norm rather than an exception for commercial real estate transactions may help ease tension among the parties and their respective counsel and pave the way for a successful Closing.

Like it or not, this is the way it is. Prepare for the frenzy and be available to respond. This is the way it works. Anyone who tells you differently is either lying to you or has had little experience in Closing commercial real estate transactions.
* * *

So there you have it. The four KEYS TO CLOSING a commercial real estate transaction.

1. HAVE A PLAN
2. ASSESS AND UNDERSTAND THE ISSUES
3. RECOGNIZE AND OVERCOME THIRD PARTY INERTIA
4. PREPARE FOR THE CLOSING FRENZY

Apply these Keys to Closing, and your chance of success goes up. Ignore these Keys to Closing, and your transaction may drift into oblivion.


R. Kymn Harp

P.S. For assistance, call me at my office or on my cell phone (847) 951-HARP. We can work the four Keys to Closing together.

POP QUIZ! - Investing In Commercial Real Estate

I read once that if you took all the real estate lawyers in Illinois and laid them end to end along the equator -- it would be a good idea to leave them there.

That’s what I read.

What do you suppose that means?

I have written before about the need to exercise due diligence when purchasing commercial real estate. The need to investigate, before Closing, every significant aspect of the property you are acquiring. The importance of evaluating each commercial real estate transaction with a mindset that once the Closing occurs, there is no going back. The Seller has your money and is gone. If post-Closing problems arise, Seller’s contract representations and warranties will, at best, mean expensive litigation. CAVEAT EMPTOR! [“Let the buyer beware!”]

Paying extra attention at the beginning of a commercial real estate transaction to “get it right” can save tens of thousands of dollars vs. when the deal goes bad. It’s like the old Fram® oil filter slogan during the 1970’s: “You can pay me now - or pay me later”. In commercial real estate, however, “later” may be too late.

Buying commercial real estate is NOT like buying a home. It is not. It is not. It is NOT.

In Illinois, and many other states, virtually every residential real estate closing requires a lawyer for the buyer and a lawyer for the seller. This is probably smart. It is good consumer protection.

The “problem” this causes, however, is that every lawyer handling residential real estate transactions considers himself or herself a “real estate lawyer”, capable of handling any real estate transaction that may arise.

We learned in law school that there are only two kinds of property: real estate and personal property. Therefore – we intuit – if we are competent to handle a residential real estate closing, we must be competent to handle a commercial real estate closing. They are each “real estate”, right?

ANSWER: Yes, they are each real estate. No, they are not the same.

The legal issues and risks in a commercial real estate transaction are remarkably different from the legal issues and risks in a residential real estate transaction. Most are not even remotely similar. Attorneys concentrating their practice handling residential real estate closings do not face the same issues as attorneys concentrating their practice in commercial real estate.

It is a matter of experience. You either know the issues and risks inherent in commercial real estate transactions - and know how to deal with them - or you don’t.

A key point to remember is that the myriad consumer protection laws that protect residential home buyers have no application to – and provide no protection for – buyers of commercial real estate.

Competent commercial real estate practice requires focused and concentrated investigation of all issues material to the transaction by someone who knows what they are looking for. In short, it requires the exercise of “due diligence".

I admit – the exercise of due diligence is not cheap, but the failure to exercise due diligence can create a financial disaster for the commercial real estate investor. Don’t be “penny wise and pound foolish”.

If you are buying a home, hire an attorney who regularly represents home buyers. If you are buying commercial real estate, hire an attorney who regularly represents commercial real estate buyers.

Years ago I stopped handling residential real estate transactions. As an active commercial real estate attorney, even I hire residential real estate counsel for my own home purchases. I do that because residential real estate practice is fundamentally different from commercial real estate.

Maybe I do “harp” on the need for competent counsel experienced in commercial real estate transactions. I genuinely believe it. I believe it is essential. I believe if you are going to invest in commercial real estate, you must apply your critical thinking skills and be smart.

* * *

POP QUIZ: Here’s is a simple test of YOUR critical thinking skills:

Please read the following Scenarios and answer the questions TRUE or FALSE:

Scenario No. 1: It’s Valentine’s Day. You are in hot pursuit of the love of your life. A few weeks ago, she confided in you that all she ever dreamed of for Valentine’s Day was that her lover would show up at her door, dressed in a white tuxedo with tails and a top hat, and present her with a beautiful bouquet of flowers. You’ve rented the tuxedo, but now you are concerned about how much money you are spending.

TRUE OR FALSE: Since flowers are pretty much all the same, it is OK for you to skip the roses and show up with a bouquet of fresh yellow dandelions.


