SMART FAQs about Commercial Real Estate Closings
DISCLAIMER: The FAQ presented on this page are for informational purposes only.
If you have purchased residential real estate in the past, you may think you have a handle on the closing process for commercial real estate as well. In reality, parts of a commercial real estate property transaction are very different, especially when it comes to issues related to intended use and development. Lucky for you, SMART is here to help!
Did you know that smart settlements handles commercial closings?
Below, you will see the steps we take when closing on your commercial property. If you have questions about commercial transactions or the commercial real estate market in general, continue reading our most frequently asked questions. Click a link to jump to a topic or scroll down to read them all.
If you have specific questions about a property of interest or are ready to start the process, contact one of our Agents at 202.753.7400.
What is commercial real estate and how is it different from buying a home?
What could possibly go wrong?
What is due diligence and when is it done?
Do I need a real estate broker or lawyer for a commercial real estate closing?
What is escrow and is it required?
How do I know if the title is good?
What do I need to know about the preliminary title report?
Why do I need title insurance?
What are the different types of deeds and which one do I need?
What is in a real estate purchase contract?
Why do I need a real estate contract in addition to the escrow instructions?
What exactly does “as is” mean?
Do I need an environmental site assessment?
How do you close on a commercial real property?
What is a 1031 Exchange?
“Commercial real estate” refers to any deal that involves property in a business context. This sounds broad, and that is because it is a broad term that encompasses a wide variety of properties. The property is not defined as a residence that houses its homeowner, renter, or subletter, although some residential buildings used for income-producing purposes are considered commercial real estate.
There are many differences between residential and commercial real estate transactions. Residential property is more likely to be sold outright rather than leased, while the opposite is true for commercial property. If a residence is leased to tenants, the term is usually for one year; meanwhile, commercial property leases can last three, five, or even ten years.
Many residential properties are owned by an individual or small business, while you find more often that large real estate holding companies are owners in the commercial market (especially in urban areas such as DC).
Residences have a clear intended use: to provide a home for an individual or group of people. On the other hand, commercial property can be used for many different purposes. Specific types of commercial real estate transactions must consider legal implications and permissions, especially when it comes to zoning, development, and intended use.
Finally, buyers and owners of commercial real estate are not protected in the same way as buyers and sellers of residential real estate are protected. Those in the commercial real estate market are considered to be more sophisticated, and as such, are usually advised by real estate professionals such as brokers and lawyers. In contrast, tenants may be protected by certain ordinances, laws, and even special housing courts.
Possible problems in your transaction could include:
Defects in title - In an ideal world, the deed of a property is accurately recorded as public record in its state and/or county each time it changes ownership. Unfortunately, this is not always the case. Title defects can occur if deeds or easements are not recorded or if there is an unknown lien against the title.
Debt service and lender requirements - When you borrow money to purchase commercial property, your lender will want collateral for the loan. Repayment terms and conditions, such as restrictions on any other loans on the property, can make it more difficult to run a successful commercial business.
Mechanics liens - Contractors, laborers, and suppliers can use a statutory lien called a mechanics lien to ensure they get paid for work they do on a property. They are required to give advance notice prior to filing the lien and must follow through within a strict timeline. But if successful, the filer can foreclose on a property with a mechanics lien.
Zoning and land use restrictions - Ensure that not only your property is properly zoned, but also check the zoning of nearby and adjacent properties to identify any conflicts of interest. Other potential issues can occur if nearby entities try to change the zoning in which your property sits.
Market fluctuations - The real estate market (and its performance) has a huge impact on your business and its operations. Higher property values may drive out your tenants, while low property values could make it impossible to leave your location. You must also consider business trends, such as neighborhood renovations and population changes.
Environmental contamination or hazardous waste - Even if past property owners are at fault, you (the current owner) are held responsible if any environmental contamination or hazardous waste issues arise.
During the contract negotiation phase, the buyer will obtain a period of due diligence or inspection, at which time he or she inspects the property for defects, reviews all property contracts (such as leases), conducts environmental tests, and otherwise determines if there are any reasons he or she should question the suitability of the property for its intended use. Due diligence eliminates costly surprises, though its process may differ slightly depending on the intended use of the property. Typically, this period of time is built into the sales contract so it occurs before the closing of the property.
Even if you are familiar with the commercial real estate market, it would be smart to hire professionals who specialize in your type of commercial property. A real estate broker helps you locate properties and negotiate your sales contract, and a real estate lawyer provides legal expertise throughout the transaction. Plan on incorporating the fees of a broker and/or lawyer into your investment as they will help you avoid lengthy and costly missteps along the way.
