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1 GLOBAL PRACTICE GUIDEs Definitive global law guides offering comparative analysis from top ranked lawyers USA Regional Real Estate Washington Foster Pepper PLLC chambersandpartners.com 2018

2 WASHINGTON Law and Practice: p.3 Contributed by Foster Pepper PLLC The Law & Practice sections provide easily accessible information on navigating the legal system when conducting business in the jurisdiction. Leading lawyers explain local law and practice at key transactional stages and for crucial aspects of doing business.

3 Law and Practice WASHINGTON Law and Practice Contributed by Foster Pepper PLLC Contents 1. General p Main Substantive Skills p Most Significant Trends p Impact of the New US Tax Law Changes p.6 2. Sale and Purchase p Ownership Structures p Important Jurisdictional Requirements p Effecting Lawful and Proper Transfer of Title p Real Estate Due Diligence p Typical Representations and Warranties for Purchase and Sale Agreements p Important Areas of Laws for Foreign Investors p Soil Pollution and Environmental Contamination p Permitted Uses of Real Estate under Zoning or Planning Law p Condemnation, Expropriation or Compulsory Purchase p Taxes Applicable to a Transaction p Rules and Regulations Applicable to Foreign Investors p Real Estate Finance p Financing Acquisitions of Commercial Real Estate p Typical Security Created by Commercial Investors p Regulations or Requirements Affecting Foreign Lenders p Taxes or Fees Relating to the Granting or Enforcement of Security p Legal Requirements Before an Entity Can Give Valid Security p Formalities When a Borrower is in Default p Subordinating Existing Debt to Newly Created Debt p Lenders Liability Under Environmental Laws p Effects of Borrower Becoming Insolvent p Planning and Zoning p Legislative and Governmental Controls Applicable to Design, Appearance and Method of Construction p Regulatory Authorities p Obtaining Entitlements to Develop a New Project p Right of Appeal Against an Authority s Decision p Agreements with Local or Governmental Authorities p Enforcement of Restrictions on Development and Designated Use p Investment Vehicles p Types of Entities Available to Investors to Hold Real Estate Assets p Main Features of the Constitution of Each Type of Entity p Tax Benefits and Costs p Applicable Governance Requirements p Commercial Leases p Types of Arrangements Allowing the Use of Real Estate for a Limited Period of Time p Types of Commercial Leases p Regulation of Rents or Lease Terms p Typical Terms of a Lease p Rent Variation p Determination of New Rent p Payment of VAT p Costs Payable by Tenant at Start of Lease p Payment of Maintenance and Repair p Payment of Services, Utilities and Telecommunications p Insuring the Real Estate That Is Subject to the Lease p Restrictions on Use of Real Estate p Tenant s Ability to Alter and Improve Real Estate p Specific Regulations p.16 3

4 WASHINGTON Law and Practice 6.15 Effect of Tenant s Insolvency p Forms of Security to Protect Against Failure of Tenant to Meet Obligations p Right to Occupy After Termination or Expiry of a Lease p Right to Terminate Lease p Forced Eviction p Termination by Third Party p Construction p Common Structures Used to Price Construction Projects p Assigning Responsibility for the Design and Construction of a Project p Management of Construction Risk p Management of Schedule-Related Risk p Additional Forms of Security to Guarantee a Contractor s Performance p Liens or Encumbrances in the Event of Non-Payment p Requirements Before Use or Inhabitation p Tax p Sale or Purchase of Corporate Real Estate p Mitigation of Tax Liability p Municipal Taxes p Income Tax Withholding for Foreign Investors p Tax Benefits p Key Changes in Federal Tax Reform p.20 4

5 Law and Practice WASHINGTON Foster Pepper PLLC has 30 members (partners), 11 associates and four of counsel attorneys, with offices in Seattle and Spokane, Washington. The firm maintains one of the largest real estate practices in the region, with more than 40 lawyers dedicated to real estate law, allowing it to provide full-service counsel to large and small, local and national real estate development companies, real property owners, lenders and complex public projects. The attorneys focus on commercial and real estate finance, construction, creditors rights and bankruptcy, environmental and natural resources, investment management, land use and public finance. The firm s key practice areas are commercial and real estate finance; condemnation and eminent domain; condominiums and home-owners associations; distressed real estate, workouts and bankruptcy; leasing; land use, planning and zoning; public/private projects; real estate litigation; and transactional real estate. Authors Gary E Fluhrer is a partner and co-chair of the commercial and real estate finance group whose work includes the representation of local, national and international investors and developers doing business in the Pacific Northwest; development, leasing, financing, acquisition and disposition of projects, portfolio and multistate acquisitions; and workouts of distressed projects. He is a member of the American College of Real Estate Lawyers; the Pacific Real Estate Institute; and the Business Law and Real Property, Probate and Trust Law Sections of the American Bar Association and the Washington State Bar Association. Joseph E Delaney, a partner, is experienced in the practice areas of commercial real estate, leasing and financing transactions; acquisition, disposition and financing of commercial office properties, residential and mixed-use projects; leasing (both landlord and tenant); and environmental and land use law. He is a member of the American Bar Association as well as the Corporate Law and Environmental and Land Use Law Sections of the Washington State Bar Association. Michael D Kuntz is