What is due diligence in a commercial real estate transaction?

Property due diligence is a fact-finding process done by the purchaser, to ensure there are no legal and/or financial concerns relating to the property.

The purchaser would usually instruct a lawyer to conduct property due diligence, and the lawyer should inform them of any encumbrances related to the property. An encumbrance is anything that can (i) reduce the value of a property or (ii) prevent the property owner from selling the property in the future. 

Sometimes, the purchase price is held back because issues have been identified in the due diligence process. The lawyer may also write to the seller to remedy the issue before the purchase will be completed.  

Due diligence period 

During the due diligence period, the purchaser has an opportunity to review and evaluate information and materials related to the property.  The duration of the due diligence period is a negotiated, fixed amount of time, which varies between each transaction, but usually it is 14 -30 days from the time the sale and purchase contract is signed. Depending on the agreement, the purchaser may be able to rescind if they discover any major issue with the property. 

Content of property due diligence

The areas covered by the due diligence and documents reviewed by the purchaser, their lawyer, and third party consultants will depend on each purchase. Generally, the following due diligence will be conducted: 

  1. Title check

The purchaser’s lawyers will check the title documents of the property, by conducting searches at public registries including the Land Registry. This will reveal: 

  • the present owner and all the previous owners of the property;
  • details of the property (e.g. the address of the relevant land lot);
  • whether there is any government order in respect of the property that has not yet been obeyed (e.g. a repairing order, or an order to demolish an unauthorized structure);
  • whether there is any existing mortgage;
  • whether there is any lawsuit concerning the property (e.g. a bank suing the owner for some outstanding mortgage repayments).

If there is an existing mortgage, the seller would usually have to pay it off, and the bank will issue discharge documents to prove that all mortgages have been paid off. The seller’s lawyer will send the discharge documents to the purchaser’s lawyers after completion of the purchase. 

After conducting the title check, the purchaser’s lawyer will usually request the seller’s lawyers to deliver original copies of the title deeds for inspection and to cross-check the information against the Land Registry.

  1. Structure of the building 

To ensure that the building and all of its structures are authorised, the purchaser’s lawyers will check to see what approvals, if any, have been obtained from the Buildings Department. This can ensure that there are no unauthorised building works or building defects, as it may undermine the value of the property. The lawyers may also review the property for compliance with the designated use of land by the Planning Department.

The purchaser may employ third party consultants to carry out the inspection of the physical condition of the property. They will conduct mechanical and engineering inspections if the plant and equipment will be included in the sale to ensure it is operating properly. Sometimes, environmental due diligence is necessary to identify if there are potential environmental liabilities (e.g. contaminated land) regarding the property. The purchaser may also obtain an opinion on the price of the property from the consultants. 

  1. Existing issues with the property

The purchaser’s lawyers will often have to write to another party to understand if there is an existing issue with the property, like whether there is a tenant or there are any unpaid fees. 

The purchaser’s lawyer may raise an enquiry to the seller’s lawyers, on whether there are existing tenancies, trust agreements or other unregistrable documents that affect the property. If there is a tenancy, the terms of the tenancy agreement will be inspected, including the rental amount, deposit paid by the tenants and the term of the tenancy, as the property will have to be sold subject to the tenancy.  

The purchaser’s lawyer will also raise an enquiry to the management company or incorporated owners of the building, to ensure that there are no outstanding management or other fees, or whether there would be any planned construction work in the common areas of the property. 

They may also write to the relevant Government authorities regarding any unpaid Government rent, rates or bills.

  1. Other due diligence 

Depending on the circumstances, other due diligence may be necessary. 

For example, the lawyer may conduct litigation due diligence to ensure that the property is not involved in any litigation or unsettled disputes which may affect the value of the property. If the property is being acquired through a company structure or effected via a share sale, corporate due diligence is also required.

Key takeaways 

  • Conducting due diligence is important so there are no encumbrances related to the property 
  • Title check, an inspection of the structure of the building, enquiring on whether there is a tenancy agreement and outstanding payments, as well as other due diligence, is conducted when necessary.