Disclosure Issues in Commercial Real Estate Transactions
A general overview for sellers of commercial real estate located in Arizona and California regarding required disclosures about the condition of the property, its prior uses, and activities in the surrounding area that might affect the property’s desired use.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
According to one recent survey, eight states (California, Maine, Michigan, New Hampshire, Minnesota, Tennessee, Texas, and Washington) have specific disclosure requirements applying to sales of commercial property. See State of Conn. Gen. Assembly, Office of Legis. Research, 2013-R-0317 (Conn. 2013)
Washington is the only state that requires sellers of commercial property to disclose certain information via a mandatory commercial disclosure form. See Wash. Rev. Code 64.06.013 (West 2012). This form requires information about the property title; water rights; sewer system; building structure, systems and fixtures; and environmental issues.
In several states, a seller may voluntarily complete a commercial disclosure form. For example, the Arizona Association of Realtors (“AAR”) created a disclosure form
to help a seller of commercial property inform a prospective buyer about the property. This four-page form is entitled the "Commercial Seller’s Property Disclosure Statement" (SPDS) and contains nine sections:
- Ownership and Property Identification
- Property Type
- Access Use
- Compliance with Law/Legal Matters
- Contractual Obligations
- Environmental Factors
- Material Physical Defects and Other Factors
With over 130 questions, the SPDS inquires into dozens of issues, including zoning, parking, signage, leases, contracts, security lighting, flooding, and mold.
Commercial Real Estate Disclosures in Arizona
Under Arizona law, a buyer and seller of commercial real estate have legal duties to each other arising out of their contractual relationship, including the duty to disclose facts that are material to the transaction. Lombardo v. Albu, 199 Ariz. 97, 99, 14 P.3d 288, 290 (2000) (en banc) (citations omitted)). If a seller knows that material facts affecting the value of the property are unknown to the buyer, the seller has a legal duty to disclose such facts, regardless of whether or not the buyer inquired into the subject. Id.
(citing Hill v. Jones, 151 Ariz. 81, 84–85, 725 P.2d 1115, 1118–19 (Ct. App. 1986)). Under this rule, a “matter is material if it is one to which a reasonable person would attach importance in determining his choice of action in the transaction in question.” Hill, 151 Ariz. at 85–86, 725 P.2d at 1119–20.
If a prospective buyer inquires about an aspect of the property, a seller must disclose the information, regardless of whether or not the information is material. Universal Inv. Co. v. Sahara Motor Inn, Inc., 127 Ariz. 213, 215, 619 P.2d 485, 487 (Ct. App. 1980). A seller also has the duty to disclose facts when disclosure is necessary to prevent a previous statement from being misleading or a misrepresentation, e.g., if the condition of the property changes.
On the other hand, if the buyer makes no inquiry and relies upon his own inspection of the property, he has no right to rely on the seller’s silence as to alleged defects in, or physical conditions of, the property that are discoverable upon diligent inspection. Id.
at 214, 619 P.2d at 486. This rule is specifically applicable to property that is sold “as is,” because an “as is” clause in a commercial sales contract puts the buyer on notice that the property may be defective and precludes the buyer from justifiably relying on the seller’s silence as a warranty of fitness. Id.
at 215, 619 P.2d at 487. Of course, the seller may be held liable for negligent disclosure if the buyer is prevented from discovering any defects. S Dev. Co. v. Pima Capital Mgmt. Co., 201 Ariz. 10, 16, 31 P.3d 123, 129 (Ct. App. 2001).
To that end, “a [seller] must disclose latent defects in property that are known to the [seller], notwithstanding the existence of a burden-shifting ‘as is’ clause or disclaimer of warranties.” Id.
A latent defect is “[a] hidden or concealed defect. One which could not be discovered by reasonable and customary observation or inspection . . . .” Id.
(quoting Black’s Law Dictionary 611 (6th ed. 1991)). Because the very nature of a latent defect precludes the discovery of the defect upon a reasonable inspection, this rule prevents commercial sellers from concealing latent defects and then “hid[ing] behind contract language purporting to shift the risk of nondisclosure to the purchaser.” Id.
(quotation omitted). “As is” provisions will be discussed further infra.