a partner who practices in commercial and residential real estate development and finance; real estate acquisitions, sales, leasing, partnerships, tax, debt and equity financing, and contracting; and affordable housing and tax credit development and financing. He is a member of the Real Property, Probate and Trust Law Section of the Washington State Bar Association and a speaker on topics including affordable housing and multi-family housing., a partner, has practice experience of large and complex entitlement matters and related litigation, as well as land use entitlement for private and public real estate developers of office and mixed-use projects, multi-family housing, commercial and industrial projects. He is chair of the Association of Washington Business Land Use Committee, a member of the Environmental and Land Use Section of the Washington State Bar Association and a regular speaker on topics including recent developments in land use, land use regulatory updates, the National Environmental Policy Act, the State Environmental Policy Act and impact fees. 1. General 1.1 Main Substantive Skills Transactions are increasingly complex as the industry becomes dominated by well-capitalised firms with their own in-house legal staffs responsible for the overall success of the transaction. Thus, the value provided by Washington state lawyers lies in their ability to respond to specific enquiries concerning local law and customs. Real estate development projects in Washington involve multiple opportunities for public participation and entitlement through hearings and potential appeals a highly local process. Real estate attorneys need to have multiple skills, including administrative, to achieve the client s goals in order to be successful in an industry increasingly dominated by administrative process. 1.2 Most Significant Trends Institutional-grade office buildings and industrial projects continue to be valued at low cap rates and high demand. Large tech users are the major players in the urban markets, particularly Seattle, and rents for these projects are generally stable or increasing. Multi-family development continues, although the pace has eased somewhat. Canadian multi-family developers continue to be active in the 5

6 WASHINGTON Law and Practice market, while the demand for retail space is not as strong. The bulk of development and transaction activity remains in the three-county mid-puget Sound region. The largest lease transaction in the past twelve months involved Amazon.com leasing approximately 700,000 sq ft of office space in Rainier Tower, a new high-rise development under construction in downtown Seattle. The largest project under development remains the Washington State Convention Center expansion in downtown Seattle. 1.3 Impact of the New US Tax Law Changes The impact of the new US tax law changes remains somewhat uncertain, although it appears income taxes will be reduced for owners of commercial real estate (see US summary). The uncertain interest rate environment makes it hard to predict whether this will translate into higher values. Washington state continues to explore sources of new revenue to support the public schools and other programes. Real estate generally fares well under the Washington tax regime: Washington does not have a state income tax and rents from real estate are treated favorably. As the demand for additional local and state revenue increases, this favorable treatment is likely to be altered. Commercial property owners should anticipate potential changes in the rental tax regime and allocate risk accordingly during negotiations for long-term leases. Similarly, lenders should consider the impact of potential tax changes on their real property collateral and interest income. Finally, as local governments are forced to deal with social issues, they will likely be empowered to expand their taxing authority to apply additional fees and impositions on new development, thereby increasing the cost of new construction in urban areas. 2. Sale and Purchase 2.1 Ownership Structures The most common ownership structure for real estate in Washington state is complete ownership of the property (otherwise known as fee simple ownership), either by individuals or most commonly by limited liability companies, corporations or other business entities. Fee simple ownership allows full alienability of the property: the owner has the right to transfer the ownership by sale, gift and bequest; the right to lease the property for any length of term; the right to encumber the property by mortgage or other forms of lien to secure the repayment of indebtedness; and the right to transfer lesser interests in the property, such as easements and licenses. Washington observes the common law rule against perpetuities, but as modified by statute, the rule has little applicability to commercial transactions and applies only to future interests in property intended to be effective after 120 years. Ownership rights arising from marriage, such as dower and curtesy, have been abolished by statute. However, Washington is a community property state. If real property is owned by a married individual, community property concepts require both spouses to join in any transaction involving a conveyance of any portion of, or interest in, the property or any lease. 