In real estate transactions, due diligence is the reasonable analysis or research that is done to check or verify material information about a property.
Due diligence is not part of the legislation per se. What is referenced is “material fact.” According to the REBBA 2002 Code of Ethics:
“material fact” means, with respect to the acquisition or disposition of an interest in real estate, a fact that would affect a reasonable person’s decision to acquire or dispose of the interest
Brokers/salespeople must take reasonable steps to determine these materials facts and disclose them to their clients or customers at the earliest practical opportunity. As such, due diligence is a commonly accepted and prudent business practice.
Residential Real Estate
In residential real estate, due diligence means, among other things, advising clients to have the property inspected professionally. A home inspection should uncover problems relating to physical structure and mechanical systems. The home inspector would examine the roof, attic, walls, floors, ceiling, windows, doors, insulation and all other visible components of the structure, as well as the heating, central air conditioning, electrical, and plumbing systems. The home inspector then provides a written report.
A ‘typical’ home inspection report is shown below.
If the house is suspected of being a grow op, the home inspector would examine the integrity of any repairs to correct the electrical wiring and seal any breaks in the foundation or other holes used for venting. Home inspectors would also determine if the wiring is safe and check for problems arising from excess moisture within the structure.
Some chemical contamination and health risks are beyond the expertise of a home inspector. Visible mould would require the services of a mould investigator.
If a specific defect is identified, it must be disclosed. In addition, registrants may want to include the following clause into the Agreement of Purchase and Sale:
REP/WARR-1: Seller Not Liable
The Buyer acknowledges the Buyer has been informed of the following possible latent defect(s) in the property: __________________________ .
The Buyer further acknowledges it is the Buyer’s sole responsibility to complete their own due diligence concerning this defect, for example, obtaining a report concerning this defect, and the Buyer releases the Seller of all liability for current and future damages resulting from this possible defect.
Another aspect of due diligence vis-à-vis residential real estate relates to stigmatized property. These types are properties are shunned for reasons unrelated to the house’s physical condition or features. Examples include a suicide/murder/death on the property, or rumours the house is haunted. Failure to provide full disclosure about these properties may lead to legal proceedings/lawsuits, and disciplinary action by RECO.
Due diligence also applies to title defects and easements. Both are covered in the Agreement of Purchase and Sale.
Finally, although it is neither mandatory nor a warranty, registrants may want to advise seller clients to complete the Seller Property Information Statement (SPIS). The form enables sellers to provide information about the property under three main headings – general, environmental, and improvements and structures. General information would include third-party ownership interests, leases, easements, encroachments, surveys, zoning, restrictive covenants, and taxes. Environmental information would include possible soil contamination, flooding, oil tanks, and grow houses. Improvements and structures would include known structural problems, renovations, and any moisture and/or water problems.
Because an SPIS is not a warranty, buyers must still make their own enquiries regarding the property.
Commercial Real Estate
In commercial real estate, due diligence means taking all reasonable steps to confirm financial, legal, structural, zoning, and environmental concerns. It is a lot more expansive than due diligence for residential real estate.
In this context, due diligence can range from a straightforward direct inquiry by the prospective buyer to a team of accountants, lawyers, and other professionals scrutinizing every aspect of a business or investment property and developing a substantial, customized audit. Whatever the extent, the ultimate goal is full knowledge of relevant facts.
Following is a brief description of due diligence as it relates to financial/operational, legal, structural, and environmental concerns: [this is not an exhaustive list]
Financial/Operational Audit:
- for an income-producing property – analysis of documents, such as income statements, balance sheets, rent rolls and leases, bank statements, tax bills and returns, employee records, operating costs
- analysis of seller supplied documents, such as financial records, lease documents, inventory of equipment and other assets, utility bills, building service contracts, and insurance policies
Legal Audit:
- title to the property and major assets
- existing mortgages and other encumbrances
- surveys
- licences
- contracts
- permits
- zoning compliance
Structural (Building Condition Report) Audit:
- visual inspection of the building
- review of relevant documentation (and interviews, if necessary)
- identification of physical deficiencies
- photo documentation
- detailed summary report
Please note: Many inspection reports are now completed in accordance with the ASTM (American Society of Testing and Materials) International standards. This guideline details standards and procedures for all aspects of the research process, the identification of physical deficiencies, and the final property condition report.
Environmental Audit:
- hazards
- contamination
Environmental audits are broadly grouped under three levels of analysis, referred to as phases. Phase 1 and Phase 2 audits could apply in the case of due diligence. Phase 3 involves remedial work.
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References
Burgard, M. (2005). Commercial properties: commercial transactions, question 1708. Legal Forum. Retrieved from http://www.orea.com/Members/Legal-Forum/Commercial-Properties/Commercial-Transactions/Question_1708.
Burgard, M. (2006). Miscellaneous: legal concepts, question 1974. Legal Forum. Retrieved from http://www.orea.com/Members/Legal-Forum/Miscellaneous/Legal-Concepts/Question_1974.
The Commercial Real Estate Transaction, 2012.
The Real Estate Transaction – General, 2012.
The Residential Real Estate Transaction, 2012.
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