Even Modest-Sized Land Deals Involve Loads of Details, Due Diligence
Just a short time ago, we had the pleasure of handling a deal that had many of the components of a complex commercial real estate transaction. Our client proposed to form a venture to acquire an outparcel in a shopping complex in a major United States city. The deal required the seller to lease the property back from the buyer in a sale/leaseback arrangement. The buyer required mortgage financing in order to close. In sum, we had many of the elements of a typical commercial real estate transaction: the acquisition of an improved parcel, the formation of a venture, the negotiation of a major commercial lease, and the arrangement of secured mortgage financing. What made the deal so challenging? The million purchase price.
When I evaluated the tasks at hand, I immediately considered the anticipated legal costs in light of the deal size. It became abundantly clear that we needed to focus on the big picture and only the big picture. If we fretted over the details, the legal fees would jeopardize the deal economics.
Protecting Against Fraud
The acquisition items came first. We learned that the seller owned multiple fast food locations and that it was selling and leasing back most of these locations. In essence, the seller was cashing out of its real estate portfolio. The seller and buyer agreed upon a purchase price that was designed to give the buyer a return of approximately 7 percent per annum. While the seller was prepared to support the purchase price, and the buyer’s return, with a solid lease, the buyer needed to ascertain if the seller’s business was strong enough to support the rental stream for years to come. This would not be the first transaction in which the purchase price was predicated on rents that ultimately proved to be inflated or at least overly optimistic.
The seller responded favorably to a request for financial statements. However, the first statements that the seller delivered were rough monthly operating statements of uncertain origin. While they might be legitimate, we wanted to be sure. The next set of statements, which included the most recent annual balance sheet and the most recent quarterly operating statements, came under cover of an accountant’s letterhead. This was an improvement, but the statements came from the seller rather than the accountant. We decided to reach out to the accountant. We found the accountant’s telephone number through directory service, and we contacted him through his firm’s main number. In a friendly manner, we indicated that we were simply calling to thank the accountant for the statements. We asked questions to elicit answers that would confirm that we were looking at the same statements. They checked out.
While the seller’s operating performance suggested that its operations were likely to support the rental stream, we wanted to be sure that the seller’s franchise was in good standing. We requested a letter from the franchisor in support of our seller, the franchisee, which letter was intended to confirm the absence of any default under the seller’s franchise agreement or any operational deficiencies. After some initial resistance, we received such a letter by facsimile from the seller. Of course, as a facsimile, the franchisor’s letterhead was not in color, and the signature was not in original ink. Again, we endeavored to determine the authenticity of the letter. We found the franchisor’s number through directory assistance, and we contacted the franchisor’s representative by calling the main number of the franchisor. The franchisor’s representative appreciated our calling him to express our gratitude, and he offered a number of complimentary remarks. Our low key due diligence was checking out.
Tackling Due Diligence
We next turned our attention to many of the traditional aspects of a real estate acquisition. Because we were blessed with a sophisticated client who could make practical decisions and manage important responsibilities, we were able to have our client handle many of the tasks that we might ordinarily perform ourselves. We charged representatives of the buyer with obtaining satisfactory environmental and physical reports on which the buyer and its lender could rely. We provided our client with the terms of engagement for the environmental and physical consultants, and they engaged the consultants. We gave our clients forms of reliance letters, and the client obtained suitable reliance letters enabling the client’s lender and the parties’ respective assignees to rely on the work of the consultants.
It is our firm practice never to offload arrangements for delivery of surveys and title insurance commitments. In our experience, the engagement of the surveyor and the title insurer represent opportunities to "get it right the first time." This is particularly true with respect to the surveyor’s duties. If the surveyor can produce a satisfactory survey in the first instance, the buyer and its counsel can save time requesting improvements to the work product and managing the inquiries of lender’s counsel. We like to say that our standards are every bit as tough as the standards of lender’s counsel, and if we are satisfied, lender’s counsel will be as well. With respect to the title insurance, the seller proposed using a title agent located in the heartland of the state and with whom we had no experience. While it would have been possible to obtain an insured closing letter from the ultimate title insurer, which letter essentially guaranties the agent’s performance, we concluded that we could proceed more efficiently if the parties were to utilize a title insurer with whom the buyer had substantial experience. Fortunately, the seller accepted our reasoning and allowed the buyer to designate the title insurer.
As attorneys who perform a large amount of acquisition work, we generally do not want to rely on the basic zoning reports provided by the national service companies. We also do not want to rely on a zoning endorsement to a title insurance policy. A zoning endorsement is often issued by a title insurer on the basis of underwriting risk and not on the basis of an actual inquiry. If a buyer wants to ascertain that a property as presently developed complies with zoning laws, or if a buyer wishes to determine whether a property constitutes a legal but non-conforming use, then the buyer must analyze the pertinent zoning laws and, in many instances, make inquiry of zoning administrators. With respect to the subject transaction, the buyer was able to make that inquiry and satisfy itself that the property existed in conformance with existing zoning laws.