2.2 Important Jurisdictional Requirements Washington state observes the Statute of Frauds, which requires all agreements for the transfer of real property to be in writing. To comply with this requirement, Washington courts have held a purchase and sale agreement must: identify the parties; contain a complete legal description of the property to be conveyed; specify all material terms regarding the transaction; and be properly signed by the parties. If the transaction involves the sale of personal property valued at more than USD500, the Uniform Commercial Code (UCC) as enacted in Washington also requires the agreement to be in writing to be enforceable. Parties who are individuals must be legally competent; ie, of legal age (18 years) and not subject to mental incapacity. If the seller is a married individual, the spouse generally must join in the execution of the agreement. Corporate entities must have taken all requisite corporate action to authorise the execution of the agreement. Aside from certain statutes applicable to public entities disposing of real property intended to ensure the entity receives fair market value for the property, there are no requirements for prior governmental or court approval of sales of real property. Additional terms in typical purchase and sale agreements include the purchase price and method of payment, inspection rights, conditions to the obligations of the buyer and seller, the required condition of title at the closing of the transfer, and representations and warranties of the buyer and seller. Sales of residential property require additional terms mandated by state law and local ordinances. Most residential transactions use pre-printed forms prepared by real estate agents, the most common of which is the Northwest Multiple Listing Service form. As a result, lawyers are rarely involved in residential transactions. Pre-printed forms for commercial transactions are less common, but are used occasionally for smaller deals. In contrast to residential transactions, buyers and sellers in commercial real estate transactions typically engage lawyers. The typical purchase and sale agreement is structured with the buyer making an earnest money deposit to secure per- 6

7 Law and Practice WASHINGTON formance under the agreement. Earnest money serves as liquidated damages in the event the buyer breaches the agreement and fails to complete the purchase without legal excuse. Washington law has an earnest money/liquidated damages safe harbour, which provides that agreements calling for the forfeiture of deposits not exceeding 5% (in the event of a buyer default) are presumptively enforceable. Larger deposits are sometimes used, but any amount over 5% may be subject to clawback by the buyer, depending upon the specific facts and circumstances of the transaction. Specific performance is available to buyers faced with sellers who refuse to close in accordance with the purchase and sale agreement. In the absence of contractual provisions to the contrary, both buyer and seller are responsible for contract damages in the event they breach their obligations to complete the transaction. 2.3 Effecting Lawful and Proper Transfer of Title Conveyance of title is completed through the delivery and acceptance of a properly executed deed. In Washington state, title insurance companies search the condition of title and insure the status of title rather than attorneys. The legal description of the property will be confirmed when the buyer obtains a preliminary commitment for title insurance from a title insurance company designated in the purchase and sale agreement. Washington is a race notice state, so recording the deed at closing is critical. The transfer of any personal property involved in the transaction is made by a bill of sale, which does not need to be recorded. Although rents reserved under existing leases are considered part of the real property and are therefore automatically transferred with the deed, it is common in commercial transactions to use a separate assignment of leases pursuant to which the seller assigns existing leases and all reserved rents to the buyer and the buyer agrees to assume and perform the obligations of the seller under the leases. The assignment of leases also addresses the obligation to refund any security deposits held by the landlord and often includes basic indemnity provisions. To comply with the Statute of Frauds, the deed must be in writing, contain a complete legal description and be signed by the grantor. The signature of the grantor of the deed must be acknowledged before a notary public. Washington has three forms of deeds specified by statute: a statutory warranty deed, a bargain and sale deed, and a quit claim deed. Any of these forms are sufficient to convey title. The forms differ in the extent of grantor warranties, with the warranty deed containing the most comprehensive warranties and the quit claim deed conveying title with no warranties. The complete and correct identification of the grantor in the deed is required to ensure proper indexing of the deed in the property records maintained in each county following recording. Recording the deed in the recording office in the county in which the property is located provides constructive notice of the conveyance. The failure properly to record the deed exposes the buyer to title challenges arising from any subsequent grantee acquiring title for value without actual or constructive notice of the prior conveyance. Most transactions are completed through an escrow established at the title insurance company insuring the buyer s title, although residential transactions are often closed through an escrow established at the mortgage company providing the buyer s financing. The escrow is responsible for properly disbursing funds and delivering the deed together with any additional transfer instruments such as the bill of sale and assignment of leases. Typical instructions to the escrow completing a real estate sale will condition any disbursement of funds upon (i) recording of the deed conveying title to the buyer and (ii) obtaining an irrevocable commitment from a title insurance company to insure buyer s title in the condition required by the purchase and sale agreement. 