How CRE Deal-Making Dynamics Are Shifting
As the market cools, buyers are gaining the upper hand when it comes to concessions, says Gil Uhlhorn of Bass, Berry & Sims.
For almost as long as any purchaser or seller of real estate in the U.S. can remember, good deals have been extremely competitive for buyers in virtually all markets and sectors due to limited supply, low interest rates and an abundance of available cash (both debt and equity). In such an environment, purchasers look for off-market deals or find themselves in competitive “best and final” rounds with multiple potential buyers. As a result, sellers have been able to demand concessions that require purchasers to step outside their standard acquisition process comfort zone.
Over the past few months, purchasers and sellers have started to see a shift in their relative bargaining position due to a rising interest rate environment, inflation concerns and continued supply chain issues. Sellers are recognizing that they can no longer expect certain seller concessions related to due diligence/closing timelines or hard earnest money and are finding that purchasers are no longer willing to accept certain financing risks that have been commonplace in this market. However, sellers still value certainty of close, and an aggressive purchaser may still make its offers more attractive by proposing a “nonrefundable” deposit at the time of contract execution or offering a short diligence period with a quick close.
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Nonrefundable Deposit Risks
While posting a “nonrefundable” deposit can help an interested purchaser win a deal, the purchaser must understand and accept the risk that it will actually lose its deposit if it walks away. First and foremost, a purchaser must be comfortable with the physical condition of the property and the market where the property is located. A standard “free look” inspection period (where a purchaser can get a return of its earnest money deposit at any time during a set number of days for inspection) allows a purchaser to conduct a thorough investigation of the physical and financial condition of the property. During this “free look” inspection period, a purchaser can build a comprehensive financial model taking into account rent growth, improvement costs and local market conditions, etc. Without that time for due diligence after contract execution, a purchaser must conduct research upfront and be confident that it will not discover facts later that will upend its financial model.
Carve-outs for Negotiating Nonrefundable Deposits
If a purchaser is willing to accept the potential risk of losing its deposit, there are certain important carve-outs that a purchaser must ensure are included in the contract so that its “nonrefundable” deposit is actually refundable in certain limited circumstances. While it sounds contradictory that the “nonrefundable” deposit is refundable, sellers generally accept limited carve-outs as no rational purchaser would agree to shift the risk for certain diligence matters without a chance to review.
The list of generally acceptable carve-outs includes: (1) seller default, (2) casualty, (3) condemnation, (4) title/survey/zoning matters and (5) environmental condition. All sellers recognize that, if they default, the purchaser should be entitled to a return of its earnest money deposit, whether it has been classified as “nonrefundable” or not. Similarly, in the case of a major casualty or condemnation, most sellers agree that a purchaser should be able to walk away with its earnest money if an event outside of the control of either party results in a material change to the property. The key with these carve-outs is to agree on what is considered a major casualty or condemnation.
Finally, most sellers understand that a purchaser will want some assurance that it will acquire a property with a clean title and no adverse environmental condition. Ideally, a purchaser would have the ability to conduct full title/survey/zoning analysis and to review an updated environmental report after contract execution with a refund of the “nonrefundable” deposit if the results of that diligence are not acceptable to purchaser. However, a popular way to tighten this carve-out is to require a purchaser to review existing title/survey/zoning reports and environmental site assessments prior to contract execution and sign off on the existing title/survey/zoning status and environmental condition. If a purchaser and seller agree to this approach, the seller should have existing reports available and ready to share with the purchaser, and both purchaser and seller must accept that the time necessary for the purchaser and its counsel to review of the existing reports will delay contract execution.
Shorter Due Diligence, Closing Timelines
With respect to due diligence and closing timelines, sellers negotiate hard to limit the time between contract execution and closing, and purchasers have been willing to push to meet those time demands. Unfortunately, in today’s environment with supply chain delays and worker shortages across all sectors, third-party real estate diligence vendors (like title companies, surveyors, environmental engineers and appraisers, etc.) are feeling the strain like other industries. As a result, it is taking purchasers and their lenders longer to get standard diligence reports for review from providers. This trend is making the push for shorter diligence and closing periods even more stressful on potential purchasers.
Purchasers can prepare for an aggressive timeline by kicking off title commitments, surveys, property condition reports, environmental site assessments and appraisals, etc., as soon as awarded a deal while a purchase agreement is being negotiated, but that requires purchasers to commit capital to a project before they are under contract. Alternatively, for purchasers who are reticent to spend money before a purchase agreement is signed, purchasers could have these consultants and vendors lined up and ready to engage immediately upon contract execution.
While there are growing indications that the real estate market may be softening in many sectors and that purchasers may no longer be required to step outside their standard acquisition process comfort zone to offer “nonrefundable” deposits or tightened diligence/closing timelines to win good deals, some sellers may still be able to make such demands, and purchasers may still be willing to take those risks for the right deal. If so, purchasers should work hard to limit those risks where possible in line with what has been reasonable and acceptable in a “hot market” and should push back harder in a “cooling market.”
Gil Uhlhorn is a member at Bass, Berry & Sims PLC in the Memphis, Tenn., office.