The disclosure of certain material facts and latent defects is required because Arizona law “implies a covenant of good faith and fair dealing in every contract” so that “neither party will act to impair the right of the other to receive the benefits which flow from their agreement or contractual relationship.” Id.
(quoting Rawlings v. Apodaca, 151 Ariz. 149, 153, 726 P.2d 565, 569 (1986)).
The duty to disclose information is not a one-way street—a buyer of commercial property may also have a duty to disclose certain information. Lombardo, 199 Ariz. at 99, 14 P.3d at 290. For example, because the main consideration flowing from a buyer to a seller is the purchase price, Arizona courts hold that a buyer has a duty to disclose to the seller facts that are critical to the buyer’s ability to perform the transaction. See Id.
; see also Wells Fargo Bank v. Ariz. Laborers, Teamsters & Cement Masons Local No. 395 Pension Trust Fund, 201 Ariz. 474, 485, 38 P.3d 12, 23 (2002).
Under certain circumstances, nondisclosure of a fact is the same as asserting the fact does not exist. Consequently, nondisclosure procures the same legal effect as fraud, which can result in civil liability. See, e.g., Hill, 151 Ariz. at 85, 725 P.2d at 1119 (noting that nondisclosure is given the same legal effect as fraud and misrepresentation); Alaface v. Nat’l Inv. Co.,
181 Ariz. 586, 598, n. 3, 892 P.2d 1375, 1387, n. 3 (Ct. App. 1994) (“Negligent misrepresentation may be by omission or nondisclosure of material facts as well as by overt misrepresentation.” (citations omitted)). As explained by Lerner v. DMB Realty, LLC,
the Restatement (Second) of Torts (hereinafter “Restatement”) provides that nondisclosure constitutes:
1. One who fails to disclose to another a fact that he knows may justifiably induce the other to act or refrain from acting in a business transaction is subject to the same liability to the other as though he had represented the nonexistence of the matter that he has failed to disclose, if, but only if, he is under a duty to the other to exercise reasonable care to disclose the matter in question.
2. One party to a business transaction is under a duty to exercise reasonable care to disclose to the other before the transaction is consummated,
(a) matters known to him that the other is entitled to know because of a fiduciary or other similar relation of trust and confidence between them; and
(b) matters known to him that he knows to be necessary to prevent his partial or ambiguous statement of the facts from being misleading; and
(c) subsequently acquired information that he knows will make untrue or misleading a previous representation that when made was true or believed to be so; and
(d) the falsity of a representation not made with the expectation that it would be acted upon, if he subsequently learns that the other is about to act in reliance upon it in a transaction with him; and
(e) facts basic to the transaction, if he knows that the other is about to enter into it under a mistake as to them, and that the other, because of the relationship between them, the customs of the trade or other objective circumstances, would reasonably expect a disclosure of those facts.
234 Ariz. 397, 322 P.3d 909, 916 (Ct. App. 2014) (quoting Restatement § 551); see also Frazier v. Sw. Sav. & Loan Ass’n,
134 Ariz. 12, 17, 653 P.2d 362, 367 (Ct. App. 1982) (adopting Restatement § 551).
In Frazier, the plaintiff purchased several lots in a subdivision from the group building the subdivision. 134 Ariz. at 14, 653 P.2d at 364. The group had entered into a financing arrangement to pay for the construction. Id.
While meeting with the plaintiff and the financing company, representatives of the group told the plaintiff that the subdivision had obtained city and state approval and was “ready to go,” even though no public reports had been filed and substantial work needed to be done on the road bordering the subdivision before building permits could be issued. Id.
The financing company did not inform the plaintiff of either of these misstatements. Id.
After the plaintiff bought the property and learned of the additional requisite work, he sued the financing company for not disclosing the group’s misstatements. Id.
The court reasoned that in order to hold the company liable for nondisclosure, the plaintiff needed to prove it had actual knowledge of the falsity of the statements. Id.
at 18, 653 P.2d at 368. The plaintiff was unable to meet this burden, and, therefore, the court ordered a directed verdict be granted to the company. Id.
at 19, 653 P.2d at 369.