2.4 Real Estate Due Diligence Most purchase and sale agreements condition the buyer s obligation to close upon the completion of due diligence examinations to the satisfaction of the buyer during an inspection period. If the buyer is not satisfied with the results of the due diligence, it has the right to terminate its obligation to purchase the property. Typical due diligence items include: examination of the condition of title; physical inspection of the property; confirmation of zoning and building permit status; examination of leases and service contracts affecting the property; review of income and expense statements for the property; inspections related to the presence of hazardous substances on the property; historical repair records; and other items necessary to confirm the property is satisfactory for the buyer s intended use. The length of the inspection period and the manner of completing the buyer s due diligence reviews are negotiated between the buyer and seller, and specified in the purchase and sale agreement. The duration and extent of the buyer s due diligence varies depending upon the nature of the property. The negotiated time period should be sufficient to allow the completion of the buyer s contemplated investigations. For example, with regard to commercial transactions, it is advisable to obtain a survey in connection with the review of the condition of 7

8 WASHINGTON Law and Practice title, so any due diligence period should be long enough for the survey to be completed. In commercial transactions, lawyers are involved in the review of the condition of title, contracts affecting the property (such as leases and service contracts) and closing documents. Lawyers are not normally involved in due diligence associated with residential transactions. Other due diligence is carried out by the buyer and third parties, such as engineers and architects for review of the physical condition of the property and environmental inspection firms for presence of hazardous substances on the property. Zoning and building permit reviews are performed by architects with assistance from lawyers if interpretation of the zoning or building code is required. 2.5 Typical Representations and Warranties for Purchase and Sale Agreements Representations and warranties are subject to negotiation between the buyer and the seller. The extent of warranties and representations in any transaction depends on the relative bargaining position of each party. Typical warranties and representations made by the buyer include (i) authorisation to engage in the transactions, (ii) availability of funds to complete the purchase and (iii) legality of the obligations undertaken by the buyer. Sellers representations and warranties are normally more extensive and can include: the physical condition of the property; environmental matters, such as the presence of hazardous materials; the status of zoning and building code compliance; the validity of underlying leases; the condition of title; the authority to enter into the transaction; the legality of the obligations of the seller under the purchase and sale agreement; and the status of any existing or threatened litigation affecting the property. It is typical for both parties to warrant their status as nonlisted organisations under the federal Patriot Act. A seller of real property in Washington state must deliver to the buyer a completed Seller Disclosure Statement in the form provided by the statute within five business days of executing the purchase and sale agreement. This statutorily required form includes disclosures relating to the seller s title to the property, the property s water resources and sewer or septic system, the structural condition of improvements, environmental disclosures and other matters. A buyer who has not received a Seller Disclosure Statement as required by law has a right of rescission until the earlier of three business days after receipt of the disclosure statement or the date of closing. The disclosures made in the form are not considered to be part of the contract between the buyer and seller, but may be the basis of a claim of misrepresentation or fraud if the statements are inaccurate. A buyer may waive the right to receive the Seller Disclosure Statement under certain circumstances. There are no statutory express warranties applicable to commercial transactions in Washington, apart from those contained in the deed, which is discussed above. There is a common law-implied warranty of habitability applicable to newly constructed single-family residences in favour of the first owner of the residence. There is a statutory warranty of habitability applicable to residential condominiums enforceable against the developer of the condominium project. Prior to closing, if representations or warranties by one party are found to be untrue, the other party typically will have the right to rescind the transactions. If warranties and material representations made by a party are discovered to be untrue after closing, the other party may rescind the transaction (subject to some limitations) or seek damages. The exact remedy available depends upon the nature of the breach and the timeliness of the injured party s action. Damages are generally measured under the benefit of the bargain rule, which allows recovery based upon the difference between the purchase price of the property and the value of the property, taking into account the effect of the breach of warranty or inaccurate representation. In the context of residential real estate, the application of this rule usually results in damages in the amount of repairs required to correct the breach. In commercial transactions, it is common for the parties to negotiate limits on liability for the breach of representations and warranties, such as time limits within which a claim must be presented (typically up to one year) and recoverable damages, which can also include a minimum claim threshold, a limit on consequential or indirect damages and an overall cap on damages. These provisions are not typically applicable to claims arising from acts constituting fraud or material misrepresentations. 