Scenario No. 2: For several years you eyesight deteriorated to the point where you can barely see your alarm clock. You are now considering corrective eye surgery so you won’t need glasses. Your sister-in-law had corrective eye surgery and has had spectacular results. She recommends her eye surgeon, but mentions the cost is about $5,700 for both eyes and that the surgery is not covered by insurance. A few years ago, you had surgery to correct your hemorrhoids and it cost you only eight hundred bucks.

TRUE OR FALSE: Since surgeons all went to medical school and are all medical doctors, you are being frugal and wise by asking the surgeon who performed your hemorrhoid surgery to perform your corrective eye surgery.


Scenario No. 3: Several years ago, when you first got married, you asked a former classmate who is a lawyer to represent you in the purchase of your townhome. The cost was only $375. A year later, you started a family and decided you needed a Will. The same attorney prepared Wills for you and your wife for a total cost of $700. You started your own business and your attorney friend formed a corporation for you and charged you only $600 plus the cost of the corporate minute book. Years later, when your son was arrested for misdemeanor reckless driving, your attorney friend handled the criminal case and got your son off with supervision for only $1,500.

Your business has been successful and you have built a pretty sizable nest egg, but you are tired of working for every dime and want to try investing in real estate. You have your eye on a strip shopping center. It includes a grocery store, bank, hardware store, dry cleaners (on a month to month tenancy), a couple of fast food restaurants, a gift shop, dental office, bowling alley (with a lease about to expire), and wraps behind a gas station/mini-mart on the corner. The purchase price is $8,000,000, but the net operating income looks pretty good. You figure if you turn the bowling alley into a full service restaurant/banquet facility, and convert the dry cleaners into a 24-hour coin laundry, the net operating income will increase and the shopping center will turn into a spectacular investment. You plan to pull together much of your life savings and put down $2,000,000 to buy this strip shopping center, borrowing the balance of $6,000,000. You remember that your lawyer friend handled the purchase of your home several years ago, so you know he handles real estate.

TRUE OR FALSE: Commercial real estate is the same as residential real estate [Hey, its all dirt, isn’t it (?)], so you are being a shrewd businessman by hiring your lawyer friend who will charge much less than a lawyer who handles shopping center purchases several time a year. [What is this “due diligence” stuff anyway?]




ANSWERS:


If you answered “TRUE” for any of the foregoing Scenarios . . .

PLEASE ~

Do NOT call me.

Do NOT write me.

Do NOT email me.

You are too dense.

I do NOT want to be your lawyer.

Go away. Please!

If, on the other hand, you understand that the answer to each of the foregoing questions is FALSE, I am available to help you in Scenario No. 3.

For Scenario No. 2, you should follow your sister-in-law’s suggestion and contact her eye surgeon, or some other eye surgeon with equal skill.

For Scenario No. 1, you are on your own. [But, if you answered TRUE for Scenario No. 1, you may be FOREVER on you own.]

Investing in commercial real estate can be profitable and rewarding – but it requires good critical thinking skills and competent counsel.

Give me a call. Lets talk about your transaction.

Thank you,

Kymn




P.S. Please excuse me for harping on due diligence. ~ It is my birthright. ~ With the last name “Harp”, I am entitled to “harp” on anything I wish. ”

DUE DILIGENCE CHECKLISTS - For Commercial Real Estate Transactions

Are you planning to purchase, finance or develop any of the following types of Commercial or Industrial Real Estate?

o Shopping Center?
o Office Building?
o Restaurant/Banquet property?
o Parking Lot/Parking garage?
o Store?
o Gas Station?
o Manufacturing facility?
o Warehouse?
o Logistics Terminal?
o Medical Building?
o Nursing Home?
o Hotel/Motel?
o Pharmacy?
o Bank facility?
o Special Use facility
o Other?

A KEY element to successfully investing in commercial or industrial real estate is performing an adequate Due Diligence Investigation prior to becoming legally bound to acquire the property. An adequate Due Diligence Investigation will assure awareness of all material facts relevant to the intended use or disposition of the property after closing.

The following checklists will help you conduct a focused and meaningful Due Diligence Investigation.


Basic Due Diligence Concepts

Caveat Emptor: Let the Buyer beware.

Consumer protection laws applicable to home purchases seldom apply to commercial real estate transactions. The rule that a Buyer must examine, judge, and test for himself, applies to the purchase of commercial real estate.

Due Diligence: "Such a measure of prudence, activity, or assiduity, as is proper to be expected from, and ordinarily exercised by, a reasonable and prudent [person] under the particular circumstances; not measured by any absolute standard, but depending upon the relative facts of the special case." Black's Law Dictionary; West Publishing Company.

Contractual representations and warranties are NOT a substitute for Due Diligence.

Breach of representations and warranties = Litigation, time and $$$$$


* * *



WHAT DILIGENCE IS DUE?

