Who should pay for phase I diligence on a wholesale deal, the wholesaler or the eventual buyer

Question

Take a 35 day diligence window on a 19,000 square foot older retail and service building, two bays, one former dry cleaner space from the 80s that everybody in the chain of title seems to have politely ignored. Say the property is under contract at a price that works, with maybe six buyers who touch this shape of asset. Typical quotes: phase I around $3,400, property condition assessment around $2,900, ALTA survey around $4,300. Call it $10,600 if everything gets ordered up front, and if the deal dies or no assignee is found, that money is spent with nothing to show. The case for ordering it as the wholesaler: the dry cleaner history is exactly the kind of thing that makes a buyer walk before they even look at the rent roll. Handing over a clean phase I, or one with a defined recommendation and a cost, sells a known quantity instead of a question mark. Buyers who have to order their own reports also build in an extra 30 days, and that is 30 days of renegotiation risk. The case against: the wholesaler does not own the building. Every dollar spent on third-party reports becomes a sunk cost in someone else's asset, and sophisticated buyers usually want reports in their own name anyway. Funds with in-house diligence teams will often ignore what is sent and order it again, which argues for spending nothing and putting the money into more tie-ups instead. Both approaches work on different deals, and the sample size needed to prove either one out is larger than most operators think.

samantha_ruiz · Answer

My rule was nothing out of pocket until the assignment is signed and the buyer's deposit is hard. I held that line for about a year and it mostly worked, then I lost a four tenant flex deal because the buyer's own environmental came back with a phase II recommendation on day 40 and by then my seller had another offer and no patience left. Would the report have changed the answer if I'd ordered it on day 5? Maybe not the finding. It would have changed who was standing there when the finding landed.

So I softened it. Phase I I'll pay for when there's a use history that scares people, which is the situation you're describing. Survey and PCA never, those are the buyer's problem and their lender will want them fresh anyway.

aliyah_b · Answer

@brandonlee36 the part I don't understand yet is whether the report you order is even usable by your buyer. When I've read about this the report gets issued to whoever engaged the firm, and someone else relying on it needs a reliance letter, which the firm may charge for or may just decline. If your two funds have to re-order regardless, then your $3,400 buys you a talking point rather than a document, and I'd want to know the price of the reliance letter before I decided anything.

Also, does spending the money change what you have to tell the seller or the next buyer if it comes back ugly? That feels like the actual risk in your $10,600, not the $10,600.

hannah_west29 · Answer

Put numbers on it and it stops being a philosophy question. Say the assignment fee here is $55k. Say without a phase I the odds of assigning inside the window are 45%, and with one they're 65%. That's a 20 point swing on $55k, so $11,000 of expected value against $3,400 of certain cost. Order it. Now say the swing is only 5 points because all six buyers are going to re-order anyway. That's $2,750 against $3,400 and it's not worth ordering. Same deal, same building, opposite answer, and the only input that moved was the read on buyer behavior. So the honest work here is figuring out an operator's own hit rate, which nobody wants to do because the number is usually worse than assumed. @samantha_ruiz raised the real data point though. The value wasn't the report, it was controlling when the bad news arrived.

Rena Expert · Answer

The transferability question @aliyahb raised is the one that decides most of this. Environmental and engineering reports are generally issued for the benefit of the party in the engagement letter, and a third party who wants to rely on the findings normally needs a reliance letter from the consultant, sometimes for a fee, sometimes refused outright. Ask the firm about reliance terms before you sign the proposal, not after the report lands. Lenders also apply their own standards on report age and on which consultants they accept, and those standards differ lender to lender, so confirm in writing with the lender your buyer expects to use rather than assuming a report has general currency. On @hannahwest29's framework, the input doing the work is not really your hit rate. It's whether the unknown is what's blocking the assignment. If your buyers are asking about the dry cleaner space, information is your constraint and buying it early is rational. If they're passing on price or on the submarket, a clean phase I changes nothing and you've bought yourself a nicer looking dead deal. One caution on your last paragraph, @aliyah_b. Once a wholesaler holds a report showing a recognized environmental condition, what has to be disclosed to a subsequent buyer, and to whom, is a state law question and it varies. Some states impose affirmative disclosure duties that a contract can't paper over. Get that answered by an attorney licensed where the property sits before you order anything, because the answer shapes whether you want the knowledge at all.

Who should pay for phase I diligence on a wholesale deal, the wholesaler or the eventual buyer

4 replies