We did encounter a title matter that we could not address to our satisfaction. Our client ultimately agreed to bear the risk. As an outparcel in a shopping center, the property was encumbered by several instruments that affected the entire shopping center. It took some time to wade through the documents affecting the outparcel, and we limited our objections to only material items. One of these documents was a memorandum of a supermarket lease, which provided that the outparcel could not be used for any purpose that would violate the use restrictions contained in the lease. We were unable to obtain a copy of the supermarket lease. The age of both the shopping center and the restaurant on the outparcel suggested that the current use of the outparcel comported with the use restrictions in the lease. However, we could not make the same judgment regarding any future use of the outparcel other than as a restaurant. In light of the anticipated use of the property as a restaurant for the full term of the lease, our client decided to accept the possibility that a future use, other than a restaurant use, might be prohibited.
One by one, we became comfortable with the material acquisition issues. As we proceeded toward closing, we negotiated the lease terms, venture operating agreement and financing documents. Of these, the lease terms presented the greatest challenge.
The Lease Supporting the Deal
The seller presented its form of tenant lease to the buyer as an exhibit to the purchase and sale agreement. While the lease was generally acceptable and provided for sufficient term (twenty years), it contained many deficiencies from the buyer’s perspective. Armed with the knowledge that the buyer wanted a truly triple net lease that was both financeable and transferable and provided for rents that roughly kept pace with inflation, we engaged the seller in substantive discussions regarding terms. Fortunately, the seller had a "pro-deal" bent and understood the buyer’s concerns.
We went about adding provisions covering the delivery of financial statements, mortgagee protection provisions, estoppel certificates, limitation on the landlord’s liability to its interest in the premises, an absolute obligation to restore the premises following any casualty, standards relating to proposed assignments of the tenant’s interest in the lease, and fixed rent steps. While the rent adjustments may or may not keep pace with inflation, the tenant will be responsible for all costs of operation and maintenance. As a result, the landlord can expect regular, annual growth in the net rent payable under the lease. Unfortunately for the buyer, the parties could not agree on percentage rent in addition to fixed rent or on rent re-set provisions. The fixed rent, with small annual adjustments was deemed to be adequate.
Perhaps our biggest negotiations centered around the use of the premises and the tenant’s present and future creditworthiness – including the creditworthiness of any assignee. While the seller/tenant owned numerous franchised restaurants, it refused to agree to own or operate a minimum number of franchised restaurants. It also refused to agree to any ongoing financial covenants or net worth tests. Finally, the tenant refused to offer any support in the form of collateral or guaranties. However, the tenant did agree to operate the restaurant under the same brand name for the lease term (or a restaurant of an equal or better class, caliber and financial standing, as reasonably determined by the landlord). The buyer derived some comfort from knowing that the national franchisor’s standards, or an equivalent franchisor’s standards, would be imposed upon the tenant. In addition, any assignee of the tenant must be an approved franchisee. Because the franchisor currently imposes and is likely to continue to impose financial and operational standards upon the franchisee, the buyer, as landlord, would enjoy the benefit of these safeguards. In a perfect world, we would have wanted to include these items in the lease, but we felt that the overlay of franchise obligations afforded the buyer, as landlord, the best protections that could be obtained under the circumstances.
The Venture Agreement
Negotiations over the terms of the venture agreement proceeded concurrently with negotiations over the tenant lease and the conduct of due diligence. We were fortunate to find that the investor group kept the big picture in mind. The non-managing members ceded control over management of the venture to the managing member, but they did so in light of the right of members holding two-thirds of the percentage interests to control decisions such as sale and financing of the venture’s assets. The super-majority control over a few critical decisions satisfied the non-managing members and enabled the investor group to avoid protracted discussions over venture management. The members agreed to a punitive but not unfair dilution provision in the event that they failed to fund a capital contribution (which had been approved by members holding two-thirds of the percentage interests in the venture).
The purchase agreement between the buyer and seller did not contain a financing contingency. However, the buyer absolutely needed mortgage financing in order to close the transaction. The buyer secured a commitment from a lender with which it had previously done business in an amount equal to seventy-five percent of the purchase price. The lender’s familiarity with the buyer paid huge dividends. We were able to utilize previously-negotiated documents satisfactory to both parties. The lender’s counsel accepted reasonable and customary opinions and supporting certificates. When it came to the numerous third party deliveries, the lender imposed reasonable requirements upon the buyer, which entered the deal with a strong idea as to what would and would not be acceptable to the lender. Neither party treated the loan as a CMBS transaction involving standard demands, standard responses and inflexible requirements. The same flexibility that characterized the purchase, lease and venture negotiations governed the loan closing.
At the end of the day, the buyer and its counsel did a lot of work on a small deal. The legal costs exceeded our expectations. Prior to commencing work, the buyer and its attorneys separately recorded a written estimate for legal fees, and neither of us told the estimated amount to the other. Following closing, we compared notes and discovered that we had both used the same estimate. However, the actual costs were greater than either of us hoped. We settled on the fees and are looking forward to the next deal. We are both hoping it is a bigger one.
Reproduced with permission from Real Estate Law & Industry Report, Vol. 1, No. 1 (Sep. 23, 2008) pp. 8-10.
© 2008 by The Bureau of National Affairs, Inc. (800-372-1033)