Do Your Homework! Thorough, Fact-finding Due Diligence Mitigates Risks for Public Agencies
By Nancy Park, Best Best & Krieger LLP
They can tarnish an agency’s reputation, diminish public trust and put taxpayer dollars at risk. There is a positive, however. Negative outcomes are almost entirely avoidable. When it comes to real estate acquisitions, the importance of a thorough, fact-finding due diligence process cannot be stressed enough.
Take, for example, the City of San Diego’s acquisition of 101 Ash St., a downtown high-rise that was evacuated in mid-January after numerous asbestos-related violations. The City, which took possession of the building in early 2017, had signed a 20-year, lease-to-own agreement totaling $127 million.
When approving the deal months earlier, the San Diego City Council was told the building needed some $10,000 worth of work to clean, caulk and pressure wash the exterior, although there was a $5 million allowance worked into the deal with an obligation that the City repay the tenant improvements.
The renovation workload quickly spiraled.
The City would go on to spend over $30 million on renovations and asbestos abatement before moving employees into the building in December 2019. Weeks later, City employees were asked to leave the building and reassigned to other locations. In the months following, the acquisition led to the resignation of City officials, prompted legal complaints from contractors who claimed the City denied there was any risk of asbestos exposure and sparked investigations.
One such investigation, written by a law firm already advising the City on asbestos litigation, offered a look into the flawed handling of the Ash Street acquisition. Of concern, the City did not conduct an independent assessment to determine the extent of asbestos-containing materials in the building, nor did it assess the building’s various systems before its acquisition and commencing of its year-long renovations.
Instead, the City relied on environmental assessments and reports provided by the seller.
It’s a complex situation, but the moral of the cautionary tale is straightforward: Do your homework.
Whether purchasing an aging structure or open space, there are steps agencies can take throughout the real estate acquisition process to mitigate risks and avoid later surprises.
First Steps: Setting the Stage for a Successful Due Diligence Investigation
Before moving ahead with an acquisition, you’ve likely answered a number of project-scoping questions, such as: Who are the involved parties? How will the acquisition be paid for? Will it use bonds? What is the timeline? Are there California Environmental Quality Act implications? Is an environmental impact report necessary? What is the property zoned for? Does your agency have zoning and/or approval authority? What rights are being acquired? Is it an out-right purchase? A lease or an easement?
Your purchase and sale agreement will provide the script for the transaction. It will establish the necessary parties and provide a property description. It’ll lay out pricing and terms, leases and contracts, as well as representations and warranties. And it will set timing for due diligence and closing.
You’ll want the most time available to review all documents to look for, and consider, any red flags.
The next steps of the process involve reviewing everything you can about a property. With any acquisition, it all comes down to the details.
Title Report: The Review Everything Phase of an Acquisition
Obtaining a title report after the open of escrow is critical to your agency learning all it can. This report will outline the property taxes and include information on liens (such as federal tax and mechanics liens) and other encumbrances currently made against the title to the property. In this report, you’ll learn about easements and encroachments. The covenants, conditions and restrictions will also be laid out.
Review all items recorded in the public record and other items known by the title company about the property (called “exceptions” in the preliminary title report) to better understand them and their effect on the property. This is where easements, agreements to others that affect property use and judgments owed to others show up, as well as rights or restrictions on the property’s use are available for review. Any items that are recorded in the public record, or which could be observed by a property inspection, are imputed as items a buyer knows, or should have known, when they buy the property. So failure to review these items carefully could bite you later if you fail to review relevant recorded documents and visit the property to look around for things that don’t fit in with your understanding of the rights being conveyed in the deal. Curiosity will serve you well here (unlike the cat!). Further physical inspection issues are discussed below.
Once you understand the items of record, are there any issues that might inhibit the current or planned use? Are there issues that can be remedied? This is your agency’s opportunity to analyze issues and determine if they can be resolved or lived with after closing.
Due Diligence: The Leave-no-Stone-Unturned Phase of an Acquisition
Due diligence is a comprehensive and critical stage in any real estate acquisition. This is the stage in which you’ll inspect both the contractual and physical aspects of a property. It will likely involve hiring an environmental consultant to do a Phase I or Phase II site investigation and, if the value and project size warrant it, a surveyor, as well as reviewing contracts, records and entitlements. You may also contract for an appraisal or broker valuation to verify the contracted price is in line with the market.
During this phase, your agency can examine contractual conditions and third-party approvals, look into a property’s economic performance and request the seller’s books/records, especially if acquiring an income property where you want to see the projected income and future expenses. It is helpful to see older reports on buildings and properties, but building conditions change and so do standards, so a 5- or 10-year-old report may not include items that are now non-code-complaint. It is penny wise and pound foolish to rely on another party’s reports and, in fact, for hazardous materials, a report older than 6 months is too old to rely on for a Comprehensive Environmental Response, Compensation, and Liability Act, best known as CERCLA, due diligence compliance.
Physical improvement inspections or condition reports done by third parties will determine a property’s operational viability by looking into its fire and life safety systems, structural functionality, accessibility, roofing, heating and cooling systems or, on agricultural lands, the soil, wells and pumps. Inspections should also be conducted to identify asbestos, lead and toxic mold, and other hazardous substances, as Phase I and II reports do not cover these items.
With physical site inspections, a surveyor can identify encroachments and boundary problems or uses that are inconsistent with your understanding of the property’s size, condition or ownership.
It’s important to inspect a property in its entirety and also do your environmental due diligence. Consider future uses and what might be the worst case scenarios or discovery. If not cost-prohibitive, try to cover those areas in your investigation. By doing your exploratory due diligence, your agency can avoid most surprises and potentially damaging issues in real estate acquisitions.
Nancy Park, the leader of Best Best & Krieger LLP’s Business practice group, represents clients in real estate transactions, leasing, finance and business contracts. An over 30-year real estate veteran, Nancy works with private and public entities across California. Reach her at firstname.lastname@example.org.