REAL ESTATE DUE DILIGENCE (Part 1 of 2)

This is part 1 of a 2 section article about conducting due diligence on real estate transactions and should be read in conjunction with the sister article.

One of the most important, if not the most important, parts of any real estate transaction is conducting a through due diligence review of the property to be purchased. The prospective purchaser should investigate the property thoroughly before signing a contract of sale.

WHAT IS DUE DILIGENCE?

Due diligence is the process by which an attorney representing the purchaser checks the records and paperwork on a property to ensure there are no issues or problems with the property. As an analogy, I explain that due diligence is like buying car – you comparison shop, you read reviews and you read consumer reports. The finances of a co-op or condo, operating documents and policies and physical facilities will have a significant impact on the use and enjoyment of the property and the value of the property. Whether you are purchasing your first home or investing in a commercial property, probably the most important aspect of the transaction is to insure that there are no issues with the premises. This process is called due diligence.

In New York, the due diligence must be completed before the contract is signed on most if not all residential transactions. Unlike many other states which gives the purchaser a right of rescission after a certain period of time after the contract is signed to conduct due diligence, New York does not. The law in New York State is simple: once the contract is executed by both parties, the contract is firm and enforceable. To learn of problems in a transaction after the contract is signed will generally not entitle the purchaser to rescind the transaction except when there is a title defect.

There are a variety of documents that need to be reviewed including financial statements, proprietary lease, house rules, by-laws, board application and board minutes as well as the original offering plan).

For cooperative and condominium apartments, it is essential to have an attorney review the offering plan and amendments, corporation or condominium minutes, financial statements, house rules and building application as well as the proprietary lease for a co-op and the declaration for a condo. This will provide insight as to the financial well-being of the building. But there are numerous other facts and information that should be obtained which will not be found in the financial statements or minutes (ex. Pending or threatened litigation, maintenance or common charge history, sponsor owned apartments and reliability, mechanical systems, capital improvements, investor concentration).

These issues will not only have an impact on whether the Purchaser will want to conclude the transaction, but will also have an impact on whether a lender will make a loan to a purchaser buying an apartment in that particular building.

Needless to say, in an aggressive market, the time periods to conclude these reviews are severely shortened. When negotiating under a time sensitive situation, it is important to be extra vigilant in completing due diligence.

COOPERATIVE AND CONDOMINIUM DUE DILIGENCE

Inspections

An inspection by a professional company may not always be required in connection with the purchase of a co-op or condo apartment. In a large building, the cost to make a repair to a mechanical system like a boiler, elevator or plumbing system may be absorbed by many shareholders. However, in a small building, the cost to repair a roof, for example, may result in unit owners contributing substantial funds. It is imperative to determine how large a reserve fund a building has and what plans has the building made for future repair costs. Another area frequently overlooked is soundproofing. Ask the neighbors above and below and adjacent to see if they have received or made complaints.

The results of the inspection may have an impact on the amount of the purchaser’s offering price. If there are many repairs required or forthcoming, the purchaser may want to reduce the offer.

Minutes – If a purchaser is buying a co-op or condo apartment, every attorney should review the minutes of the board meetings.  The minutes will shed light on what issues currently exist and what issues existed in the past. The minutes are usually maintained at the office of the managing agent for the building (if there is no managing agent, the seller should be able to introduce the board member who maintains the minutes). The minutes vary greatly amongst buildings – some are very detailed, some are vague, some are entered monthly and some not as frequent. At least 2 years of minutes should be reviewed. Usually after minute review the attorney may have more questions for the managing agent or the board member.

Co-op/Condo Questionnaires

Many of the concerns raised in this article cannot be answered by reading the building financial statements or minutes. In addition, there will always be a gap between the last financial statement (which usually ends at the end of the prior year) and the date that the due diligence is being completed (ex. The last financial statement may be 12/31/15 and the accepted offer may be ie May of 2016). Most managing agents for large buildings maintain a document called a “generic questionnaire.” The generic questionnaire is a questionnaire which answers general questions about the building and is usually provided free of charge. If however, an attorney or purchaser has a specific list of questions, the managing agent may charge a fee to answer these questions (usually between $150 to $350).

Financial Statements

A vital source of information about a condo or a co-op is the annual financial statement prepared by an independent public accountant. At a minimum, the last 2 years of financial statements must be reviewed. This is probably the most important part of due diligence. Financial statements are usually released 6 months after the end of the fiscal year.

1. Surplus/Deficit.

   The 2014 Financial Statement indicates that the Apartment Corporation received $244,116 per annum in maintenance and roof rental payments and that operating expenses were $240,738. This resulted in a surplus of $3,376.00 for the year ending 2014. As part of the operating income, the Apartment Corporation received $21,611 in 2014 for roof space rental to Verizon for an antenna. As a note, the Apartment Corporation operated at a deficit of $10,609 the prior year. The Managing Agent has advised that although the 2015 financial statement has not been released, he believes that the Apartment Corporation operated at a break even in 2015.

2. Reserve Fund/Working Capital Funds and Repairs.<

   Every Co-op or Condo will have a reserve fund and/or a working capital fund. These funds are usually in the form of investments made by the co-op or condo and are held until a major repair or capital improvement is necessary. The general rule is that lenders usually require at least 10% of the maintenance or common charges to be held in reserves but that amount may not be sufficient if a major repair or improvement is forthcoming. I usually recommend a minimum of 33% of the annual maintenance or annual common charges to be held in escrow. If substantial repairs or improvements have recently been made, the reserve fund can be lower. If major repairs and/or improvements are forthcoming, the reserve fund should be higher (remember, if there is insufficient reserve for a big project, the building will usually impose an assessment (see Paragraph ___). In addition, when looking at financial statements of a co-op or condo, inquire why reserves may have substantially increased or decreased.

3. Litigation.

   The purchaser’s attorney should make sure that there is no pending or expected litigation against the co-op or the condominium or that the co-op or condominium is not in litigation with the sponsor/developer. This info may be in the footnotes of the financial statement. If there is substantive litigation, it should be determined if the building’s insurance company is defending the lawsuit. If not, the cost to pay for legal fees can be quite expensive and result in a reduction of the reserve fund. As a note, it is not unusual that there may be small lawsuits against the building (slip and fall) and these are generally handled by the building’s liability insurance company. “Slip and fall” cases and other actions of a small nature, are usually not of concern but if the co-op or condo is being sued for discrimination, this can be very costly and the legal fees and judgment can be passed on to the unit owners or deducted from reserves. Furthermore, if there are lawsuits against the developer/sponsor, this may be a sign that something material aspect of the construction or representations in the offering plan were inaccurate. Lenders usually are wary in making loans to purchasers of apartments in buildings were there is litigation.

4. Commercial Leases.

   The purchaser’s attorney should determine if there are any commercial spaces located in the building. If the space is owned by the co-op or condominium, rent is usually included in income for the building and is used to offset operating expenses. It is prudent to determine when the lease ends and if rental income will be increasing or be reduced over the lease term. If rental income is reduced or the lease terminates, there may be insufficient income to pay for expenses may result in an increase in maintenance or common charges. Rental income is usually reflected in the income page of the financial statement of the building.

*DISCLAIMER – Nothing herein is offered as legal advice. All information in this article is for informational purposes only. Please consult with an attorney before taking any legal actions.