What’s in Your Orchestra? Evaluating the "Bundle of Sticks" in Your Real Estate Transaction
Developing real estate can be a lot like building an orchestra from scratch. In order to build an orchestra, management will of course hire musicians. By custom, not all musicians bring their own instruments. Management will also need to know which instruments (e.g., percussion and keyboard instruments) need to be purchased. Along with purchasing instrument, management needs to get concert space, advertising, music rental and other equipment necessary for a performance.
Acquiring commercial real estate is a lot like an orchestra in that purchasing real estate consists of purchasing many more assets than meets the eye. When you buy commercial real estate, you know you are getting the land and buildings. Yet, as with an orchestra, there are leases, contracts, personal property and intellectual property, which also may be part of a real estate acquisition.
In law school, professors refer to real estate as a “bundle of sticks.” This refers to the different types of ownership rights that comprise a fee simple interest in real estate. Some of these rights include the right to current possession, future possession, easements, air rights, and the like.
What law professors don’t talk about as much is that, in addition to the land and buildings, there are a lot of other things purchaser buy along with commercial real estate.
What Are You Buying with Your Real Estate
For instance, the buyer may also purchase personal property like lobby or computer equipment, exercise equipment, kitchen appliances, or maintenance and repair inventory. If a purchaser assumes an existing mortgage loan, then the purchaser usually will assume both the benefits and obligations under the loan documents.
The purchaser also may assume rights or obligations under contracts and leases, obligations to pay public utility bills or special assessments, or rights to intellectual property (such as trade names, URLs, trademarks, or copyrighted designs). A buyer may even “inherit” the former owner’s claims history under insurance policies and employee benefits.
When a buyer purchases a real-estate-based business, such as a hotel or senior housing community, the buyer also will acquire goodwill associated with the business.
Don’t Be Surprised!
Failure to understand what is being bought and sold can lead to unpleasant surprises after closing. For example, a purchaser of an apartment complex showed up after closing to find all computer equipment had been removed from the leasing office. That made it impossible for the buyer to access tenant records from cloud storage until the buyer bought new equipment. As it turns out, the computers that the seller had used were not included in the sale. The seller's property management company owned them.
The new owner of an assisted living facility discovered that it was unable to replace an expensive, monstrous multi-function copier even though it took up half of the office, was expensive, and had capabilities beyond what the facility would ever need. The owner had assumed all of seller's operating contracts. Among those contracts was a five-year lease for the copier–with three years left on the lease.
A seller of an apartment building learned that even though it had not sold the right to collect delinquent rent, that it could not collect delinquent rent after the sale. The contract said that the seller was not selling its accounts receivable - but the contract also prohibited the seller from attempting collection from any tenant that continued to reside in the building. In addition to not being able to collect the rent, seller had to pay a collection agency cancellation fees for collections.
These unpleasant surprises could have been prevented through careful review of the real estate purchase contract and thorough due diligence.
What Does Your Contract Say You Are Buying?
One of the most important provisions in a real estate purchase contract the description of what is being bought and sold. This crucial provision often is either in the recitals to the contract or in the definitions section. Often the lengthy list of items being bought and sold is overlooked as boilerplate.
The first step in determining what is going to be bought and sold is to determine whether the transaction will involve the sale of an entity, such as a corporation or limited liability company or whether just assets will be sold. If the entity (LLC or corporation) is sold, the buyer will acquire all assets and liabilities associated with the real estate or business.
If, as is more common, the buyer is acquiring only assets, then the parties must agree what assets will be acquired. Most assets fit into one of three categories–real estate, personal property, and intangible property.
Real estate includes the land and buildings on the land, but it should include much more. The buyer should take title to any easements and license rights, access rights, water rights, mineral rights, air rights, and other rights owned by the seller. The buyer also should take title to any fixtures (personal property, such has HVAC units, which has been “attached” to the real estate).
Buyers and sellers also should agree on what liens and encumbrances the buyer is accepting. Most buyers will want to have all tenant leases assigned to them, as they produce the revenue stream for the property. A buyer may not be as excited about a laundry lease or cable lease, which results in antiquated services or produces below-market revenue. The buyer and seller should address these issues in the real estate contract.
Most real estate purchase contracts also include acquisition of at least some personal property. The types of personal property will depend upon the real estate asset class involved. Personal property might include refrigerators in rental units, exercise machines in the fitness room, computer equipment in the office, lounge chairs in a pool area, maintenance supplies and equipment, janitorial supplies and equipment, office or lobby furniture, or landscaping, snow removal, or even kitchen equipment.
Intangible property includes phone numbers, domain names, trademarks, trade names, licenses, social media accounts, permits, software licenses, contract rights, and certain other intellectual property. Intangible assets usually will be transferred to a buyer. If licenses and permits are not transferrable, buyer will need to apply for new licenses and permits.
The seller also may have assets, such as accounts receivable, cash, or prepaid rent, which do not fit perfectly into any of the three categories. Prepaid rent should be pro-rated between buyer and seller. Sellers generally will keep their accounts receivable and cash.
Finally, the contract should say whether the buyer (or its management company) may make employment offers to the individuals currently working at the property. Good on-site personnel at real estate can be valuable assets that can help to make an ownership transition run like clockwork.
Conduct Good Due Diligence.
When conducting due diligence, many buyers focus only on the condition of the real estate. The buyer also should learn what assets seller owns that buyer will need to operate the property. Buyers should ensure that the list of property they are buying includes all assets necessary to operate the property.
Buyers should ensure that seller owns the personal and intangible property used to operate the real estate. Buyers should also determine the condition of personal property and the terms of any personal property leases.
The buyer should confirm that any contract, license, or permit rights it wants to assume are transferrable. And, the buyer should determine whether there are specific forms or processes required for those transfers.
If, during due diligence, the buyer determines that assets aren't listed in the purchase contract, then the contract should be modified. Likewise, if the buyer discovers some listed assets are not owned by the seller, the buyer might ask that seller purchase those assets (e.g., by buying out a lease). Or, the buyer might ask for a reduction in the purchase price or a seller allowance to provide buyer with the funds to purchase the needed items.
Read Your Closing Documents
Finally, buyers and sellers alike should work with their attorneys to be sure that the closing documents are consistent with the real estate purchase contract. There should be a bill of sale (used to transfer title to personal property), an assignment of leases, and an assignment of intangible property.
Some assets, such as motor vehicles, trademarks, permits, and domain names, can only be transferred using special forms. Seller should sign all forms required to transfer those assets at closing.
With careful planning and the right people, instruments, license rights, and contract rights, an orchestra can have a smooth concert season. Likewise, a real estate buyer can experience a smooth ownership transition if it assures that it is buying the necessary personal property, intangible property, and contracts for personnel, in addition to the real estate.
© 2018 by Elizabeth A. Whitman
DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information contained in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless and until a written contract is signed by all parties and any conditions in such contract are satisfied.