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Legal due diligence – common risks in real estate transactions
In times such as these, where real estate investors are competing to conclude the most attractive real estate deals, we are seeing the return of phenomena from before 2007. Back then, as today, the deal is made by those who not only offer the seller a good price, but also a high level of transaction security, and, finally, decide to buy the property before their competitors do. The latter in particular often makes investors fear that they do not have enough time to conduct proper due diligence (DD). For the last 18 months or so, this also seems to be one of the main reasons for increasing client requests to secure the deal for them first, and then start the DD as a second step.
From a lawyer’s perspective, this approach presents the following challenges:
- If no DD is performed, the purchaser cannot assess with certainty if the parameters used for the purchase price calculation will stand up to legal review. For instance, they might not become aware of the fact that a long-term commercial lease agreement does not comply with the written form requirements. As a consequence, the fixed lease term is no longer secured, as the tenant may terminate the lease agreement with the statutory period of notice even within the fixed lease term on the grounds of non-compliance with the written form requirements pursuant to § 550 BGB in conjunction with § 580a (2) BGB [Bürgerliches Gesetzbuch; German Civil Code].
- In respect of warranty issues, the following legal provision has to be taken into account (§ 442 (1) BGB): “The rights of the buyer due to a defect are excluded if he has knowledge of the defect at the time when the contract is entered into. If the buyer has no knowledge of a defect due to gross negligence, the buyer may assert rights in relation to this defect only if the seller fraudulently concealed the defect or gave a guarantee of the quality of the thing.” So, if the seller offers to conduct DD and the purchaser does not make use of this opportunity or decides to conduct only a limited DD, the purchaser takes the risk that the provisions laid down in § 442 (1) BGB are later used against them. They may, in fact, be held accountable for having no knowledge of the defect due to gross negligence, with the consequence of warranty rights being excluded for this reason.
- Furthermore, if an investor purchases a property without performing DD, they risk encountering in later litigation proceedings over guarantee and warranty claims the argument that a purchaser acting prudently and with adequate due diligence may never have acquired the property without performing DD. The decision not to perform DD thus represents considerable negligence in exercising this proper consideration. In the case of guarantee or warranty claims, this objection – if justified – may lead to the limitation of damage to the disadvantage of the purchaser if this is qualified as violation of the purchaser’s statutory duty to minimise damages (§ 254 (1) BGB).
What advice can be given to investors acting in this difficult field of competing considerations? The decision to buy a property without performing DD is mainly driven by commercial concerns. The challenge for us lawyers is finding out how an acquisition without DD can be provided the highest degree of legal certainty possible, given the circumstances. From our perspective, the following considerations are decisive:
- If the sale is carried out excluding any kind of warranty, the purchaser is effectively making a blind bargain when they don’t perform DD. In this case the purchaser’s management risks being held personally liable if the view can be taken that a manager acting considerately may not have acquired the property without performing DD first.
- The risks for the purchaser can be limited if the seller is generally willing to grant comprehensive contractual guarantees. As described above, however, also in this case the purchaser may be accused of having violated their duty to minimise damages.
- If the purchaser intends to conclude the transaction first and perform DD subsequently, it is advisable that they provide for a contractual right of withdrawal, which entitles them to rescind the contract if the DD review reveals formerly unknown facts with negative consequences for them. In this respect it is particularly important to identify the sensitive issues for the parties to the individual transaction and to strike a balance between them.
- If the seller refuses to agree on such a right of withdrawal, from the perspective of the purchaser, waiving DD altogether should be considered, even if the seller offers to perform it. In this case the purchaser’s position may even be better if they are not or could not be aware of a defect as DD was not performed (§ 442 (1) BGB). However, also in this case, the purchaser risks being accused of having violated their duty to minimise damages.