While not always legally required, escrow is a good idea for many reasons. One, the escrow company can facilitate your commercial real estate transaction. And two, the escrow company can take care of many details, such as paperwork, escrow instructions, title reports, title insurance, deed recordation, and payments.
A clear title refers to a title in which the property’s ownership interests are clear. You want a clear title before you buy a property to avoid a third party claiming ownership of a portion of the real estate property. Depending on where you live, specialized lawyers or title insurance companies research public records to determine the status of a title.
A preliminary title report is prepared in the time period after escrow is opened and before the property's closing. The report tells the buyer important information such as how the title is held and any recorded exceptions. The buyer has the right to approve the report or object to portions of it, and he or she can even back out of the deal if the seller cannot provide a clean title prior to closing.
But, the buyer has a short window of time to review the preliminary title report and take action. Otherwise, the preliminary title report turns into the final title report, which the title insurance company uses to determine coverage and standard exclusions from coverage.
Title insurance does not guarantee that a title is perfect or clear, but it does provide assurances to the buyer and lender that the title is good and marketable. As you can expect, title insurance offers various policies with different types of coverage and exceptions.
In most jurisdictions, the seller of the commercial property pays for standard coverage for the buyer. If the buyer needs additional protection, he or she can purchase a separate owner’s policy. Finally, a lender’s policy can be issued to protect the lender against title defects.
In residential real estate, you may find the absence of title insurance in transactions between related parties. However, many lenders of commercial loans will require that title insurance be carried.
You need to ask your real estate lawyer which type of deed you should accept when purchasing commercial property. Some deeds, such as a quitclaim deed, are more risky than others. A quitclaim deed hands over the owner's claim to the buyer, but the owner makes no guarantees about other claims to the title. A grant deed, which many states use, says that the seller has interest in the property, that there is no other buyer, and that the property is not burdened by any undisclosed encumbrances. Other states recognize warranty deeds, which provide the warranties of a grant deed plus a warranty that the title has no other claims or defects.
Real estate contracts are long and complex because they contain all of the “what if” situations that might occur during the transaction. Common parts of a commercial real estate purchase contract include:
The names and addresses of all parties involved.
Background facts as to why the parties are engaged in this transaction (also called recitals).
A description of the property, including borders and coordinates.
The sales price and terms of payment.
Information about the title and title insurance.
The closing date.
The conditions to closing.
Representations and warranties.
A disclosure of known conditions and defects, including environmental and hazardous waste provisions.
Relevant information about zoning and land use issues.
The buyer’s right of inspection.
1031 Exchange provisions.
Liability insurance requirements.
Provisions about indemnification and hold harmless.
Remedies for breach of contract.
The rights to amend and modify the contract.
The rights to assignment or delegation of rights.
Responsibilities of lawyers’ fees.
A dispute resolution provision.
All governing laws.
As a best practice, use standard form documents offered by state REALTOR® associations for the drafting process because they provide a starting point for you, your broker, and your lawyer.
Although most escrow instructions are comprehensive, they do not always contain all provisions that can resolve disputes during the transaction. Escrow instructions protect the escrow company, and a buyer needs a real estate contract to properly protect him- or herself.
Here are areas of the real estate contract that are not typically present in escrow instructions:
The performance of all parties
Tax and legal advice
Representations and warranties from the parties
The consequences of breaking the deal
A dispute-resolution provision
When a seller lists a property “as is,” he or she is offering no warranties to the property’s quality. Issues with the property are not uncommon, and the buyer expects the listing price to reflect these faults. However, some jurisdictions require the seller to disclose conditions and problems as part of the sales contract, and others have legislation that penalizes sellers who do not disclose major and dangerous conditions.
Not every lender requires an environmental site assessment, and there are types of commercial properties where it is clear you need one. However, it is a best practice to have an environmental site assessment done in every commercial real estate transaction. If the possibility of finding an environmental issue seems small, you can invest in the less expensive “Phase I” assessment, which doesn’t involve excavation, drilling, soil samples, or water testing. For all other properties, though, it is highly recommended to have a “Phase II” environmental site assessment done.
During the property’s closing, the purchase money is paid to the closing agent, and all closing documents (including the deed) are signed.
Under the Internal Revenue Service’s Code, Section 1031 stipulates that the tax amount owed after the sale of a business or investment property can be postponed if you reinvest your financial gain in a similar property as part of a like-kind exchange (which includes property and possibly cash and liabilities). This method is called a 1031 Exchange.
If you plan to take advantage of a 1031 Exchange, it is crucial that you involve an escrow company or facilitator in the process because Section 1031 says that you are responsible for the taxes on any cash gains you receive. As with the commercial real estate closing, it is best to hire a lawyer to help with the complexities and the exchange itself.