The scope, intensity and focus of any Due Diligence Investigation of commercial or industrial real estate depends upon the objectives of the party for whom the investigation is conducted. These objectives may vary depending upon whether the investigation is conducted for the benefit of (i) a Strategic Buyer (or long-term lessee); (ii) a Financial Buyer; (iii) a Developer; or (iv) a Lender.

If you are a Seller, understand that to close the transaction, your Buyer and its Lender must address all issues material to its objective – some of which require information only you, as Owner, can adequately provide.

IN GENERAL:

(i) A "Strategic Buyer" (or long-term lessee) is acquiring the property for its own use and must verify that the property is suitable for that intended use.

(ii) A "Financial Buyer" is acquiring the property for the expected return on investment generated by the property's anticipated revenue stream, and must determine the amount, velocity and durability of the revenue stream. A sophisticated Financial Buyer will likely calculate its yield based upon discounted cash-flows rather than the much less precise capitalization rate ("Cap. Rate"), and will need adequate financial information to do so.

(iii) A "Developer" is seeking to add value by changing the character or use of the property – usually with a short-term to intermediate-term exit strategy to dispose of the property; although a Developer might plan hold the property long term as a Financial Buyer after development or redevelopment. The Developer must focus on whether the planned change in character or use can be accomplished in a cost-effective manner.

(iv) A "Lender" is seeking to establish two basic lending criteria:

(1) "Ability to Repay" - The ability of the property to generate sufficient revenue to repay the loan on a timely basis; and

(2) "Sufficiency of Collateral" - The objective disposal value of the collateral in the event of a loan default, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.

The amount of diligent inquiry due to be expended (i.e. "Due Diligence") to investigate any particular commercial or industrial real estate project is the amount of diligence required to answer each of the following questions to the extent relevant to the objectives of the party conducting the investigation:


I. THE PROPERTY:

1. Exactly what PROPERTY does Purchaser believe it is acquiring?
· Land?
· Building?
· Fixtures?
· Other Improvements?
· Other Rights?
· The entire fee title interest including all air rights and subterranean rights?
· All development rights?

2. What is Purchaser's planned use of the Property?

3. Does the physical condition of the Property permit use as planned?
· Commercially adequate access to public streets and ways?
· Sufficient parking?
· Structural condition of improvements?
· Environmental contamination?
o Innocent Purchaser defense vs. exemption from liability
o All Appropriate Inquiry

4. Is there any legal restriction to Purchaser's use of the Property as planned?
· Zoning?
· Private land use controls?
· Americans with Disabilities Act?
· Availability of licenses?
o Liquor license?
o Entertainment license?
o Outdoor dining license?
o Drive through windows permitted?
· Other impediments?

5. How much does Purchaser expect to pay for the property?

6. Is there any condition on or within the Property that is likely to increase Purchaser's effective cost to acquire or use the Property?
· Property owner's assessments?
· Real estate tax in line with value?
· Special Assessment?
· Required user fees for necessary amenities?
a. Drainage?
b. Access?
c. Parking?
d. Other?

7. Any encroachments onto the Property, or from the Property onto other lands?

8. Are there any encumbrances on the Property that will not be cleared at Closing?
· Easements?
· Covenants Running with the Land?
· Liens or other financial servitudes?
· Leases?

9. Leases?
· Security Deposits?
· Options to Extend Term?
· Options to Purchase?
· Rights of First Refusal?
· Rights of First Offer?
· Maintenance Obligations?
· Duty on Landlord to provide utilities?
· Real estate tax or CAM escrows?
· Delinquent rent?
· Pre-Paid rent?
· Tenant mix/use controls?
· Tenant exclusives?
· Tenant parking requirements?
· Automatic subordination of Lease to future mortgages?
· Other material Lease terms?

10. New Construction?
· Availability of construction permits?
· Utilities?
· NPDES (National Pollutant Discharge Elimination System) Permit?
o Phase II effective March 2003 – Permit required if earth is disturbed on one acre or more of land.
o If applicable, Storm Water Pollution Prevention Plan (SWPPP) is required.


II. THE SELLER:

1. Who is the Seller?
· Individual?
· Trust?
· Partnership?
· Corporation?
· Limited Liability Company?
· Other legally existing entity?

2. If other than natural person, does Seller validly exist and is Seller in good standing?

3. Does the Seller own the Property?

4. Does Seller have authority to convey the Property?
· Board of Director Approvals?
· Shareholder or Member approval?
· Other consents?
· If foreign individual or entity, are any special requirements applicable?
o Qualification to do business in jurisdiction of Property?
o Federal Tax Withholding?
o US Patriot Act compliance?

