The Problem With Due Diligence Periods In Real Estate Contracts

When an owner of commercial real estate wants to negotiate a sale, the buyer will often have a general idea of what they are willing to pay. This idea usually reflects limited investigation and analysis, because more extensive investigation and analysis costs more than the potential buyer is willing to spend without knowing that the property is under contract.

Except in a very seller-friendly market, the parties usually address the buyer’s concern by signing a contract of sale but also giving the buyer a due diligence period – 30 to 90 days – in which to further investigate the property. In that time, the buyer can carefully review the leases, check out any physical issues, look for environmental issues, and satisfy itself that its plans for the property make financial sense. Above all, the due diligence period gives the buyer time to find the money – both debt and equity – necessary to acquire the property.

A few days before the end of a due diligence period, the seller will often receive a phone call from the broker on the deal. In the best case, the broker will announce that the buyer needs an extension of the due diligence period to check out some issues that need more time, often environmental-related. In the worst case, the broker will announce that the buyer’s due diligence investigations have disclosed that the buyer’s estimate of property value was overly high, and the deal doesn’t make sense without a price reduction.

Either way, the seller faces a dilemma. The other prospective buyers who might have been in the picture earlier in the process have all gone on to other things. At this point, they have probably all lost interest. If the seller and its broker go back to any of those buyers, they may perceive the property as damaged goods. If the seller pulls the property off the market, it may have to wait many months—or years—before going to market again. As a result of all that, sellers usually accommodate buyers to some degree.

Allowing more time is easy. A seller might try to tie down what needs to happen in that time. For example, if the buyer needs more time to investigate a pile of unidentified materials in the back yard of the property, then the parties might agree that the due diligence period extension relates only to that investigation. As long as the cost to solve any problem falls below an agreed ceiling, then the buyer must close.

A buyer’s request for a price adjustment, on the other hand, creates more trauma for the seller. Can the seller obtain some benefit in exchange for the price adjustment? The seller might try to accelerate the closing, or have the buyer waive some contingencies or increase the deposit. In theory, the seller might demand a right to future payments if the property exceeds some agreed-upon benchmark of performance. In practice, though, buyers won’t agree to such measures. If any buyer does agree to such measures, then they will be hard to negotiate and even harder to apply and enforce.

A seller could protect itself from some of these risks by charging the buyer a nonrefundable option fee for taking the property off the market during the due diligence period. That fee would give the buyer control of the property while it performed its investigations. It would also compensate the seller if the buyer decided not to proceed. Although this route makes a lot of sense, sellers can typically obtain option fees only in very seller-friendly markets.

As another possibility, a contract might give the buyer a due diligence period but allow the buyer to terminate only if the buyer identifies genuine problems with the property that exceed a certain defined threshold. This approach would scare buyers because they typically count on having total optionality as the result of a due diligence period.

Sellers can perhaps protect themselves, at least a bit, by not pretending that the due diligence period will end and the buyer will either go ahead or go away. Instead, the contract could build in the possibility of an extension. For example, the contract might say that if the buyer wants more time, it needs to pay an extension fee not credited against the purchase price. The buyer would, of course, prefer to just increase the deposit and have that increase held in escrow to be applied against the purchase price. Even if the contract expressly requires an extension fee if the buyer wants more time, the buyer might still request a free extension, but that has a bad flavor to it because it varies from what the parties agreed.

If the seller has other buyers waiting in the wings, that can offer an appealing mechanism to prevent buyers from taking too much advantage of due diligence periods. Toward that end, the seller might want to make it very clear that it has the right to negotiate with, and even sign backup contracts with, other potential buyers. The seller will want to avoid agreeing to exclusivity with any buyer – a reasonable position given that a buyer with a generous due diligence period has no solid commitment to the transaction either.

As its best strategy, of course, a seller should try to time its sale to occur during a seller-friendly market. Today’s commercial real estate markets, unfortunately, are not very seller-friendly. That state of affairs seems likely to escalate in the short term. Sellers must either wait for a better day somewhere down the road – but not all sellers have a long-term view – or figure out some other way to mitigate the effect of generous due diligence periods in contracts.