2.6 Important Areas of Laws for Foreign Investors Washington state law recognises limited liability companies, partnerships (general and limited), trusts, corporations and other business entities to own and operate property. The form of entity for many foreign investors will depend on the United States Internal Revenue Code and tax structuring. Because Washington does not have a state income tax, issues associated with the Internal Revenue Code, such as the Foreign Investment in Real Property Tax Act (FIRPTA), do not have Washington equivalents. The most common vehicle for owning commercial real estate in Washington is the limited liability company. Less common, but still utilised, is the limited partnership. The rights and obligations of members in limited liability companies and general and limited partners in limited partnerships if not otherwise specified in their agreements are specified by state statute. The limited liability company agreement may 8

9 Law and Practice WASHINGTON limit or modify these obligations. Investors must carefully review the terms of the limited liability company operating agreements before investing to understand the extent of the obligations of the sponsor of the investment, potential conflicts of interest among the members and a variety of other important legal and economic considerations. The same is true of limited partners investing in limited partnerships. In certain instances, state securities law statutes may be applicable to the investment, in which case the investor is entitled to state mandated disclosures. These disclosure rules are in addition to any disclosure requirement under federal securities statutes. Common law theories applicable to misrepresentation and fiduciary duty may apply to disclosures made to real estate investors. In general, sponsors of real estate investments operating in a limited liability company framework have limited fiduciary obligations to their investors beyond an obligation to disclose materials features and risks of the proposed investment. The identity of members of limited liability companies, limited partners in limited partnerships and shareholders in corporations need not be disclosed under Washington law. For development projects, foreign investors should be aware of the extensive process required under state and local law to obtain entitlements and confirm the right to develop commercial property. Delays are common and investors should allow for long lead times to complete the required planning and permitting process prior to the time the right to develop the property vests. 2.7 Soil Pollution and Environmental Contamination Washington has adopted the Model Toxics Control Act (MTCA), the primary state law relating to remediation of real property contaminated by hazardous substances. The MTCA supplements federal law and is modeled in many respects after the federal Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA). The MTCA programe is implemented by the Washington Department of Ecology (DOE) and operates very much like the federal clean-up programe. There are some important differences, however, such as: the MTCA includes petroleum and petroleum-based products as hazardous substances; the specification of more stringent clean-up standards than federal standards; and the public involvement and private initiative in the MTCA clean-up process, including the ability to clean up properties without prior state approval ( independent or voluntary clean-ups). This latter feature of the MTCA can be very useful for purchasers considering the acquisition of contaminated property. The MTCA imposes strict, joint and several liability upon those entities or persons the MTCA refers to as potentially liable parties (PLPs). Under the MTCA, joint and several liability is based upon the current owner and any prior owner or operator who caused a release of hazardous substances. The ability of the current owner to receive contribution towards the payment of remediation costs from prior owners and tenants of the property depends upon the ability to locate the financial resources of the prior owners and tenants. At a minimum, prospective buyers should engage a third party consultant to conduct a Phase I environmental report, which involves a review of public records for prior use of the property and adjacent properties, public records of local and state agencies, and a non-invasive inspection of the property. Of particular concern to a buyer will be prior uses of the property or adjacent properties involving hazardous substances, such as dry cleaners and industrial uses, the current or prior presence of buried tanks and the presence of substances such as asbestos, urea formaldehyde, polychlorinated biphenyl and other hazardous substances in improvements. If particular concerns are identified during the Phase I report, the consultants may recommend a Phase II report, which involves physical testing of soil and groundwater. The purchase and sale agreement should provide adequate time for the buyer to complete these investigations. The allocation of liability for existing contamination known or unknown is a matter of negotiation between the buyer and the seller in the purchase and sale agreement. It is possible under certain circumstances for a buyer to limit its liability under the MTCA as an innocent purchaser. This defense, however, requires adequate investigation on the part of the buyer, reinforcing the necessity to conduct studies of the environmental condition of the property. Upon completion of remediation action of contaminated property in accordance with a plan approved by the DOE, it is possible to receive a no-action letter from the DOE confirming no additional remediation is required to address the contamination previously identified in the remediation plan. 2.8 Permitted Uses of Real Estate under Zoning or Planning Law Washington state has an extensive and complicated system of regulating land development. Land use regulations are generally imposed at the municipal and county level through the adoption of zoning codes. Land within a municipal jurisdiction will have a zoning designation indicating the permissible uses of the property. If the property has been improved, review of certificates of occupancy issued by the jurisdiction and occasionally building permits are important evidence of compliance with zoning and building codes. The zoning code and maps adopted by the municipal jurisdiction in which the property is located must be consulted to confirm permissible uses. 9