5. Who has authority to bind Seller?

6. Are sale proceeds sufficient to pay off all liens?


III. THE PURCHASER:

1. Who is the Purchaser?

2. Will the "Purchaser" be the "Grantee"? If not, who is the Grantee?

2. What is the Purchaser/Grantee's exact legal name?

3. If Purchaser/Grantee is an entity, has it been validly created and is it in good standing?
· Articles or Incorporation - Articles of Organization
· Certificate of Good Standing

4. Is Purchaser/Grantee authorized to own and operate the Property and, if applicable, finance acquisition of the Property?
· Board of Director Approvals?
· Shareholder or Member approval?
· If foreign individual or entity, are any special requirements applicable?
o Qualification to do business in jurisdiction of the Property?
o US Patriot Act compliance?
o Bank Secrecy Act/Anti-Money Laundering compliance?

5. Who is authorized to bind the Purchaser/Grantee?


IV. PURCHASER FINANCING:

A. BUSINESS TERMS OF THE LOAN: What loan terms have the Purchaser, as Borrower, and its Lender agreed to?

· What is the amount of the loan?

· What is the interest rate?

· What are the repayment terms?

· What is the collateral?
o Commercial real estate only?
o Real estate and personal property together?

· First lien? A junior lien?

· Is it a single advance loan?

· A multiple advance loan?

· A construction loan?

· If it is a multiple advance loan, can the principal be re-borrowed once repaid prior to maturity of the loan; making it, in effect, a revolving line of credit?

· Are there reserve requirements?
o Interest reserves?
o Repair reserves?
o Real estate tax reserves?
o Insurance reserves?
o Environmental remediation reserves?
o Other reserves?

· Are there requirements for Borrower to open business operating accounts with the Lender? If so, is the Borrower obligated to maintain minimum compensating balances?

· Is the Borrower required to pledge business accounts as additional collateral?

· Are there early repayment fees or yield maintenance requirements (each sometimes referred to as “pre-payment penalties”)?

· Are there repayment blackout periods during which Borrower is not permitted to repay the loan?

· Is there a Loan Commitment fee or "good faith deposit" due upon Borrower's acceptance of the Loan Commitment?

· Is there a loan funding fee or loan brokerage fee or other loan fee due Lender or a loan broker at closing?

· What are the Borrower’s expense reimbursement obligations to Lender? When are they due? What is the Borrower's obligation to pay Lender's expenses if the loan does not close?


B. DOCUMENTING THE COMMERCIAL REAL ESTATE LOAN

Does Purchaser have all information necessary to comply with the Lender's loan closing requirements?

Not all loan documentation requirements may be known at the outset of a transaction, although most commercial real estate loan documentation requirements are fairly typical. Some required information can be obtained only from the Seller. Production of that information to Purchaser for delivery to its lender must be required in the purchase contract.

As guidance to what a commercial real estate lender may require, the following sets forth a typical Closing Checklist for a loan secured by commercial real estate.


Commercial Real Estate Loan Closing Checklist

1. Promissory Note

2. Personal Guaranties (which may be full, partial, secured, unsecured, payment guaranties, collection guaranties or a variety of other types of guarantees as may be required by Lender).

3. Loan Agreement (often incorporated into the Promissory Note and/or Mortgage in lieu of being a separate document)

4. Mortgage [sometimes expanded to be a Mortgage, Security Agreement and Fixture Filing]

5. Assignment of Rents and Leases

6. Security Agreement

7. Financing Statement (sometimes referred to as a “UCC-1”, or “Initial Filing”)

8. Evidence of Borrower’s Existence In Good Standing; including

(a) Certified copy of organizational documents of borrowing entity (including Articles of Incorporation, if Borrower is a corporation; Articles of Organization and written Operating Agreement, if Borrower is a limited liability company; Certified copy of trust agreement with all amendments, if Borrower is a land trust or other trust; etc.)

(b) Certificate of Good Standing (if a corporation or LLC) or Certificate of Existence (if a limited partnership) or Certificate of Qualification to Transact Business (if Borrower is an entity doing business in a State other than its State of formation)

9. Evidence of Borrower’s Authority to Borrow; including

(a) a Borrower’s Certificate;

(b) Certified Resolutions

(c) Incumbency Certificate

10. Satisfactory Commitment for Title Insurance (which will typically require, for analysis by the Lender, copies of all documents of record appearing on Schedule B of the title commitment which are to remain after closing), with required commercial title insurance endorsements, often including:

(a) Affirmative Creditors Rights Endorsement (extending coverage over policy exclusion 7 and policy exclusions 3(a) and 3(d) as they relate to creditor's rights matters)

(b) ALTA 3.1 Zoning Endorsement modified to include parking

(c) ALTA Comprehensive Endorsement 1

(d) Location Endorsement (street address)

(e) Access Endorsement (vehicular access to public streets and ways)

(f) Contiguity Endorsement (the insured land comprises a single parcel with no gaps or gores)

(g) PIN Endorsement (insuring that the identified real estate tax permanent index numbers are the only applicable PIN numbers affecting the collateral and that they relate solely to the real property comprising the collateral)

(h) Usury Endorsement (insuring that the loan does not violate any prohibitions against excessive interest charges)

(i) other title insurance endorsements applicable to protect the intended use and value of the collateral, as may be determined upon review of the Commitment for Title Insurance and Survey or arising from the existence of special issues pertaining to the transaction or the Borrower.

