Due Diligence is Required in Residential Transactions; Unless You Feel Lucky

May 23, 2016

By Stephen D. Richman

Most investors of commercial real estate understand the importance of “due diligence”; a term often used to describe the process of investigating anything and everything about the property to be purchased. Confirming what property is being received, what condition it is in, what can or cannot be done with the property, and what risks are inherent in its ownership are of critical importance and warrant formal and extensive due diligence inspection rights in the commercial contract.  Title commitments, surveys, environmental

audits, and building inspection reports are the most often utilized tools found in a “diligence tool box.”

There is no need for diligence in a residential transaction, is there? Don’t the broker forms all have inspection rights already in their contract forms? It is not like we are dealing with multi-million dollar properties, right?

We often hear questions like these, and unfortunately, most often we hear them after the contract has been signed, when it is usually too late to be intelligently preemptive.  The answers are:  (1) yes, there is need for diligence in residential transactions; (ii) yes, the broker forms all have inspection rights already in their contract forms, but thee forms don’t go far enough; and (iii) it doesn’t matter if the property being purchased is for $100,000 or $1,000,000; most real estate issues/problems don’t discriminate based upon price. Actually, buyers of lower priced properties often fare worse than buyer-investors of higher priced real estate because they are less likely to be able to absorb a loss, unwanted litigation or unbudgeted for expenses.

Simply put, diligence is needed in any real estate transaction because the buyer is usually at a disadvantage. More often than not, the buyer has little or no knowledge concerning the property, but must diligently investigate and inspect it or risk understanding, all too well, the still surviving doctrine of “caveat emptor” (let the buyer beware).  Most broker forms, do indeed give the buyer the right to perform inspections, but they are often limited to the following: “General Home Inspection”; “Pest Inspection”; “Radon Inspection” and “Lead Paint Inspection”.  I have yet to see a broker contract form that calls for a title commitment to search for title issues such as liens and easements, or allows for a survey to check for boundary lines and encroachments.

Additionally, with respect to the limited inspection rights that are included within a broker contract, (i) sellers and brokers usually push for tight inspection time frames (3-7 days), and (ii) the canned contract language to deal with a problem is often muddled and more seller than buyer friendly. For example, most broker forms only allow the buyer to terminate, if a “latent, material defect is discovered that was not previously disclosed by seller”. Of course, none of the adjectives are defined in the contract. Moreover, buyer can only get its deposit back if buyer and seller agree and sign a mutual release. Obviously, when issues arise between buyer and seller, they seldom agree with each other.

What Due Diligence is recommended for Residential Transaction?

  1. Pre-contract Diligence”

Talk to neighbors. Find out, for example if they can hear the train from nearby tracks, or commercial activity from the next door commercial property. Visit the property after a hard rain to see if there are visible drainage issues. Observe traffic patterns during rush hour vs. quiet, open-house Sundays. Surf the Net. Crime statistics, sexual predator registries, County Auditor tax information and local issues (such as overflowing street sewers or a new planned highway overpass) can easily be found online these days. Make sure you ask for the state mandated “Property Disclosure Form.” The lack of information should not convince you all is well, but the fact of recent roof leaks, for example may dissuade you, or give you more room to negotiate price. If you are buying a condo, ask to see the Declaration, By-Laws, Rules, Budget, and Statement of Reserves of the Homeowner’s Association. The rules, for example might disallow pets or leasing the condo. The financial information (or lack thereof) might indicate that the old roof may stay old awhile longer.

“Pre-contract diligence” may not produce information to discourage a purchaser. On the other hand, if it does, the time, money and stress inherent in the real estate purchase/sale process can be avoided early on. Of course, the purchaser may be happy with the results. While that is “a good thing”, the diligence process, at this point should be considered as just beginning, not ending.

  1. “Post Contract Diligence”

Every buyer should have the property they are buying inspected to minimize the risk that they are also buying the property’s problems. Whether or not using a broker form, the purchase agreement should, at a minimum authorize physical inspections, allow for an adequate time period for the inspections and provide remedies/contingencies to the buyer in the event any of the inspection reports reveals defects (i.e. seller’s obligation to cure defects; buyer’s right to cancel the purchase). One way to get beyond the issues with the broker forms discussed above would be to define “material defect” in terms of a dollar threshold to repair.

While a purchaser should certainly be happy if its prospective property is free of physical defects, the buyer should be equally concerned that title to the property is free of defects, or “marketable”, and seek assurance of the same. You wouldn’t buy a car with a lien against it, or if there was a question as to whether or not the seller owned it. The same basic principle is involved when buying a house, except there could be a lot more and different types of encumbrances/claims against the title. For example, your neighbor might have a recorded right to use your driveway to get to his/her house (also generally known as an “easement”).

Most contracts and forms will provide that Seller is to provide buyer with a title insurance policy at closing, but many of those forms state that the title will be subject to items of record, and facts a survey would show. So, if a search of title shows the afore-mentioned driveway easement of record, you get title to the property, but it is subject to that easement. Moreover, if a survey later shows that your neighbor is also using 10’ of your property, as its own, you could be in for costly litigation, after closing to try and get that10’ back. Can this be prevented? Easily. All you need to do is  add to the contract, that in addition to the physical inspections, you want a Title Commitment and Survey (and a right to terminate if there are defects/encroachments). A “title commitment” is simply a contract by the insurance company to enter into an insurance policy (contract) with the buyer, whereby the title insurance company will guarantee good title, subject to exceptions it finds upon a title search of the property. If your title commitment or survey show problems such as easements and liens having been filed against the property, better to know this sooner vs. later so you can, if you need to, walk away, get your money back and find a property without title/survey issues.

One other way to ensure that you cover your diligence tracks, without having to write in the margins of a form contract is to add an Addendum to the Contract, comparable to the following, sometimes referred to as a “free look”:

“Buyer shall have a period of fifteen (15) days (the “Due Diligence Period”) from the latest date the mutually signed Agreement and this Addendum were signed by a party hereto (the “Effective Date”) to inspect the Property and to perform such investigations, review of title, survey, condominium documents (if applicable) and otherwise engage in such inspections and investigations as desired by the Buyer.  Seller agrees to cooperate with Buyer to allow Buyer and its agents to enter the Property for such inspections and investigations and to assist (without expense to Seller) in obtaining information requested by Buyer.  Should Buyer determine that the Property is not suitable for any or no reason in Buyer’s sole and absolute discretion, Buyer may terminate the Agreement by providing written notice thereof to Seller no later than the last day of the Due Diligence Period.  Upon such termination, all earnest money deposits will be promptly returned to Buyer (without further action of the parties), and the parties will have no further obligations hereunder.  Should Buyer fail to timely terminate the Agreement as described above, Buyer shall no longer have the right to terminate the Agreement under this provision.  The inspections set forth in this Addendum are in addition to, and not in lieu of, the other inspections of Buyer under the Agreement, and in the event of conflict (between any provisions of the Agreement and this Addendum concerning timing, rights of the parties and otherwise re: inspections), this Addendum shall control.

Do you have to go through the above-mentioned diligence process when buying a house or condo? Many buyers purchase property without doing any diligence, and have lived happily ever after, right? The simple answers to the above questions are no, and yes. However, if you are considering buying any real estate without a due diligence process, to quote Clint Eastwood, in the movie Dirty Harry: “You’ve gotta ask yourself one question: “Do I feel lucky? Well, do ya…” As lawyers, we only see the unlucky ones after the sale.