10 WASHINGTON Law and Practice Changing land use designations is a combination of legislative and judicial action. Projects that require modification of existing zoning designation proceed through an administrative hearing process and are ultimately approved or disapproved by the elected municipal legislative body: the city or county council. Land use decisions are reviewable by courts under the Land Use Petition Act (LUPA). Disappointed proponents or opponents of development proposals have the right to appeal under LUPA. The statute imposes strict time periods for reviews and the failure to observe these time periods can result in the denial of the appeal. Similar procedures are applicable to building permit applications. Large projects can also be subject to review for environmental impacts under the State Environmental Policy Act (SEPA) and permits for waterfront projects are reviewable under the Shoreline Management Act (SMA). Special rules are applicable to developments affecting wetlands and other areas designated as critical areas, such as steep slopes. Although land use regulation is generally subject to local control, the state has enacted a Growth Management Act establishing uniform state-wide standards to be observed in order to protect agricultural and other resource lands, and open spaces, as well as accommodate anticipated population growth. 2.9 Condemnation, Expropriation or Compulsory Purchase The state, municipalities and certain municipal entities such as water and sewer districts, public utility districts and local improvement districts have the power of eminent domain and may condemn property for public purposes, such as roads, right-of-ways, parks and easements for utilities. Under state law, condemnation for the benefit of private persons is not allowed and it is generally believed the Washington state constitution imposes more restrictions on the authority to condemn private property than the federal constitution. That said, state court decisions have adopted expansive interpretations of activities benefitting the public, including redevelopment activities. The owner of private property must be compensated for the fair market value of the condemned property calculated at the property s highest and best use. Compensation must be paid as a condition of delivering possession to the condemning authority. Washington recognises the theory of inverse condemnation, which is applicable to the imposition of land use regulations held to exceed governmental authority or adopted in violation of the property owner s right to due process. The remedy associated with these claims is the invalidation of the land use restriction or an award of damages. Washington law has certain provisions allowing forfeiture of private property, including real estate, used in criminal activity. Forfeiture proceedings are summary in nature and can adversely affect the ownership interests of persons not directly involved in the criminal activity, such as landlords and mortgagees Taxes Applicable to a Transaction As noted above, Washington state does not have a state income tax. However, Washington has a number of transaction taxes. Washington imposes a real estate excise tax upon the transfer of real property and a sales or use tax upon the transfer of personal property. The real estate excise tax is currently 1.78% of the gross purchase price for the real estate. The amount may vary slightly in some cities and counties due to the ability of local jurisdictions to impose increased taxes. The sales tax for tangible personal property is between 9% and 10% of the purchase price allocated to personal property. Again, the taxes may vary based on the local taxing options. These taxes are calculated based on gross values with no deduction for mortgage indebtedness or other liens. With some limited exceptions, the real estate excise tax is also applicable to a sale or transfer of more than 50% of the capital or profits interests in the property owner. The real estate excise tax is typically paid by the seller and sales tax on personal property is typically paid by the buyer. The real estate excise tax is due as of the date the sale is completed and must be paid at the time the deed is recorded. If not paid, the real estate excise tax is a first priority lien on the real property. In those instances in which there is a delay in the recording of the deed and payment of the tax, there is the possibility of significant penalties accruing due to the late payment of the tax. Sales tax is also payable on the price paid to contractors for construction improvements and on some services Rules and Regulations Applicable to Foreign Investors There are no Washington state laws similar to the federal regulations applicable to foreign persons or entities acquiring real property in the United States. Foreign entities or individuals are, however, subject to the same laws and regulations applicable to Washington residents and domestic entities. For this reason, most foreign investors choose to establish an entity formed under Washington or some other state law and qualified to do business in Washington through which the investment will be made and operated. 3. Real Estate Finance 3.1 Financing Acquisitions of Commercial Real Estate Acquisitions of commercial real estate in Washington state are financed in a manner customary in other areas of the United Sates. Funds are obtained through a combination of debt and equity. The source of financing depends upon the preferences of the buyer and the type of property acquired. 10