11. Current ALTA/ACSM Land Title Survey (3 sets), prepared in accordance with the 2005 Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys including items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from "TABLE A: Optional Survey Responsibilities and Specifications" [generally referred to simply as "Table A"].

12. Current Rent Roll

13. Certified copy of all Leases (4 sets – 1 each for Buyer, Buyer's attorney, Title Company and Lender)

14. Lessee Estoppel Certificates

15. Lessee Subordination, Non-Disturbance and Attornment Agreements [sometimes referred to simply as "SNDAs"].

16. UCC, Judgment, Pending Litigation, Bankruptcy and Tax Lien Search Report

17. Appraisal - complying with Title XI of FIRREA (Financial Institutions Reform, Recovery and Enforcement Act of 1989, as amended)

18. Environmental Site Assessment Report (sometimes referred to as Environmental Phase I and/or Phase 2 Audit Reports)

19. Environmental Indemnity Agreement (signed by Borrower and guarantors)

20. Site Improvements Inspection Report

21. Evidence of Hazard Insurance naming Lender as the Mortgagee/Lender Loss Payee; and Liability Insurance naming Lender as an “additional insured” (sometimes listed as simply “Acord 27 and Acord 25, respectively)

22. Legal Opinion of Borrower’s Attorney

23. Credit Underwriting documents, such as signed tax returns, property operating statements, etc. as may be specified by Lender

24. Compliance Agreement (sometimes also called an Errors and Omissions Agreement), whereby the Borrower agrees to correct, after closing, errors or omissions in loan documentation.

* * * * * *
It is useful to become familiar with the Lender's loan documentation requirements as early in the transaction as practical. The requirements will likely be set forth with some detail in the lender's Loan Commitment – which is typically much more detailed than most loan commitments issued in residential transactions.

Conducting the Due Diligence Investigation in a commercial real estate transaction can be time consuming and expensive in all events.

If the loan requirements cannot be satisfied, it is better to make that determination during the contractual "due diligence period" – which typically provides for a so-called "free out" – rather than at a later date when the earnest money may be at risk of forfeiture or when other liability for failure to close may attach.

CONCLUSION

Conducting an effective Due Diligence Investigation in a commercial or industrial real estate transaction to discover all material facts and conditions affecting the Property and the transaction is of critical importance.

The existence of these factors and their impact on a Purchaser's ability to use the Property as intended can only be discovered through diligent and focused investigation and attention to detail.

Exercise Due Diligence.

IF YOU NEED HELP, CALL ME!

R. Kymn Harp

WHEN WRAP-AROUND MORTGAGES RETURN - The Time To Plan is NOW!

This article was written in September 2003. The predicted rise in interest rates is occuring and is expected to continue for the foreseeable future. Interest in Wrap-Around Mortgages has increaed dramatically in the past year. For this reason, I am recirculating this article for those wishing to learn more about this topic.

For the complete article, with all footnotes and citations, please feel free to request a copy via email.

Enjoy!


WHEN "WRAP-AROUND MORTGAGES" RETURN*
*The Time to Plan is NOW

With interest rates near historic lows, commercial real estate is being financed at rates few believed possible only a short time ago. The commercial real estate loan market is extraordinarily competitive. Lenders are scrambling to find borrowers, and are willing to be flexible to attract borrowers with fiscally sound commercial real estate projects. Forward thinking Investors and Developers will use this time wisely to negotiate loan terms enabling them to take advantage of today's low interest rates when interest rates rise.


WHERE ARE WE NOW? (September 2003)

For over two years – especially since September 11, 2001 - we have watched interest rates decline. It has not always been steady. Rates have occasionally inched up 10, 20 or 30 basis points for a few weeks at a time but, generally, the trend has been downward. In mid-June 2003, interest rates were at their lowest levels in over 40 years. Although the economy is showing signs of recovery, analysts predict interest rates to remain historically low until after the 2004 presidential elections.

With this trend of falling interest rates it is easy to see how some investors have become complacent. As interest rates have fallen, commercial real estate values have risen due to investor willingness to accept lower yields. With traditional optimistic blindness, a significant number of investors seem to believe the current low interest rates, or even lower rates, are here to stay. Many are "taking advantage" by financing projects with floating or adjustable rate mortgages tied to the prime rate, LIBOR or other indexed rates.