If the buyer in a commercial, arms-length transaction could have discovered a material defect in the property upon diligent investigation, the seller will not be liable for non-disclosure, even if the seller knew of the defect. Universal, 127 Ariz. at 214, 619 P.2d at 486. In Universal, the seller of a motel knew the motel’s electrical system was in violation of the city code but did not inform the purchasers. Id.
Instead, the contract provided the motel “will be accepted in an ‘as is’ condition, except the pool will be cleaned and painted.” Id.
The buyer inspected and approved the premises, but upon closing, the buyer was notified by the city that the electrical system was in violation of the city code. Id.
After the electrical service was discontinued and the motel closed, the buyer sued the sellers for fraudulent concealment and nondisclosure. Id.
Ultimately, the court held that even though the seller failed to disclose the known violations which “were material under the circumstances,” the seller did not have a legal duty to disclose the violations to the buyer and the buyer did not have the right to rely on the seller’s silence. Id.
The court reasoned because the sale was an arms-length transaction, no special relationship existed that would give rise to a duty to disclose. Id.
(citing Klinger v. Hummel, 11 Ariz. App. 356, 464 P.2d 676 (Ct. App. 1970)). The court opined that if the buyer had inquired about the condition of the electrical system, a duty of disclosure would have been placed on the seller to disclose all it knew. Id.
However, because the buyer made no inquiry and made its own inspection of the system, the court reasoned the “as is” clause implied that the property was in some way defective and the buyer could not justifiably rely on the seller’s silence as a representation that the electrical system met code specifications. Id.
Accordingly, because the buyer “knew or should have known” of the “material defects,” the court ordered the lower court to enter judgment to the sellers. Id.
at 216, 619 P.2d at 488.
In Abromovitz Inv. Props., L.L.C. v. Red Eyed Jack Sports Bar, Inc., the plaintiff entered into sales negotiations with a part-owner of a piece of commercial real estate. 2014 Ariz. App. Unpub. LEXIS 490, 15–17 (Ariz. Ct. App. 2014). Despite owning only one-half of the property, the seller claimed that he owned all of the property, the property was not encumbered, and he could convey the property. Id.
Moreover, the seller failed to disclose he knew the other part-owner had not and would not give consent to sell the property and that his agent had entered into a contract to force the other part-owner to buy him out. Id.
The court held that the seller defrauded the buyer by “making statements it knew were false and disclosing some facts while concealing others.” Id.
In Formento v. Encanto Bus. Park, the plaintiffs bought an industrial property lot from the defendants. 154 Ariz. 495, 496, 744 P.2d 22, 23 (Ct. App. 1987). During negotiations, the defendants told the plaintiffs that the lot’s zoning classification permitted construction of forty-foot buildings on the property. Id.
After learning the lot had a one-story height restriction, the plaintiffs sued for misrepresentation. Id.
The defendants claimed the plaintiffs should have reviewed the lot’s zoning file at the zoning office, and because they did not, should not be able to recover. Id.
The court reasoned when a “positive, distinct and definite representation regarding the zoning status of the property is made, the buyer is entitled to rely on that representation with no duty to make independent inquiry.” Id.
at 500, 744 P.2d at 27. Accordingly, because the plaintiffs relied on the defendants’ statements, the court held that the plaintiffs pled a valid claim for misrepresentation. Id.
; see Barnes v. Lopez,
25 Ariz. App. 477, 480, 544 P.2d 694, 697 (Ct. App. 1976) (holding that a buyer of commercial real estate has a “right to rely” on a seller’s representations that the property is zoned entirely for business despite and has “no duty to make further inquiry”).
Commercial Real Estate Disclosures in California
Similar to Arizona, California law provides that “where the seller knows of facts materially affecting the value or desirability of the property which are known or accessible only to him and also knows that such facts are not known to, or within the reach of the diligent attention and observation of the buyer, the seller is under a duty to disclose them to the buyer. . . . Failure of the seller to fulfill such duty of disclosure constitutes actual fraud.” Lingsch v. Savage,
213 Cal. App. 2d 729, 735, 29 Cal. Rptr. 201, 204 (Ct. App. 1963).
In California, the elements of a cause of action for damages for fraud based on nondisclosure are: (1) nondisclosure by the defendant of facts materially affecting the value or desirability of the property; (2) Defendant’s knowledge of such facts and of their being unknown to or beyond the reach of the plaintiff; (3) Defendant’s intention to induce action by the plaintiff; (4) inducement of the plaintiff to act by reason of the nondisclosure and (5) resulting damages. Id.
at 738, 29 Cal. Rptr. at 206.