- If the seller makes the conclusion of the contract dependent on largely excluding warranty rights, the purchaser is strongly recommended to at least roughly examine all purchase-price relevant factors and issues as part of a cursory due diligence procedure. With respect to legal DD, this comprises in particular the verification of all relevant commercial lease agreements as regards their effectiveness and/or compliance with written form requirements. In addition, lease periods and rent amounts should be verified. In particular, the statutory written form requirement for lease agreements with a fixed lease period of more than one year (§ 550 BGB) poses increasingly significant problems for investors in practice. With its decision of 22 January 2014 (XII ZR 68/10), the German Federal Court of Justice put a stop to the common practice of post factum inserting clauses into commercial lease agreements to secure the healing of violations of the written form requirements, and also ruled that such clauses are invalid from the perspective of the purchaser of the property. In addition, with its decision of 25 November 2015 (XII ZR 114/14), the German Federal Court of Justice even tightened its judgement relating to § 550 BGB by ruling that even minor changes to the rent amount and agreements between the parties to the lease contract pertaining to remodelling and expansion works in the rented property are subject to the written form requirements. Thus, the risk of investors “buying” a commercial lease agreement that does not comply with the written form requirements (and irreversibly so) has increased drastically over the past two years. Reflecting this development, performing DD has gained increasing importance for real estate investors.
Dr Tara Kamiyar-Müller
AC Tischendorf Rechtsanwälte Partnerschaft mbB
T + 49 69 24 70 97 - 0
Requirements for real estate due diligence from the perspective of financers
The review requirements for financing are as multi-faceted and complex as the real estate market is variable and unique. In view of the ever-increasing competition, prompt lending decisions and risk-appropriate terms and conditions are gaining in importance. The market is increasingly dominated by competitive pressure, and market participants have to act quickly and flexibly as a result. This leaves them vulnerable to overlooking potential risks.
Financers are thus faced with the challenge of reviewing their investments with the necessary diligence. Detailed information has to be collected systematically, analysed and evaluated. Here, banks focus on several review issues, covered by due diligence (DD).
Importance and systematics of DD from the perspective of the banks
DD reviews comprise the systematic analysis of strengths and weaknesses of the financed property, and a sustainable valuation and the analysis of risks related to the financing in order to provide transparency and enable a realistic and long term assessment of the opportunities and risks of the real estate investment.
The analysis specifically looks for deal breakers and deal restrainers, i.e. risks that inhibit financing or require additional collateral to be provided.
The scope and content of financers’ DD requirements vary according to the risk criteria established by the individual bank. Due diligence reviews focus, for instance, on the market situation and property condition, on financial, tax and legal aspects, environmental issues, the borrower’s financial situation and the strategic approach of the bank.
Market DD evaluates the state of the real estate market and requires a detailed analysis of the market and location. Data are analysed and scrutinised relating to market and location, market conditions, market development and the rental situation in view of its development potential.
Within technical DD, the construction and technical aspects of real estate are analysed, and strengths and weaknesses of the investment property are compared. The profitability of the property over its remaining useful life, its structural quality and particularities in terms of constructions law, such as warranties, are reviewed.
The findings from the above-mentioned DDs form the basis for a well-founded real estate valuation report.
Legal DD focuses on the ownership structure and corporate documents (shareholders’ agreement and articles of association, and contracts and agreements concluded). Issues relating to property rights and corporate law are reviewed for legal uncertainties.
So the financer can obtain a clear picture of the borrower, tax and accounting records (normally for the previous three years) are reviewed and evaluated within the scope of tax DD.
All financial data relating to the financed property and the borrower are compiled and processed within the scope of financial DD. The decisive benchmarks for identifying financing risks are the analysis of rental agreements and the rental situation, the creditworthiness of the tenants, collateral provided, profit situation and costs. For example, the earnings are impaired by caps on operating expenses, cost contributions for expansions and special rights of termination. On the other hand, earnings can be more easily planned over longer periods of time, and are more sustainable and valuable if there are long-term lease agreements with only a few special agreements and special rights of termination.
As real estate financing mainly focuses on the property due to the long credit term, the bank evaluates the property in view of potential risks leading to loss of rental income. In certain asset categories, changing the use of properties is often restricted due their specific purpose. The more specific the property, the more difficult it is to find an alternative use and the higher the risk of rent losses.
To assess the borrower’s financial situation, the financers review the borrower’s accounting policies, finance structure, assets and liabilities, capital structure, liquidity, financing possibilities and costs, and transparency of reporting. The information is taken from the balance sheets, the profit and loss account, and the cash flow statement.
Other DD investigations comprise contingent risks, such as environmental risks (e.g. contaminated sites and operating risks). Although these hidden risks are often neglected, they can seriously jeopardise the property’s profitability and the debt servicing of the finance provided. From the perspective of banks, the quality and the expertise of the operator of a property, e.g. of a commercial property, gain increasing importance. The attractiveness and value retention of operator-run properties are determined by the market conditions and the successful cooperation between tenants, operators and their management. This requires a conclusive and sustainable operating concept as well as professional marketing.