The combination of lower yield expectations and higher annual cash flows (with ballooning debt coverage ratios as interest rates have dropped) has raised concerns by some, including the FDIC, that commercial real estate values and performance may be distorted in the current economic climate. A concern is that some commercial real estate loans and investments financed with "typical" underwriting ratios may be at risk when interest rates rise

Fortunately, to mitigate this risk, some borrowers and some lenders are opting to lock in fixed rates for longer periods of time. Lenders, to attract borrowers and to protect against the risk of a further decline in interest rates; and Borrowers, to protect against the risk of rising interest rates. Borrowers may pay a slightly higher yield to lock-in a fixed rate over an extended term, but in the current climate of historically low rates and lender competition for borrowers, long term fixed rates remain attractive.

Since interest rate increases are not likely to be any more predictable or steady than their recent decline, and because lenders can hedge their interest rate bets by matching long term loans to annuity contracts, long term Certificates of Deposit or other long term investments, lenders are likely, for the foreseeable future, to be flexible and negotiable on some loan terms – especially if the terms do not directly affect their agreed upon yield or impair their collateral.


PLANNING FOR RISING RATES

With interest rates at near historic lows, and lenders clamoring to make loans secured by quality commercial real estate, NOW is the time to plan for the future. NOW is the time for investors to lock in attractive loan rates for extended periods, if possible, and to make sure they have the flexibility to keep those rates when economic conditions and future needs change.

INVESTORS: Now is the time to negotiate provisions in your commercial real estate mortgage to allow you to leverage current low interest rates to your advantage when interest rates rise. Here's how:



Leveraging Low Interest Rates

In one respect, the value of locking in low interest rates for extended periods when interest rates are likely to rise is obvious. If you knew today that interest rates were rising and that in the foreseeable future interest rates were going to be 7.5%, 8.5%, 9.5% or higher, who wouldn't lock in today's low interest rates if they could? That is not really the issue. That concept is self-evident.

But what if, for example, you lock in a low interest rate today for the next 10, 20 or 30 years - interest rates rise significantly, and then, say 5 or 6 years from now, you wish to sell your investment?

Assuming pre-payment of your loan is allowed , one solution is to simply sell the property. In this case, you would receive your equity and would be free to reinvest at then prevailing returns. Unless you have a "portable mortgage" allowing transfer to a new project, you would promptly loose any future benefit of your long-term low interest rate because the project would be gone and, most likely, the mortgage paid off.

If the mortgage is "assumable", you may gain some advantage by being able to negotiate a higher sale price for the project because the assuming buyer will be able to benefit from your lower rate. An obvious problem with this scenario is that, if the project has appreciated substantially, the amount of the down-payment the buyer may be required to produce to pay the equity between the purchase price and the remaining loan balance may be prohibitive to most buyers, thereby reducing demand for your property and creating downward pressure to lower the price.
Are there other solutions?

Consider the following hypothetical facts:

Today: Investor acquires an office building, strip shopping center, single use building, or other typical investment property (the "Property") for $2,000,000. Investor obtains a loan for $1,500,000 [75% loan to value] with a fixed interest rate of 6.25 % amortized and payable over 20 years, secured by a first Mortgage on the property.

Five years later: Now, project yourself five years into the future: Interest rates on first mortgage loans have risen to 9.5%. Interest rates on loans secured by second position mortgages are, perhaps, 10.5% to 11%. Because of built-in rental increases under existing leases, the Property has appreciated in value to, say, $2,200,000. Perhaps the tax shelter benefits of the Property to the Investor have diminished somewhat because the Investor used segregated cost accounting to accelerate cost recovery in the early years of the investment, so Investor has decided to sell. The sale price is $2,200,000.

Case No.1. Investor could simply sell the property to a willing buyer (the "Buyer") who would be responsible for obtaining its own financing. Under a typical scenario, the Buyer will obtain a mortgage loan for 75% of the value of the property at current market interest rates. Under the hypothetical facts given, the Buyer will invest equity of $550,000 (25% of the purchase price) and will obtain a first mortgage loan in the amount of $1,650,000 (75% of value) at a current interest rate of 9.5% amortized over 20 years, with a 15 year balloon payment . The Buyer's monthly payment would be $15,380.16. The balloon payment due in 15 years would be $732,323.88. The original Investor would "cash-out" at the time of funding this loan and the original first Mortgage loan would be paid off.