In addition to common law requirements, California imposes numerous statutory disclosure obligations upon sellers of commercial real estate. For example, a seller must disclose whether the property is located in one of several hazard areas, including a “special flood hazard area,” “potential flood area,” “very high fire hazard severity zone,” “earthquake fault zone,” “seismic hazard zone,” or “wildland area” that may contain substantial forest fire risks and hazards. Cal. Civ. Code § 1103 (West 2005). Other statutory disclosures include:
- Environmental hazards (Cal. Health & Safety Code § 25359.7 (West 1999))
- Delivery of a DRE booklet regarding hazardous substances (Cal. Bus. & Prof. Code § 10084.1 (West 1991); Cal. Health & Safety Code § 25417 (West 1989); Cal. Civ. Code § 2079.7 (West 1989))
- Asbestos (Cal. Health & Safety Code §§ 25915.2, 25915.5 (West 2014))
- Certification of strapping of hot water heaters (Cal. Health & Safety Code § 19211 (West 1989))
- Disclosure if the seller is a foreign person (26 U.S.C.A. §§ 897, 1445; Cal. Rev. & Tax. Code § 18662 (West 2009))
- Delivery of earthquake guide for commercial property (Cal. Bus. & Prof. Code § 10147 (West 2013); Cal. Gov’t Code § 8893.2 (West 1991))
- Property’s location within airport influence area (Cal. Bus. & Prof. Code § 11010(b)(13)(A) (West 2013)).
On July 1, 2013, California also began requiring commercial property sellers to make disclosures on building energy use and consumption information. Cal. Pub. Res. Code § 25402.10 (West 2011). The required information includes (1) energy usage data from the prior 12 months and (2) the building’s ENERGY STAR performance score. Id.
On July 1, 2014, the energy consumption law became applicable to commercial buildings over 5,000 square feet. Cal. Code Regs. tit. 20, § 1682 (2014).
California courts have held scores of commercial real estate sellers liable for nondisclosure of material facts relating to the physical condition of the property. See, e.g., Hodgeson v. Brant,
156 Cal. App. 2d 610, 319 P.2d 684 (Ct. App. 1958) (holding that the buyer of a motel was entitled to rescission of the contract where a swimming pool, retaining wall, and parking area were integral parts of the property’s premises and plaintiff relied on the seller’s representations that the motel was well built and in good condition but the pool and wall and parking area were poorly constructed and structural defects in the areas materially affected the value of the property); Lingsch, 213 Cal. App. 2d at 735, 29 Cal. Rptr. at 204 (holding that the purchaser of a building pled a valid claim for fraud because the buyer alleged the seller knew, but did not disclose, that the building was in disrepair, contained illegal units, and had been condemned); Sanfran Co. v. Rees Blow Pipe Mfg. Co., 168 Cal. App. 2d 191, 335 P.2d 995 (Ct. App. 1959) (holding that the seller of a commercial building was liable for deceit because the seller knew, but did not disclose to the buyer, that the building contained several building code violations); Kramer v. Musser,
57 Cal. App. 2d 942, 943–44, 136 P.2d 74, 75 (Ct. App. 1943) (holding that the seller of a commercial building was liable for misrepresentation when he told the buyer that the building was free from termites and dry rot when he knew the building had been infested by both); Kallgren v. Steele,
131 Cal. App. 2d 43, 46, 279 P.2d 1027, 1029 (Ct. App. 1955) (holding that the sellers of a resort located on public land had the duty to disclose to purchasers that a portion of the resort was located within a public right-of-way and could be taken at any time by the federal forest service); Green Trees Ents., Inc. v. Palm Springs Alpine Estates, Inc., 66 Cal. 2d 782, 785, 427 P.2d 805, 807 (1967) (en banc) (decreasing the purchase price of commercial property by one-half because the seller falsely represented to the buyer that the property contained adequate water rights to support the buyer’s planned use of the land when, in fact, the lots did not have enough water).
