March 13, 2018

Hassle-free acquisition of commercial real estate

According to the Property Times, in 2017 Ukraine’s economy started showing signs of recovery. This precipitated an increase in consumer demand in the country by more than 7% and led to changes in the expansion strategies among retailers. If in 2016 key retail chains were only realizing one-time projects on opening new outlets, the year of 2017 was marked by continued systematic expansion of chains. Moreover, new outlets were being opened not just in Kiev, but also in regions. One of the most important episodes for the FMCG market last year became the acquisition of nine Caravan hypermarkets by Auchan Group, sale by BILLA Ukraine of its assets in Ukraine’s regions, including to the VARUS chain, and re-opening of the SPAR chain. 2018 should be just as eventful for the FMCG market. In particular, Ukrainian market is expecting entry of IKEA and H&M at the very minimum.

Changes in the balance of power among FMCG market operators in Ukraine inevitably resulted in more deals on real estate acquisition. Most of them were structured as assets deals, less often – as acquisitions of legal entities that owned the assets in question.

The buyer’s main expectation in these deals is assuming legal control over desired assets without the risk of their subsequent loss. To reach this goal and develop the deal’s legal structure, it is necessary to conduct legal due diligence first. Its results allow the buyer to make the final decision whether to enter into the deal or not, and what the deal’s cost is going to be considering the market value of the asset in question and discovered risks. The scope of due diligence (i.e. areas to be inspected) usually depends on the deal’s legal structure: whether it is to be an asset deal or M&A.

Pre-transaction Due Diligence for Sale of Assets

In case of asset deals, the focus is on the target asset itself. Specifically, the results of due diligence should answer the following questions: 1) is the seller the legal owner of the target asset at the time; 2) did the seller acquire the target asset on legal grounds, and does the asset’s sale history contain circumstances that could lead to its loss by the seller or, after the deal is made, by the buyer; 3) does the seller currently have the right to sell the asset, are there any restrictions or encumbrances that limit the buyer’s right to enter into the deal; 4) does the buyer have any mandatory internal procedures that must be complied with to make the deal possible (e.g. general meeting of shareholders regarding the sale of the target asset); 5) is it necessary to get permission from state authorities or local self-government bodies (e.g. such as the permission from the Anti-Monopoly Committee of Ukraine for asset concentration).

During due diligence for asset deals, emphasis is put on the history of the seller’s acquisition of the target asset: adherence to the law when transferring ownership from one owner to another. Detailed study of sale history makes it possible to identify risks (violations) that could cost the buyer his property rights in the future.

The seller’s ownership rights to real estate can by proven by various property titles. According to Art. 328 (1) of the Civil Code of Ukraine of 16 January 2003 No. 435-IV, ownership rights are acquired on the grounds that are not prohibited by the law, specifically on the grounds of transactions. Therefore, it is necessary to establish when and on what grounds the seller acquired the real estate. The most popular grounds of commercial real estate acquisition in Ukraine are: 1) acquisition under contract (e.g. sales contract); 2) granting of real estate to a legal entity by the founder (stakeholder, shareholder) as contribution to the authorized capital; 3) construction of commercial real estate.

Another important aspect of due diligence for asset deals is the land where the target asset is located. This affects both the subsequent use of acquired commercial real estate for its intended purpose by the buyer (e.g. parking lot for visitors of a shopping mall, construction of warehouses for a commercial outlet, etc.) as well as the legal option to proceed with the asset deal. Thus, according to Art. 377 (2) of the Civil Code of Ukraine of 16 January 2003 No. 435-IV, the size and registration number of the land plot where the target asset is located are considered to be essential terms of the contracts on transfer of ownership rights to real estate (with the exception of apartments in apartment buildings). In other words, if the land plot attached to commercial real estate is not registered, it will not be possible to proceed with the deal until it is done. Due to this, land due diligence is also a necessary to step in planning out a deal. It should provide answers to the following questions: 1) is the land attached to the target asset partitioned into a separate land plot; 2) has a registration number been assigned to the land plot; 3) who is the legal owner of the land plot attached to the target asset; 4) by what right (ownership, lease or others) does the current owner own the land plot.

There are often situations when the owner of the real estate and the user of the land plot are different parties. This happens when, for instance, several real estate objects belonging to different owners are located on one land plot. The buyer should take this into account when considering whether to enter into the deal, as well as when planning the deal’s legal structure.

Pre-transaction Due Diligence in M&A

When commercial real estate is bought by acquiring corporate interest (stake, shares) in a legal entity (company) that owns the asset, the scope of due diligence expands significantly. Aside from the real estate object and land plot, the seller company is examined as well. The results are expected to answer the following questions: 1) was the company that owns the asset created on legal grounds; 2) who is the current legal owner (stakeholder, shareholder) of the company; 3) does the company possess all necessary permits (licenses) to conduct business activities; 4) what are the company’s debts; 5) are there any outstanding debts or other obligations that could result in loss of ownership to the target asset; 6) is the company that owns the target asset involved in any court proceedings that could result in significant financial obligations or loss of the target asset, etc. The scope of due diligence might vary based on the nature of the company’s business activities and how long it’s been operating, In any case, the study should last no less than 3 years, this being the standard statute of limitations for most cases under the Ukrainian law.