Case No. 2. If the Mortgage is "assumable" (or, at least, not "due-on-sale ), the Buyer could, if it chose to do so and the Seller agrees, pay the original Investor an amount equal to the Investor's equity in the Property and "assume" or "take subject to" the Mortgage obligation with its low 6.25% interest rate for the balance of 15 years. If this were to occur exactly 5 years after the original investment, the Mortgage balance would be $1,278,706.63, requiring the Buyer to invest $921,293.37 as its equity to acquire the Property and receive the benefit of the lower interest rate. An investor may be willing to do this, if it has the funds available and is willing to make a 42% cash outlay for an investment property to achieve a below market interest rate. Investor preferences, however, typically favor a lower down payment.

Case No. 3. Assume at the time of obtaining the original Mortgage, the Investor was able to negotiate a Mortgage that did not include a "due on sale" clause and did not prohibit additional debt secured by the Property . In this case, the Investor has two additional choices if the Buyer wishes to leverage the property by financing 75% of the purchase price.

Option 1: The Investor can offer to hold a standard "second mortgage" in the amount of $371,293.37 at an agreed upon rate close to market rates for second mortgage loans (perhaps, 10.5%), amortized over an agreed upon period (say, 20 years with a 15 year balloon) and buyer can assume or take subject to the existing first Mortgage bearing interest at 6.25%. In this case, the Buyer would get the benefit of the lower interest rate on the first Mortgage, while paying a 10.5% market rate of interest on the second mortgage; or

Option 2: the Investor might offer the Buyer a "wrap-around mortgage" for the entire amount being financed ($1,650,000) at a below market interest rate for a first mortgage loan with interest of, say, 9% on the entire amount, amortized over 20 years with a 15 year balloon.

If Option 1 is chosen, the Investor will receive at closing the sum of $550,000 in cash, and will "hold paper" for $371,293.37 secured by a second mortgage, earning 10.5% interest per year, generating a monthly payment of $3,706.92, and a final balloon payment of $172,463.73 in 15 years. The effective yield to the Investor would be 10.5%.

If Option 2 is chosen, the Investor will receive at closing the sum of $550,000 in cash, and will "hold paper" for $1,650,000 bearing interest of 9% (desirable to Buyer because it is .5% less than market, and results in a monthly payment of only $14,845.48, an amount $534.68 per month less than available at the hypothetical current market rate of 9.5%). Of the $1,650,000 held by Investor, only $371,293.37 represents funds actually "loaned" by Investor .

At first glance, it may seem that these funds will earn interest at only 9% instead of 10.5% available under Option 1, but consider further: Through use of a wrap-around mortgage, the Investor would also earn a 2.75% return on funds of the original lender because of the spread between the 6.25% interest rate on the first mortgage loan and the 9% interest rate on the wrap-around mortgage loan. Since the mortgage "wraps around" the original first mortgage loan, the balance of the wrap-around mortgage amount, $1,278,706.63, represents funds actually advanced by (remaining unpaid to) the original first mortgage lender.

As a consequence, the monthly payment received on the wrap-around mortgage would be $14,845.48. After payment of the underlying monthly payment of $10,963.92 due on the existing first mortgage, the net amount retained from the wrap around mortgage payment during the life of the underlying first mortgage is $3,881.56, (in this case, $174.64 per month more than the monthly payment receivable under Option 1, above, with only a second mortgage position. More significantly, at the end of 15 years, when the underlying first mortgage has been fully amortized and paid off, the balloon payment receivable under the wrap-around mortgage proposed in Option 2 would be $715,156.77 ($542,693.04 greater than in Option 1 - and, in fact, nearly double the amount originally loaned, due to accumulated interest from negative amortization), generating an effective overall yield on Investors actual cash investment of $371,293.37 at a rate of 14.32% per annum compounded monthly during the life of the loan.

Under Option 2, both the Investor and the Buyer benefit, and the original lender continues to receive the rate of return originally contracted for under the first mortgage.


Wrap Option Available to Banks Also

In the foregoing examples, we have assumed that it is the Investor/"Seller" who is providing the financing and who will be the "wrap-around Mortgagee". This is not necessarily the case. There is no legal reason a Bank or other lender could not be the wrap-around Mortgagee under similar circumstances provided it is not prohibited by regulatory mandate or internal loan policies from securing loans through use of a "junior mortgage".

In this case, the transaction would be structured by having the Bank be the wrap-around lender. The Bank would advance to the Buyer the additional $371,293.37 needed to pay off the Seller, as a loan secured by a wrap-around mortgage. The Buyer would contribute $550,000 as 25% of the purchase price, the Bank would lend the Buyer an additional $371,293.37, taking back a wrap around mortgage for $1,650,000 (75% of the purchase price). At closing, the Investor/Seller would receive its entire equity of $921,293.37, and the original lender would continue to carry its first mortgage with a principal balance of $1,278,706.63 at 6.25% for the balance of 15 years.