California courts have also held commercial sellers liable for concealment of non-physical features of the property. See, e.g., Ach v. Finkelstein, 264 Cal. App. 2d 667, 70 Cal. Rptr. 472 (Ct. App. 1968) (holding that purchasers of an apartment building were entitled to damages because the sellers did not disclose rent concessions given to tenants but rather inflated rentals above their true market value); Storage Servs. v. Oosterbaan, 214 Cal. App. 3d 498, 262 Cal. Rptr. 689 (Ct. App. 1989) (holding that sellers of commercial property had duty to disclose that the state was interested in buying the property for future development after the seller’s agent represented the state had no such interest); De Spirito v. Andrews,
151 Cal. App. 2d 126, 311 P.2d 173 (Ct. App. 1957) (holding the seller of a nightclub liable for nondisclosure when the seller did not disclose that the property did not have the required government permits to operate a particular business on the premises that the buyer intended to operate).
Under California law, commercial real estate brokers are not required to inspect and disclose to prospective buyers all facts materially affecting the value or desirability of property that such investigation might reveal. Smith v. Rickard, 205 Cal. App. 3d 1354, 254 Cal. Rptr. 633 (Ct. App. 1988). In Smith, after being asked by the buyer whether trees on a piece of commercial property had “root rot,” the real estate broker for the seller did not investigate the health of the trees, but simply responded: “Not to my knowledge.” Id.
at 1357–58, 254 Cal. Rptr. at 634–35. Unfortunately, the trees did indeed have root rot—a disease significantly affecting the value of the property. Id.
at 1358, 254 Cal. Rptr at 635. The court reasoned that a broker in a commercial transaction has no duty to inspect the property in order to disclose to the buyer facts that would affect value or desirability of the property. Id.
at 1360, 254 Cal. Rptr. at 636. Accordingly, the court held that the real estate broker did not have a duty to inspect the trees to determine if they had root rot. Id.
In Sweat v. Hollister,
the purchasers of commercial real estate sued the sellers alleging negligence and misrepresentation based on a disclosure document stating there was no “nonconforming use” relative to the property. 37 Cal. App. 4th 603, 606, 43 Cal. Rptr. 2d 399, 400 (Ct. App. 1995). The disclosure document revealed the property was in a designated floodplain, but the buyers alleged that the sellers were liable for failing to disclose that because of the floodplain designation, the local municipal code prevented the property from being altered or enlarged in the event of destruction by fire or other calamity, which the buyers claimed materially reduced its value. Id.
at 606–08, 43 Cal. Rptr. 2d at 400–02. The court reasoned the sellers did all they had to do when they informed the buyers that the property was in the floodplain. Id.
The court noted “[t]he existence and effect of city ordinances regulating rebuilding or improvement of a house in a floodplain constitute information as readily available to the plaintiffs as to the defendants.” Id.
Accordingly, because “[a]ctionable nondisclosure relates to facts not discoverable by the plaintiffs,” the court held there was no triable issues of material fact and affirmed summary judgment for the sellers. Id.
Other states impose statutory disclosure obligations upon sellers of commercial property, as well. For example, Texas requires sellers of commercial property to provide the buyer with a copy of each Certificate of Mold Damage Remediation issued for the property during the previous five years. Tex. Occ. Code Ann. § 1958.154(b) (West 2005). Texas law also requires sellers of property containing underground or aboveground storage tanks to provide written notice to the buyer of the tank owner’s obligations to register and comply with self-certification and certain construction and notification requirements. 30 Tex. Admin. Code § 334.9.
As mentioned supra, Washington requires sellers of commercial property to disclose a wide range of concerns to prospective buyers via a mandatory disclosure form. Wash. Rev. Code § 64.06.013 (West 2012). The disclosure form is required to be supplied to the buyer before a commercial property closing, unless the buyer waived the right to receive it.