11 Law and Practice WASHINGTON Commercial property acquired for future development, such as vacant land or property requiring substantial improvements, requires a higher percentage of equity as a source of funding than income-producing property with predicable cash flows and expenses. Sources of equity include individuals, pension funds, REITs and investment funds specialising in equity positions. Sources of debt include commercial banks, insurance companies, pension funds and hedge and other investment funds. Financing provided by sellers is not common, but does occur in certain circumstances, such as financial institutions disposing of foreclosed property. Loans are often facilitated by commercial mortgage brokers and investment advisers, although loans from commercial banks generally do not involve intermediaries. The amount of debt is determined by property type and condition, location and the lender s metrics such as loan-to-value and debt service coverage ratios. Loans from commercial banks tend to be relatively short term (two to five years), secured by a lien on the acquired property and fully recourse to the borrower and any guarantor. Loans from insurance companies, pension funds and other lending sources typically are longer term (five to ten years), secured by a lien on the acquired property and are normally non-recourse. Non-recourse loans are structured with special purpose, bankruptcy-remote entities with borrower and guarantor liability for certain types of breaches, such as fraud, misappropriation of rents and seeking bankruptcy protection. Most commercial bank lenders require a credit-worthy entity to guaranty the obligations of single-asset borrowers. Bank loans are typically floating rate at a margin over a reference rate with payment terms of interest and nominal periodic principal payments; longer-term loans are typically fixed rate based on a margin over a reference rate (such as ten-year US Treasury obligations) with payments of principal and interest based on an amortization schedule. Terms on all loans will vary based on the specific transaction and borrower. Typical loan structures prohibit subordinate financing. Additional financing can be in the form of subordinate mezzanine loans secured by a pledge of the equity interests in the special purpose entity owning the property, but this type of financing is customized for the particular transaction and requires the co-operation of the senior lender. Equity investment structures take into account investor requirements for investment return and tax considerations. Typically, equity investors receive distributions based on a defined cash-flow waterfall after taking into account debt service and property-related expenses. 3.2 Typical Security Created by Commercial Investors The most common security instrument granted in real estate financing in Washington to secure a loan is a deed of trust, which is authorised pursuant to Washington s Deed of Trust Act. Mortgages are seldom used except for loans secured by agricultural property. Both instruments create liens on the property securing the repayment of the financing. In unusual transactions involving seller-financed sales of agricultural property, real estate contracts (or contracts for a deed) may be utilised, creating a lien on the property in favour of the seller to secure the payment of the balance of the purchase price. In addition to security interests in real property, lenders receive a security interest in all personal property, including IP, associated with the real property. Washington has enacted the Uniform Commercial Code and the creation and perfection of personal property security interests are governed by the UCC. Perfection of the personal property lien is obtained by filing a financing statement with the state department of licensing or the county recording office depending upon the collateral. State statutes specify the document formalities for mortgages and deeds of trust. A deed of trust is a special form of mortgage allowing the foreclosure of the lien following default in payment in a private sale process. Mortgages are foreclosed by court action. The foreclosure sale in both cases is a public auction conducted after notices specified by statute. Following a mortgage foreclosure, the lender may pursue the borrower and any guarantor to collect the difference, if any, between the amount obtained from the auction of the property and the total amount owed. The borrower may reclaim title to the property by paying the debt within a period specified by statute, commonly referred to as a redemption period, which may be up to one year after the date of the foreclosure sale. Following a private foreclosure sale under a deed of trust, the lender does not have the right to seek any further recovery from the borrower, although the lender may pursue a claim for deficiency against guarantors within one year following the foreclosure. The borrower has no right to reclaim or redeem the property following a foreclosure under a deed of trust. A lender may elect to foreclose a deed of trust as a mortgage, in which case the rules applicable to a mortgage apply. The security interest granted under a deed of trust or mortgage will normally include an enforceable pledge of the rents and other cash flow from the property in favor of the lender. In the case of mezzanine financing, the borrower creates and the lender perfects a security interest under the UCC in the borrower s equity interest in the special purpose entity owning the property or the borrower elects to certificate the ownership interest under Article 8 of the UCC and those certificates are pledged to the lender. In the latter alternative, the possession of the certificates by the lender perfects the security interest in favor of the lender. 11