Except for substitution of the Bank in place of the Investor as the wrap-around mortgagee, all other loan attributes remain the same: the Buyer gets the benefit of below market interest [9% instead of 9.5%]; the Seller receives all of its equity to invest or use as Seller determines appropriate; the original lender continues to receive the benefit of its contracted for fixed interest rate over the term of its loan; and the Bank, as wrap-around mortgagee, receives an effective interest yield of 14.32%. Everyone wins.


Potential Legal Advantages and Documentation

In addition to the yield enhancement benefits enjoyed by the wrap-around lender, another advantage of a wrap-around mortgage as compared with a simple "second mortgage" is that the collateral priority of a wrap-around mortgage may, over time, migrate to a collateral priority on par with the first mortgage.

For the most part, a wrap-round mortgage should mirror the provisions of the senior mortgage around which it "wraps", with a pass through to the mortgagor of virtually all mortgagor covenants. An essential element of a wrap-around mortgage, however, is that it must require the borrower to make all payments to the wrap-around mortgagee, who will, in turn, be obligated to pay the senior mortgagee. The wrap-around mortgage, and related documentation, must not permit the mortgagor to pay the first mortgagee directly. It is this arrangement which, legally, may enhance the wrap-around mortgagee's collateral position.

Although not entirely clear from reported case law, at least one respected commentator has suggested that this migration of lien priority is a natural consequence of applicable subrogation law. Judicial interpretation of this proposition in the context of wrap-around mortgages, however, has been scant, and in most jurisdictions non-existent.

While this legal position appears sound in circumstances where the indebtedness secured by a superior lien is paid in full , its application to partial payments under a wrap-around mortgage with pro rata subrogation remains largely untested.

Still, building a case for preservation of this outcome is desirable. Accordingly, the wrap-around mortgage and supporting documentation should include covenants of subrogation to establish the clear intent of the parties that subrogation to the lien of the senior loan is to occur with each payment by the wrap-around mortgagee to the senior lender. By inclusion of specific language to this effect, the doctrine of "conventional subrogation" may be sufficient to achieve this result.

From an underwriting standpoint, however, until this issue is definitively settled through judicial interpretation or otherwise, it is appropriate to analyze a proposed loan secured by a wrap-around mortgage as being a loan secured by a junior mortgage.

Some commentators have raised the additional issue of whether future payments by a wrap-around mortgagee to a senior lender enjoy priority over liens filed subsequent to the date of recording a wrap-around mortgage but prior to the date of payment of future installments to the senior lender. This issue is implicated because most wrap-around mortgages provide that the wrap-around mortgagee is required to pay the senior lender only to the extent of funds actually received from the wrap-around mortgagor, giving rise to the legal dichotomy between obligatory future advances and non-obligatory future advances .

The prevailing view is that this issue is adequately resolved through conventional subrogation and through the rule of "tacking", which provides that a mortgagee who pays a prior encumbrance (whether or not subrogation applies) is entitled to include such amount in the indebtedness secured by the lien of its mortgage.

Other covenants are useful or necessary to preserve the yield enhancement provided by use of a wrap-around mortgage. In particular, a covenant in the wrap-around mortgage that the underlying first mortgage may not be prepaid by the wrap-around mortgagor is essential, since it is the interest rate spread between the wrap-around mortgage and the underlying first mortgage that enhances the effective yield to the wrap-around mortgagee. Also, a cross-default provision in the wrap-around mortgage, providing that a default under the senior mortgage will constitute a material default under the wrap-around mortgage, is a useful protective covenant.

Proper documentation of a loan secured by a wrap-around mortgage loan is critical to maximize the potential benefits and afford the legal protections a wrap-around mortgage may provide.

Advanced Planning Is The Key

Wrap-around mortgages are useful legal devices that seldom arise except during periods of rising interest rates. When interest rates rise, wrap-around mortgages provide a legally sound tool for preserving the benefits of long-term low interest rate loans. Not only do they enable Investors and Banks to realize enhanced effective yields on commercial real estate loans, they can also make properties and loans more marketable by enabling the Buyer to pay a lower overall interest rate than may otherwise be generally available in the marketplace.

To take advantage of the benefits of a wrap-around mortgage when interest rates rise, the Investor/Borrower must plan now, while long-term interest rates are low, by negotiating loan terms that facilitate their use. Key among these provisions are elimination or limitation of the "due on sale" clause, and elimination or limitation of a negative borrowing covenant that prevents the property from securing other indebtedness. Similarly, all other provisions of the Mortgage loan must be carefully reviewed with an eye toward future use of a wrap-around mortgage to protect against unforeseen obstacles.

With proper planning and effective negotiation at the time of obtaining a low interest long-term loan secured by investment real estate, a wrap-around mortgage may provide a unique opportunity to profit when interest rates rise.

R. Kymn Harp