As mentioned supra, Arizona follows the Restatement’s guidance regarding nondisclosure liability. Amiably, in its comments, the Restatement provides a few examples of this cause of action:
A, who owns an amusement center, sells it to B without disclosing the fact that it has just been raided by the police, and that A is being prosecuted for maintaining prostitution and the sale of marijuana on the premises. These facts have seriously affected the reputation and patronage of the center, and greatly reduced its monthly income. A knows that B is unaware of these facts, could not be expected to discover them by ordinary investigation and would not buy if he knew them. He also knows that B believes A to be a man of high character, who would disclose any serious defects in the business. A is subject to liability to B for his pecuniary loss in an action of deceit.
A sells a summer resort to B, without disclosing the fact that a substantial part of it encroaches on the public highway. A knows that B is unaware of the fact and could not be expected to discover it by ordinary inquiry, and that B trusts him to disclose any such facts. A is subject to liability to B for his pecuniary loss in an action of deceit.
The Infamous “As Is” Provision
Many sellers of commercial real estate believe placing an “as is” provision in the sales contract will insulate them from liability. Sellers insert this language intending that such provision will relieve them from liability for failing to disclose a defect in the property which is not known to the buyer. While this may work in a few situations, “a party cannot free himself from fraud by incorporating an integration clause in a contract.” Formento, 154 Ariz. at 496, 744 P.2d at 23 (quotation omitted); see, e.g., Lingsch, 213 Cal. App. 2d at 742, 29 Cal. Rptr at 209 (noting that allowing an “as is” provision to negate concealment would be “to permit the seller to contract against his own fraud contrary to existing law”); Shapiro v. Hu,
188 Cal. App. 3d 324, 333–34, 233 Cal. Rptr. 470, 476 (Ct. App. 1986) (“The only exception to [the] principle [that an “as is” provision shields a seller from liability for defects] is when a seller, through fraud or misrepresentation, intentionally conceals material defects not otherwise visible or observable to the buyer”).
Thus, “[b]y operation of law, any provision that, in word or effect, requires the buyer to accept the property as is merely means that the buyer accepts the property in the condition which is visible or observable by him.” Ann J. Rosenthal & R. Stuart Phillips, Tell It Like It Is – Sellers’ Duties of Disclosure in Real Estate Transactions Under California Law, 26 Golden Gate U. L. Rev. 473, 477 (1996). Accordingly, if the seller “fails to disclose material facts regarding the condition of the property which are unknown to the buyer, an ‘as is’ provision is ineffective to relieve the seller of any fraud liability arising from the nondisclosure.” Id.
Moreover, “the existence of an ‘as is’ provision in a purchase contract generally operates only as a waiver of breach of warranty claims, not tort claims.” Pima Capital,
201 Ariz. at 15, 31 P.3d at 128; see Salt River Project Agric. Improv. & Power Dist. v. Westinghouse Elec. Corp., 143 Ariz. 368, 384, 694 P.2d 198, 214 (1984), abrogated by Phelps v. Firebird Raceway, Inc.,
210 Ariz. 403, 111 P.3d 1003 (2005) (en banc) (reasoning that “[w]hile parties to a contract may disclaim responsibility for any potential [tort] liability . . . they must expressly spell out their intention” (quotation omitted)).
At bottom, an “as is” provision in a commercial sales contract may insulate the seller from liability for some defects in the property, but not all. Such a provision will serve to put the buyer on notice of potential defects, but it will not allow the seller to perpetuate a fraud upon an unsuspecting buyer by concealing a known material fact or lateral defects. If the seller knows of a material fact or latent defect in the property that would affect the value of the property and is undiscoverable by the buyer in a diligent investigation, an “as is” provision will not shield him or her from liability.
In summary, a seller of commercial property must disclose any material facts or latent defects he or she knows about the property that affect the value of the property. If the buyer relies on his own inspection and proceeds to purchase the property, he or she may have assumed responsibility for the defects visible upon such investigation. Nevertheless, the best advice for any seller remains simple: when in doubt, disclose. Arizona provides an optional yet exceedingly useful form for sellers of commercial property to fulfill their disclosure obligations — it should always be employed.
If you would like to discuss a commercial real estate sale disclosure issues, we would be happy to consult with you. To arrange a consultation, please contact Robert Mitchell at firstname.lastname@example.org
or at (602) 452-2730.