Since it’s not the commercial real estate itself which is the deal’s subject, but corporate rights (stake, shares) in the company that owns the asset, the history of acquisition of these rights by the seller is also thoroughly inspected. As with due diligence for asset deals, the study of corporate rights’ acquisition allows identifying risks (violations) that could potentially lead to loss of ownership rights to the company in question by the buyer.

In addition, it is recommended to hire auditors or auditing company to perform the due diligence of the company in question. In the course of the audit, it will be possible to check how diligent the company has been in keeping books, submitting reports and paying taxes and other government fees. Aside from that, the audit’s results make it possible to assess the tax reputation of the target company: whether they are honest taxpayers or there are some dubious transactions that indicate that the company is being used for illegal tax optimization, which could result in criminal prosecution and tax penalties, as well as the loss of the commercial assets important to the buyer.

Technical aspect

Aside from legal due diligence and audit, it is recommended to conduct a technical audit of the commercial real estate before entering into the deal. This audit can be divided into 2 primary areas.

First, it is necessary to verify that the actual characteristics of the real estate match those indicated in the seller’s documents. This is about the technical specifications of the real estate, which contains information regarding the structure (configuration, number of rooms and stories) and area (total area, area of each floor and room) of the real estate object. This is done by special organizations – technical inventory bureaus. Such inspections are important not just for determining the actual technical characteristics of commercial real estate, but also because it gives a chance to discover changes in the real estate, which the seller must formalize before the deal can be made. In addition, if the actual area does not match the information given in the seller’s property titles, it is necessary to change them accordingly before the deal can be concluded.

Secondly, it is also recommended to inspect the infrastructure of commercial real estate. In this particular situation, it would be prudent to check not just whether it works, but also whether it is suitable for the purposes of the buyer. It is especially important if prior to the deal the object of real estate was used for some other purpose (for instance, when a warehouse needs to be repurposed into a shopping mall). This aspect is so important due to the high cost of infrastructure modernization and should be taken into account by the parties when discussing the price.

Burden of expenses

Speaking of transactional expenses, it is more cost-efficient to structure commercial real estate acquisition as M&A.

With an asset deal, the parties must agree on the payment for notary services. In accordance with Art. 657 of the Civil Code of Ukraine of 16 January 2003 No. 435-IV, contracts on sale of real estate are subject to obligatory notarization. If this provision is violated, the contract is considered invalid. The cost of notarization is regulated by the law and does not depend on whether it is a public or private notary. The cost is 1% of the real estate’s value.

In addition, buyers usually have to make the payment to the Pension Fund of Ukraine. Thus, as per Articles 1, 2 and 4 of the Act of Ukraine “On Mandatory State Pension Insurance” of 26 June 1997 No. 400/97-VR, the buyer of real estate must pay 1% of the real estate's value indicated in the contract as mandatory state pension insurance. Moreover, as per paragraph 153 of the Decree of the Cabinet of Ministers of Ukraine of 3 November 1998 No. 1740, this payment must be made before the deal is formalized. An exception to this is the first acquisition of real estate in Ukraine when the mandatory state pension insurance fee is not collected.

Special attention should be paid to the tax implications of asset deals. They depend on who the parties to the deal are: individuals or legal entities, whether they are registered as VAT payers or not. The most significant tax implications occur when the deal is between legal entities that pay VAT. In such cases, the seller will assume VAT obligations in the amount of 20% of the value of real estate indicated in the sales contract, but in any case no less than its depreciated value. Subsequently, if prior to the deal the owner of real estate wasn’t actively conducting business activities and had no VAT credit accumulated to cover taxes, he will have to pay a considerable amount of taxes after the deal is concluded. Sellers usually take this into account when determining their price.

Buyers are not exempt from special tax implications as well. It will not be possible to instantly and fully use the cost of buying commercial real estate for reducing the income in order to drive down the corporate income tax. The cost of bought real estate will be used to reduce the income tax in stages in the form of depreciation charges.

M&A deals, on the other hand, are mostly free of these negative side effects. This is due to the fact that they are not subject to notarization and VAT in Ukraine.

In lieu of conclusion

Acquisition of commercial real estate in Ukraine is a complicated process that requires a thorough pre-transaction groundwork, including legal and sometimes fiscal due diligence. This allows to detect and anticipate risks that could result in the loss of target assets as well as to shape the deal’s structure in such a way that will not lead to unexpected losses for the parties.