Professional DD management
DD reviews require team work involving several departments of the bank and, as the case may be, several service providers. Berlin Hyp has had positive experiences working with “deal teams”. Such teams are used in particular with cross-border financing, non-standard financing schemes and syndicated financing.
The deal team of the bank consists of experts from the front and back offices, the legal department and the valuation department. As all relevant departments are involved from the very beginning, working both in parallel and together, factors delaying the deal can be detected quickly from different perspectives and addressed in a solution-oriented manner. Depending on the scope, the specific requirements and complexity of the deal, experts from companies closely affiliated with the bank may also be consulted. This is agreed upon in close coordination with the client.
Open communication with the client as to which documents have to be filed, and in what form and when (using, for example, checklists and data rooms), makes the bank's requirements transparent for the client. Clear agreements on deadlines and responsibilities, and the bank's adherence to these deadlines, establish trust, appreciation and customer retention. Promptness, a good network through all levels of the bank, efficiency in day-to-day activities and swift decision-making processes are essential in meeting the requirements of the front and back offices, and to give proper attention to both assets and liabilities. That means to manage complexity, strike a balance and find an optimal credit structure.
The importance of vendor DD for financing
Risk assessment in financing not only influences whether finance is to be provided, but also, with the rating, the terms of the finance. Including a DD report with the financing application, particularly when the DD has been performed by established service providers (such as audit firms with expertise in the real estate industry), may help improve transparency at an early stage, accelerate the processes in the bank and improve financing terms. The DD costs may pay off in this respect, especially with long-term financing.
Supplementary financing agreements and risk management
Every thorough credit checks also presuppose a balanced risk strategy and a corresponding risk management by the bank. Syndication and securitisation, and the subsequent outplacement of individual tranches are often practised with high-volume finance.
In addition to DD analyses, credit checks also focus on the future of the investment, on the sustainability of the property and of the financing. Stress and exit scenarios serve to forecast potential changes to the initial data, such as different parameters on the capital market (interest rate risks), exchange rate changes, unusual changes of value-determining factors of the property and the consequences of rent losses. The bank has to be in a position to react in these cases, for instance by requesting additional collateral, concluding special repayment agreements or participating in the proceeds of a sale in order to secure the financing and avoid credit default. To do this, the bank makes arrangements with the borrower by agreeing on financial, non-financial and information covenants.
Financial covenants represent the borrower's obligation to comply with certain indicators, such as the debt service coverage ratio (DSCR), interest coverage ratio (ICR), loan to value (LTV).
Non-financial covenants describe different types of clauses, such as pari passu clauses, negative pledges, cross default clauses and collective action clauses. These clauses are to prevent providing collateral to other creditors if the initial creditor does not rank equally (pari passu) with them.
Information covenants describe agreements in which the borrower undertakes to comply with common standards and which are linked to business-relevant factors. They mainly refer to compliance with the relevant accounting standards and the conclusion of business-relevant insurance policies.
DD focusing on these issues can help to assess the future risk of covenant breaches.
In a highly competitive field, the prerequisites and key factors needed to act and react promptly, responsively and professionally, and remain successful as a financer, include care, prudence, excellent and constantly up-to-date market knowledge, solid expertise relating to property and the financing requirements for the individual asset categories, as well as a balanced risk approach.
Member of the Board of Management
Berlin Hyp AG
T +49 30 25 99 96 01
Financial due diligence for buyers and vendors
[oth parties to a transaction, the buyer and the vendor, wish to conclude transactions successfully. Although the parties’ objectives are not identical, there are numerous areas where they overlap. These comprise in particular issues such as transparency, detecting deal breakers at an early stage, and, above all, keeping costs for the transaction as low as possible. As such, it is important to plan the individual stages of a transaction in such a manner that these objectives are achieved. Achieving transparency of the target at an early stage is commonly the most important aspect for both sides. Financial due diligence (DD) can provide exactly this transparency, and in doing so establish a foundation of trust between both parties to a contract.
The advantage of financial DD for the vendor is that risks may be identified at an early stage, giving the vendor the opportunity to actively address these risks and minimise them ahead of the transaction. It also decreases the risk of lump-sum purchase price reductions suggested by the buyer within the scope of due diligence proceedings, as the buyer is in a position to better evaluate these risks.
