Ramifications of the Credit Crunch: A New Environment For Purchase Agreement Negotiations
The dismal state of today’s credit markets is having widespread adverse impacts on the purchase and sale of commercial real estate. In addition to expected downward pricing pressure from increased debt costs and the pervasive flight from risk, the terms and conditions of purchase and sale agreements (“PSAs”) are now being more closely scrutinized by buyers. They recognize that they can no longer rely on historically low interest rates and struggling alternative asset classes as an impetus for the next cash rich buyer to surface and facilitate a quick flip with quick profits. In particular, PSA negotiations currently tend to involve issues that were less contested in the market frenzy of the past five years, when the competitive marketplace essentially dismissed buyers who showed significant resistance to sellers’ form PSAs. As such, more time and energy is being spent negotiating, among other things, due diligence and other contingency periods, the terms of earnest money deposits, closing conditions, and the scope of sellers’ representations and warranties (including post-closing survival periods and “caps”). This article will describe some of these changes in the PSA negotiating environment amidst the current credit markets squeeze.
Contingency Periods and Earnest Money Deposits
One earmark of the seller’s market over the last five years was a limitation, if not complete elimination, of the “free look” or due diligence contingency period during escrow. Sellers routinely limited contingency periods to 15 or fewer days, and required earnest money deposits of up to 10% of the purchase price, often with some portion of the deposit becoming immediately “hard” or non-refundable (subject to limited exceptions) at the time of PSA execution. In many competitive bidding situations, such as those involving large portfolios, or in other instances in which sellers had significant deal leverage, due diligence information and materials were made available prior to execution of a PSA, contingency periods were entirely eliminated or shortened dramatically, and non-refundable deposits were required at the time of PSA execution.
In today’s environment, depending, among other things, on investment type (i.e., core, value-added, or opportunistic), contingency periods are being drawn out to more typical 30-90 days periods, with cash deposits not going hard until contingency periods expire. Moreover, deposits are often made in installments, with a nominal smaller “soft” or refundable deposit at the time of PSA execution and an additional deposit at the time of contingency expiration. Buyers are also now successfully negotiating multiple contingency period extension rights and, in some cases, financing contingencies, which may extend beyond the initial “free look” period. These seller concessions were, for the most part, rare in the last five years.
Various closing conditions that were commonly found in a real estate market with roughly equal buyer/seller bargaining powers were eliminated in the recent seller’s market. Conditions precedent to the buyer’s obligation to close were often limited to general matters such as the seller’s performance of contract obligations (e.g., ongoing good faith property maintenance), no court orders or injunctions prohibiting transfers in effect at closing, and limited seller representations and warranties (e.g., seller’s due organization and authorization to enter into and consummate the transaction, lists of material leases and contracts, no known condemnation, no litigation, etc.) still being true and correct in all material respects at closing.
In today’s environment, traditionally standard closing conditions, such as satisfactory title insurance coverage and receipt of tenant estoppel certificates, are coming back as conditions to the buyer’s closing obligations. Specifically, buyers are negotiating for satisfactory title insurance commitments, with seller’s obligated to provide title companies with gap indemnities (covering encumbrances which may arise between the time of disbursement of funds and deed recordation) and title affidavits (which certify to various title matters such as ownership, rent rolls, existing liens, etc.). Buyers are also requiring tenant estoppel certificates from specific tenants (i.e., anchors) and from tenants which account for 70%-90% of occupied square footage, before the transaction closes. Although buyers routinely try to ascertain their ability to obtain satisfactory title coverage and estoppel certificates before contingency periods expire, under today’s more buyer friendly purchasing environment, title and estoppel matters have become express closing conditions, thus giving buyers more flexibility during the entire escrow period.
Representations and Warranties
As noted above, seller representations and warranties have been rather limited in the recent real estate boom. Specifically, sellers have provided little in the way of representations and warranties beyond assurances regarding due organization and authorization to enter into and consummate the subject transaction, lists of material leases and contracts relating to the property, and assurances that there are no known legal violations, condemnation actions or litigation matters affecting the property. Moreover, sellers often limited survival periods for their reps and warranties to six months post-closing or less, if not eliminating their effect altogether at closing.
Recently, however, sellers have been more willing to provide representations and warranties for, among other things, complete lists of leases and contracts (i.e., without any square footage or dollar thresholds to limit the lists to “material” leases and contracts), rent rolls, operating statements and even specific leasing matters which are usually only items that a tenant will certify to in a tenant estoppel certificate (e.g., any outstanding tenant improvements, leasing commissions, and landlord lease defaults). Sellers, of course, have sought to limit these reps and warranties to the sellers’ actual knowledge about these matters, but even in their limited forms, these additional reps and warranties have added deal exposure for sellers where such exposure didn’t often exist in the recent past.
In addition to broadening their representation and warranty coverage, sellers are agreeing to longer survival periods and increasing “caps” on post-closing liability. Specifically, survival periods have once again been extended to the more customary six to 18-month range post-closing. That is to say that buyers are being given the opportunity to make a claim against sellers for breaches of the sellers’ reps and warranties (e.g., inaccuracies in the rent roll at closing) for six to 18 months post-closing. Moreover, sellers are being compelled to raise the “caps” on post-closing liability to cover post-closing claims made within the survival period. Whereas such caps were (in cases where post-closing claims were permitted at all) often seen in the range of one to three percent of the purchase price, “caps” may now reach five percent or more. These developments have, of course, given sellers all the more reason to be particularly mindful of the accuracy of their representations and warranties.
In conclusion, while sellers have become accustomed to holding the bargaining power in commercial real estate PSA negotiations during the historically low interest rate environment of the past five years, that time appears to have come to an end. With subprime woes in the residential lending market trickling over to tighten credit liquidity in the commercial market, sellers have lost much of their leverage. Accordingly, in today’s market, not only are we seeing deals being re-priced and re-traded, but the beginning of a turn back to a buyer’s market can also be seen in the concessions that are being made in the negotiation of today’s purchase and sale agreements. As such, buyers would be well advised to consult with their counsel in the early stages of a proposed transaction to better understand and appreciate the recent changes in the purchase agreement negotiating climate.