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What Are The Essential Terms In Commercial Real Estate: Your Comprehensive Guide

Inna Radford | 26th May 2024 | 12 minute read

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When navigating the commercial real estate buying process, there are several critical components to understand and processes to follow.

This guide outlines the essential terms and procedures involved in the commercial real estate buying process, providing a structured approach to ensure a smooth and informed investment experience. Understanding these elements can empower investors to make informed decisions, minimize risks, and successfully close on a commercial property.

Understanding these elements can help buyers make informed decisions, minimize risks, and successfully close on a commercial property.

What is the Feasibility Period (Inspection Period)?

One of the most critical aspects of commercial real estate investment is thorough due diligence. This process involves meticulously examining the property and all relevant documents to identify potential issues and ensure the investment aligns with your goals. A key component of due diligence is the feasibility period (also known as the inspection period). During this time, the buyer has the opportunity to review all information about the property, referred to as due diligence information.

To secure this review period, the buyer will typically pay a negotiated option fee (independent consideration), signaling their serious interest. Additionally, the buyer deposits earnest money into escrow as a sign of good faith. This deposit becomes non-refundable after the feasibility period ends but is applied towards the purchase price at closing. There may be additional fees for extending the feasibility or closing periods, which may or may not be applied to the final purchase price.

Here are some key points to remember when dealing with earnest money:

Escrow: Always ensure the earnest money deposit is placed with a trusted third-party title company for secure handling.

Distribution: Both the seller and buyer must agree to release and distribute the earnest money deposit. The title company cannot release the funds without mutual consent, even if the contract outlines specific instructions.

  • Time For Assessment: The feasibility period is crucial as it allows buyers to thoroughly evaluate the property to confirm it meets their investment criteria and expectations. This period typically involves inspections, appraisals, and reviews of various financial and legal documents.
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  • Option Fee: The option fee serves as a non-refundable payment for the privilege of this review period, indicating the buyer’s serious interest. The amount of this fee is negotiated between the buyer and seller and compensates the seller for taking the property off the market during this time.
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Activities During Feasibility Period

 

  • Property Inspection: Physical inspection of the property’s condition, including the structure, systems, and any existing issues.
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  • Review of Financials: Analysis of the property’s income and expenses, including rent rolls, operating expenses, and profit and loss statements.
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  • Legal Due Diligence: Examination of title, zoning, and any legal encumbrances or restrictions on the property.
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  • Environmental Assessment: Conducting environmental site assessments (ESA) to identify potential contamination or other environmental risks.

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What is an Earnest Money Deposit?

An Earnest Money Deposit is a sum of money deposited by the buyer in escrow as a sign of good faith to pursue the purchase. This deposit shows the seller that the buyer is serious and committed to closing the deal.

 

  • Non-refundable Post-Feasibility: The deposit becomes non-refundable after the Feasibility Period but is applicable to the sales price at closing. If the buyer decides not to proceed with the purchase during the Feasibility Period, the deposit is typically refunded.
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  • Escrow Requirement: It is crucial to escrow the earnest money deposit with a third-party title company to ensure that the funds are handled properly and impartially.
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  • Return and Distribution: Both the seller and buyer must agree to return and distribute the earnest money deposit. Title companies cannot release the funds without mutual agreement, regardless of the contract’s instructions for such distribution.
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  • Protects Both Parties: Provides a level of security for both parties; the seller knows the buyer is serious, and the buyer has a secure mechanism for retrieving their deposit if the deal falls through during the Feasibility Period.

Why Should You Obtain a Property Survey?

Necessity

 

Always requesting a property survey is vital to ensure there’s no missing or incorrect information. A survey provides a detailed map of the property, outlining boundaries, easements, and any potential encroachments. Submitting the survey to the title company allows them to compare it against the current title report. This helps identify any discrepancies or potential issues that could affect ownership or use of the property.

  • Accurate Information: Always request a survey of the property to ensure there is no missing or incorrect information. A survey provides a detailed map of the property, showing boundaries, easements, and any encroachments.
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  • Title Company Examination: Submit the survey to the title company to compare against the current title report. This helps identify any discrepancies or potential issues that could affect ownership or use of the property.
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Benefits

 

  • Boundary Verification: Ensures that the property’s boundaries are accurately defined and that there are no encroachments by neighboring properties.
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  • Easements and Restrictions: Identifies any easements, rights-of-way, or restrictions that could affect the property’s use.
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  • Development Planning: Essential for planning any future development or improvements on the property.