For the buyer, financial DD provides more detailed information to assess the opportunities and risks of the target that enable the buyer to come to a solid evaluation. This can represent a clear strategic advantage in the increasingly common bidding process, as it can exclude lump-sum reductions in value due to opaque risks.
Structuring financial DD
The typically successive phases of a planned transaction – starting with identifying a target through to integrating it into an existing group structure – require various examinations of differing scope for the planned transaction to be completed successfully, all while taking into consideration cost efficiency and the individual needs of the vendor/buyer.
At the start of an intended acquisition/sale process, it is advisable to receive an impression of the target, with minimum expenditure. This approach is best served by the preparation of a red flag DD report. By conducting a rough analysis of the information and documents available, the essential value drivers and risks can be identified. The findings of this analysis put the buyer/vendor in a position to make an informed decision already at this early stage of the transaction process on whether to proceed or not, without incurring substantial ancillary costs. Ideally, deal breakers are identified at this stage already.
If the decision is in favour of the transaction, the performed red flag financial DD provides the basis for the focus of the analysis in the further process.
In light of experience, financial DD focuses typically on one or several of the following issues listed below:
- Determination of a normalised sustainable net operating income (NOI):
- Adjustments of results of operations for non-recurring effects, e.g. below-average maintenance, major maintenance measures and repairs, refunds from insurance companies, one-off expenses due to adjustments of rent accounts, etc.
- Identification of expected/conceivable events that could jeopardise the sustainability of income
- Assessment of the existence/intrinsic value of assets and completeness of liability items (balance sheet analysis) to avoid incorrect purchase price calculations in the case of a share deal
- Quality of the property managers (analysis of processes), e.g.:
- Difference between market rent and current rental income (upside potential)
- Past development of vacancies
- Vacancy periods between termination and conclusion of new rental agreements in order to identify optimisation potential for leasing purposes
- How promptly is, for instance, the statement of operating costs issued and are amounts for advance payments on operating costs adjusted in a timely manner? Analysis of appeals filed against the statements of operating costs
- Cash to contract:
- Comparison between actual rental income and rent rolls/tenancy agreements used as the basis for the sales contract – avoidance of “fake tenant” acquisition
- Analysis of the tenants‘ payment behaviour and assessment of the probability of loss of rent
- Review of rental deposits
Based on the class of real estate the specific target belongs to (residential or commercial property, hotel, logistics property, etc.), the analysis may focus on other issues within the scope of financial DD. With shopping centres, for example, the analysis/assessment may focus on the expected rent rate development due to existing indexation and/or sales-based rents.
The legal and economic framework may also be a good reason to review additional areas. In the case of residential properties these would be, for example:
- Assessment and consequences of rent control
- Evaluation of the potential for rent increase taking into account the rent index
Depending on the target, DD analyses conducted in preparation for an acquisition/sale decision address a number of individual issues from various areas. However, their objective should always be to assess the expected opportunities and risks for the cash flow. The income alone is not the measure of all things. The income is rather the path to the cash flow, and it is only cash that can be distributed to the shareholders ("Cash is a fact, profit is an opinion.", Alfred Rappaport, 1986).
A financial DD report presents the findings of the business analysis of the target, which forms the basis for the final decision to buy/to sell. It, however, also regularly contains recommendations for handling the risks identified (deductions from the purchase price, representations and warranties, etc.). At the same time, the report has another, quite different, positive effect that is not immediately obvious. The buyers have a document in their hands that facilitates access to borrowed capital due to the transparency of the data presented in it. This also helps in obtaining more favourable financing terms.
After the sales contract has been signed and implemented, the transaction is often still not completed for the buyer. Opportunities and risks identified by the financial DD analysis have to be addressed and monitored in ongoing post-merger reporting.
German Public Auditor, Tax Consultant
T +49 30 89 04 82 - 182
T +49 30 89 04 82 - 451
Is tax due diligence necessary if the tax clause is to the advantage of the purchaser?
Tax risks in real estate transactions are usually covered by a tax clause in the sale and purchase agreement (asset deal or share deal). For more on this, please also refer to our Trinavis Real Estate Newsletter No. 2/2014 on “Tax due diligence and tax clauses”.
