Commercial real estate due diligence in Germany: Lawyer up and save in the long-run

German property is one of the most reliable assets in Europe. Partly for this reason, modern German commercial property market is considered a seller's market: high-quality properties are snapped up, and realtors mostly prefer working with local clients. A different matter is large and riskier transactions: for instance, international investors are often ready to pay a higher price for the properties with low yield rates but situated in high-end locations than Germans. The buyer should check such real estate with extra scrutiny: the property assessment procedure is known as due diligence.

What does due diligence check for?

Due diligence includes four types of assessment:

1. legal — examining documents associated with the property through its entire life cycle;
2. tax and financial — calculating potential maintenance costs, profitability and liable tax;
3. technical — studying the property's technical condition;
4. risk assessment — assessing prospects for the location’s development and analysing the influence of current and potential business rivals have.

The depth of due diligence may vary depending on the client's preferences. "The audit can address all the fields of law, or just provide answers to the questions the clients ask themselves", lawyer Erika Kindsvater, Tranio's partner in Germany, explained. The property type also affects the audit extent. As a rule, new builds are subjected to less thorough checks: sometimes, it is enough to examine the construction documents (e.g., the observance of the construction permit conditions), the ownership of the plot and the signed rental agreement. "I don't recommend dismissing due diligence completely lest the client fall victim to a confidence trick", Ms Kindsvater said.

For example, a legal audit could include examining:

• the rights of ownership;
• rental agreements, rental guarantee measures;
• insurance agreements;
• other agreements, rights and liabilities (e.g., loan agreements, engineering operations contracts);
• public law requirements (e.g., construction permits, concessions, pre-emption right of the state);
• land plot encumbrances (e.g., the rights of neighbourhoods or the state);
• the tenant's company (the company's structure, its solvency).

How is the audit performed?

Typically, sellers (especially those who offer their properties off-market, via private contacts) do not show the documents to everyone. To access information about the property, the potential buyer needs to address a Letter of Intent (LOI) to the seller and sign a non-disclosure agreement (NDA). After that, the investor discusses the audit extent with the lawyer. For instance, the client can limit the audit to only examining the rights of ownership and rental agreements. The lawyer's team (experts in different fields of law, for example, corporate law, tax law or construction law) issues a list of documents required for the property assessment and sends it to the seller.

After examining the documents, the lawyer draws up a report for the client. It includes information on the audit results, the property characteristics and the issues to resolve before closing the transaction.

Why is it necessary?

Due diligence helps to identify risks, assess the property's potential and make a well-considered decision about the purchase. For instance, identifying a risk could mean the investor has a chance to change the sales agreement and avoid extra costs in the future. Ms Kindsvater told Tranio about a situation when one of her Russian clients was buying a hotel in Bavaria. "The building had been standing there for decades. Having examined the construction documents, we discovered that the hotel had been expanded at a certain point, and the building partly occupied the adjoining land plot owned by the local municipality. The hotel owner did not have an agreement to prove their content to this", Ms Kindsvater explained. According to her, the situation posed two risks to the investor: the owners of the adjoining land plot could require the owner to pay a fine or demolish the part of the building that extended onto their territory. "In the sales agreement, we specified that in the event of the municipality filing a claim against the new owner, the seller should guarantee reimbursal of the correspondent’s expenses", the lawyer said. "And indeed, after the transaction was closed, the municipal territory owner appeared. The seller subsequently had to pay several hundred thousand euros".

In some cases, the audit results could help the investor when negotiating the price. For instance, according to Ms Kindsvater, sellers often promise that buyers would be  able to raise the rental rate. "However, having studied the rental agreement, the lawyer discovers that the rent increase formula is associated with the consumer price index in such a way that the rental rate can only be increased on a very long-term horizon and very insignificantly", she explained. "The buyer's lawyer comes back to the seller and achieves a reduction in the purchase price by using this information".

It is important to stress that the professional activity of German lawyers is subject to compulsory insurance, therefore, when a legal adviser commits an error for which the investor will experience losses in the future, the insurance company compensates the damages incurred. "For example, if the lawyer does not notice that the property is located in a rehabilitation area — a part of the city the municipal authorities are planning to renovate", Ms Kindsvater commented. "In such areas, changing the property usage type requires a permit from the municipality, while the investor buys this property to convert a restaurant to a supermarket, for instance. If the municipality does not give its consent to the change, the investor will receive compensation for the damages incurred by the lawyer's incompetent actions".

Author: Anna Danishek