What Are Environmental Rep

What Are Environmental Reports and Why Are They Needed?

Your lender will likely require a “Phase I Environmental Site Assessment” (ESA), which includes findings from public records and obvious surface observations.

If the Phase I report identifies potential environmental issues or if the property is near hazardous sites like oil change facilities or dry cleaners, it may recommend a “Phase II Environmental Site Assessment,” which involves soil sampling.

If you suspect environmental issues but want to avoid high costs, you can opt for a quick “desktop search.” Here are the approximate costs for these reports:


Phase I ESA: $2,000-$2,500
Phase II ESA: $8,000-$12,000
Desktop Search: $350-$550

 

 

Phase I Environmental Site Assessment (ESA)

 

  • Requirement: Most lenders will require a Phase I ESA to identify any potential environmental liabilities.
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  • Scope: This report includes findings from public records and obvious surface observations, examining past uses of the property and surrounding areas for potential contamination.
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  • Cost: Approximately $2,000-$2,500.
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Phase II Environmental Site Assessment (ESA)

 

  • Conditional Requirement: If the Phase I ESA indicates potential environmental issues, a Phase II ESA involving soil, water, and air sampling may be necessary to further investigate the extent of contamination.
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  • Cost: Approximately $8,000-$12,000.
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Desktop Environmental Report

 

  • Alternative: A quicker and less expensive option to assess potential environmental issues based on existing data and records.
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  • Cost: Approximately $350-$550.
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Importance

 

  • Risk Management: Identifying environmental issues early can prevent future liabilities and costs associated with remediation.
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  • Lender Requirement: Necessary to secure financing, as lenders want to ensure the property is free from significant environmental risks.
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  • Regulatory Compliance: Helps ensure compliance with local, state, and federal environmental regulations.

What Are Tenant Estoppel Certificates?

Estoppel certificates are documents signed by tenants to confirm they and the landlord are current on all lease obligations. These certificates provide assurance to the buyer and lender that there are no undisclosed agreements or disputes with the tenants that could impact the property’s income stream.

 

Requirements

 

  • Lender’s Requirement: Some lenders may require all or some tenants to sign these certificates to verify lease terms and conditions, such as rent amounts, security deposits, and lease expiration dates.
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  • Seller’s Affidavit: Some lenders may require all or some tenants to sign these certificates to verify lease terms and conditions, such as rent amounts, security deposits, and lease expiration dates.
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Benefits

 

  • Lease Verification: Confirms the accuracy of lease terms critical to the property’s financial performance, including rent amounts, security deposits, and lease expiration dates.
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  • Dispute Prevention: Helps prevent future disputes by ensuring all lease terms are clear, documented, and agreed upon by both the landlord and tenants. This can save time and money associated with potential legal issues.
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  • Lender Assurance: Provides lenders with the necessary documentation to confirm the stability and reliability of the property’s income stream, which can influence loan approval and terms.

How to Perform a UCC Search (Uniform Commercial Code Search)?

If the property includes equipment or fixtures, the buyer should perform a Uniform Commercial Code (UCC) search to check for any outstanding liens or third-party claims on these items.

Options for Conducting a UCC Search:


1. Do It Yourself: Use the Texas state SOSDirect system at [https://www.sos.texas.gov/ucc/index.shtml](https://www.sos.texas.gov/ucc/index.shtml). You can search by the tenant’s name (both company and personal) or by the property address.


2. Hire an Agency: Use a service like [CSC Global](https://www.cscglobal.com/service/cls/ucc-search/) to conduct the search on your behalf.

A UCC search identifies any outstanding liens on equipment or fixtures that are part of the property sale. This is important to ensure that the buyer receives clear title to all personal property included in the sale.

  • Self-Search: Use the TX state SOSDirect system to search by the tenant’s name (both company and personal) or by property address.
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  • Agency Search: Utilize a service like CSC Global for conducting the search on your behalf, which can provide a more comprehensive and accurate report.
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Importance

  • Clear Title: Ensures that the property’s fixtures and equipment are free from liens, preventing third-party claims after the purchase.
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  • Financial Security: Protects the buyer from inheriting the seller’s debts associated with the property’s personal property.

What is a Financing Contingency in commercial real estate?

Definition

 

Financing contingencies are less common in commercial real estate contracts compared to residential ones. Buyers are typically expected to have their financing secured or at least be well on their way to pre-approval before entering into a purchase agreement. This helps to streamline the process and reduces the risk of the deal falling through due to financing issues.