From the purchaser’s perspective, the tax clause aims at ensuring that potential tax burdens arising from the period prior to the transfer of ownership that only become obvious after the transfer of ownership (for instance, due to the findings of a tax audit) remain with the seller. Typically, the purchasers are not willing to assume tax burdens that have not been triggered by their actions and result from periods prior to the acquisition, and thus are beyond their scope of influence.
As such, the seller normally assures by way of the tax clause that, for the period prior to the transfer date, all tax returns and reports were filed with the competent tax authority in due time, completely and in accordance with the rules within the statutory period or within the deadlines set by the tax authority, and that all taxes and dues have been paid in time and completely. Furthermore, the seller undertakes to indemnify the purchaser or the target company from any additional taxes that may be subsequently assessed for the period prior to the transfer date.
As these warranties given by the seller within the scope of tax clauses are quite common in practice, the question arises for the purchaser whether it is necessary to spend time and money on tax due diligence (DD). This is particularly the case when the seller or the target company have already obtained tax advice, the risks resulting from tax audits are considered to be low, and it can be assumed that the seller has a good creditworthiness in respect of the recoverability of the warranties given.
However, a tax clause can only cover one aspect of tax due diligence – the analysis of risks resulting from incorrect tax returns filed in the past.
One of the main objectives of tax due diligence is, however, also to analyse the tax consequences when complying with tax law and to find an optimal acquisition structure. These tasks may be of crucial importance for the acquirer and serve firstly to identify future tax burdens, and secondly to optimise these as far as possible. In this respect there is no possibility of recourse to the seller on the basis of the tax clause, as the tax burden is triggered only by or after the transfer of ownership.
Within the scope of tax due diligence relating to the past, consequences resulting from correct tax treatment in the past, caused for example by write-downs to the lower going-concern value (Teilwertabschreibungen) or tax-free reserves, may be detected. If, for instance, the target company has written down the going-concern value in compliance with tax law in the past, but these write-downs have to be reversed after the acquisition date (Wertaufholungsgebot), these value readjustments lead to taxable income and thus to considerable tax burdens in subsequent periods. Also knowledge of tax-free reserves set up in the past that have to be allocated to newly acquired assets or – if this is not possible – be released within a certain period of time has to be taken into account in the acquisition decision.
In contrast, tax DD relating to the future forms the basis for the purchaser to actively influence tax consequences upon structuring the acquisition. For example, limited companies holding real estate may avoid real estate transfer tax (RETT) by structuring the acquisition in such a way that the (direct or indirect) legal and economic consolidation of 95 % of the shares in one hand does not take place. The forfeiture of tax loss carryforwards upon a change in shareholders may also – when detected within the scope of tax DD – be potentially avoided by finding an appropriate structure.
Tax consequences resulting from the financing of the target company should also be taken into consideration. The debt waiver of a shareholder in a limited company, for instance, may be regarded as a tax-free shareholder contribution only up to the recoverable amount of the claim, whereas the non-recoverable part of the claim has to be declared as taxable income.
Issues to be addressed within tax DD relating to the future may refer not only to the immediate acquisition proceedings, but also to incorporating the target company into an existing group structure or in view of a planned resale in future. For example, if the target company is a limited company and real properties are sold after the acquisition that have considerable hidden reserves, this results in a tax burden at the level of the target company. If these hidden reserves have been compensated for as part of the purchase price for the shares within the scope of a share deal, this compensation may not be used as additional acquisition costs for the real properties (step up). If the real properties are sold later on by way of an asset deal, the hidden reserves will be subject to taxation. It is crucial that purchasers bear this in mind in their strategic planning and the purchase price calculation.
A future-oriented tax DD provides important findings the potential acquirer should be aware of and take into account when making the purchase decision for both share and asset deals. For instance, with asset deals, input VAT refunds claimed in previous years may also have to be paid back if the use of the real property is changed.
Within the scope of tax due diligence, a tax clause helps to cover only aspects relating to the past. The findings of tax due diligence relating to the future are particularly important for the purchaser. On the basis of these findings, the purchaser can actively influence the future tax burden of the target company and its shareholders. In any event, this opportunity should not be ignored. In order to find an appropriate tax structure, competent and comprehensive advice should be obtained, tailor-made for the individual case, taking into account the company’s strategic objectives and the situation of the acquirer.
Trinavis GmbH & Co. KG
T +49 30 89 04 82 - 161