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  • Importance of Pre-Approval:
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Secures Funding

Buyers should seek pre-approval from a lender to determine the maximum loan amount they qualify for. This allows them to focus on properties that fit within their budget and demonstrates to sellers that they are serious about the purchase.

Streamlines Negotiations

Having pre-approval can strengthen a buyer’s offer and potentially lead to more favorable negotiation terms. Sellers are more likely to accept an offer from a buyer with confirmed financing.

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  • Buyers should seek loan pre-approval to ensure they have the necessary funds available by the closing date.
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Benefits of a financing contingency:

 

Risk Mitigation: While not as common in commercial deals, a financing contingency can provide some protection for the buyer in unforeseen circumstances. If there are significant changes in market conditions or the buyer’s financial situation that prevent them from securing financing, the contingency allows them to back out of the deal without penalty.

  • Encourages Due Diligence: Knowing they may not have the safety net of a financing contingency can incentivize buyers to be more thorough with their due diligence during the feasibility period. This ensures they are confident about the property and their ability to manage the investment before committing to the purchase.

What Does a Cash Offer Mean in Commercial Real Estate?

A cash offer does not necessarily mean the buyer will pay for the property entirely with cash upfront. Instead, it indicates that there is no financing contingency included in the contract. This means the buyer is committed to closing the deal regardless of whether they secure a loan. Cash offers are often more attractive to sellers as they eliminate the risk of the deal falling through due to financing issues.

Cash Offers: Flexibility for Buyers and Benefits for Sellers

 

  • Buyer Flexibility: While there’s no financing contingency, buyers may still be seeking financing but are willing to close without it if necessary. This demonstrates a strong financial commitment to the purchase.
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  • Seller Benefits: Cash offers provide sellers with greater confidence that the transaction will close on time and without complications. This can be especially appealing in a competitive market where multiple offers are on the table.
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  • Seller Assurance: Provides sellers with greater confidence that the transaction will close.
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  • Competitive Edge: Can make the buyer’s offer more attractive in a competitive market.

Complex Transactions: Land Sales and Purchase Contracts.

Land sales and purchase contracts often involve more conditions and complexities compared to typical commercial real estate transactions. These additional considerations can impact the feasibility and timeline of the deal. Here are some key factors to be aware of:

  • Platting: This refers to the approval process for dividing a large property into smaller parcels. Buyers will want to ensure the platting process is complete or well underway before finalizing the purchase.
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  • Easement Agreements: These are reciprocal agreements that grant access rights to neighboring properties. For instance, an easement agreement might guarantee access to a shared road or utilities. A clear understanding of any existing easements is crucial.
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  • Architectural Guidelines: Some land sales may have restrictions or guidelines dictating the design and construction standards for any development on the property. Buyers should be aware of these guidelines to ensure their plans comply.
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  • Utilities Access: Confirming the availability and connection points for essential utilities like water, sewer, electricity, gas, and telecommunications is vital before finalizing the purchase. The cost of installing new utilities can be significant.
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  • Detention Requirements: Stormwater management is a crucial aspect of land development. Detention facilities are often required to control runoff and prevent flooding. Understanding any detention requirements and associated costs is important.
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The Importance of Working with a Land Broker

Due to the potential complexities and unforeseen issues that can arise in land transactions, it is strongly recommended to hire an experienced land broker to assist with the process. A qualified land broker can provide valuable expertise in the following areas:

  • Expert Guidance: A land broker can ensure all legal and regulatory requirements associated with the land sale are met, preventing delays or complications.
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  • Risk Mitigation: An experienced broker can help identify potential issues early on in the process and develop strategies to mitigate those risks. This can save time and money in the long run.
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  • Negotiation: Land brokers have the experience and negotiation skills needed to secure favorable terms and conditions in the purchase contract. They can advocate for your best interests during the negotiation process.

 

Increased Chances of Success: Leveraging the expertise of a land broker can significantly improve the chances of a successful land purchase. Their knowledge of the market, negotiation skills, and ability to identify and mitigate risks can streamline the process and ensure a smooth transaction.

Conclusion

The commercial real estate buying process involves a multitude of factors and considerations. By thoroughly understanding each step, from due diligence to financing and closing procedures, investors can approach the process with confidence and make informed decisions.

This guide has provided an overview of the key elements involved in commercial real estate transactions. Remember, consulting with experienced professionals like us, is crucial for navigating the complexities of these deals and ensuring a successful investment.

We are a team of experienced commercial real estate professionals here to guide buyers, sellers, and tenants throughout Houston and the surrounding areas. Contact us today to discuss your commercial real estate needs!

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