12 WASHINGTON Law and Practice 3.3 Regulations or Requirements Affecting Foreign Lenders Washington has no restrictions on foreign or non-resident lenders doing business in the state. If the lender s sole contact with Washington is making a single loan secured by real property, the lender does not have to register to do business in the state. However, the management of the property following a foreclosure or if the lender generally solicits loans in the state will require registration. If registration is required and the lender fails to do so, the ability to conduct a foreclosure proceeding may be adversely affected. 3.4 Taxes or Fees Relating to the Granting or Enforcement of Security Other than nominal per page recording fees, there are no taxes or fees due in connection with the granting of a mortgage or deed of trust or a personal property security interest. Nominal filing fees are charged in connection with the commencement of a mortgage foreclosure and a foreclosure proceeding under a mortgage or deed of trust will result in legal and trustee fees, costs of title search and costs for publication of required notices. There are no transfer fees or taxes in connection with the conveyance of the property as a result of the foreclosure sale; however, when the purchaser of the property at the foreclosure sale subsequently sells the property, real estate excise tax is due upon delivery of the deed (see 2.10 Taxes Applicable to a Transaction). 3.5 Legal Requirements Before an Entity Can Give Valid Security Real property security interests granted by individuals who are subject to a legal disability, such as mental incompetence or not being of legal age, are not valid. Special rules as to spousal consent apply to married individuals granting real property security interests. For entities such as limited liability companies or corporations, the application of these rules depends upon the nature of the pledged property. Entities must comply with their organizational charters in order to create valid real property security interests. For corporations, this requires properly adopted corporate resolutions. Similar authorizations are required for limited liability companies and limited partnerships. Security interests granted by general partnerships normally require authorization by all partners. It is typical for a borrower to represent and warrant its power and authorization to grant the security interest. The borrowing entity must also be registered to do business in Washington and its license must be in good standing (ie, all annual registration fees paid and annual reports filed). Lenders require certificates of existence issued by the Washington Secretary of State to confirm these representations. Title insurance companies insuring the priority of the real property security interest require evidence of corporate authority of the borrower to grant the lien as a condition of issuing the title policy. Guarantors are subject to similar requirements concerning the authority to enter into the guaranty arrangement. Security instruments granted by any individual or entity must comply with the Washington Statute of Frauds; the instrument must be in writing with a complete legal description of the property, executed by the owner of the property with the grantor s signature acknowledged by a notary public. 3.6 Formalities When a Borrower is in Default Prior to commencement of the foreclosure, all default notices required under the documents applicable to the security interest, such as the note and deed of trust, must be given. Foreclosures of mortgages and deeds of trust are governed by specific statutory procedures requiring pre-foreclosure notices and opportunities to cure defaults prior to the sale. Failure to comply with notice requirements does not affect the enforceability of security interest, but may delay completion of the foreclosure process. The priority of real property security interests is governed by the Washington recording act. So long as the security instrument is timely and properly recorded, the lender is protected against priority claims raised by subsequent lenders or liens. Failure to record in a timely fashion is the most common reason for loss of priority. 3.7 Subordinating Existing Debt to Newly Created Debt An existing lender can agree with a subsequent lender to subordinate in whole or in part the existing lender s security interest to the new lien. Any agreement concerning priority must comply with the requirements for amendment stated in the original security instrument and comply with the document formalities to create a valid real property security interest. Arrangements involving senior and junior lenders, including mezzanine lenders, are documented with intercreditor agreements addressing various matters such as order of foreclosure in the event of default. Senior lenders consent to junior liens or subordination of senior liens is not common and involves difficult negotiations. Washington does recognise various common law equitable doctrines, such as equitable subordination, affecting priority. Application of these doctrines generally involves an unusual fact pattern resulting in a windfall recovery to the lender whose priority is challenged. The typical situation involves refinancing of a senior loan with unsatisfied junior liens as a result of an error in the loan closing process. Bankruptcy proceedings can also result in the altering of lien priorities. 3.8 Lenders Liability Under Environmental Laws As described in 2.7 Soil Pollution and Environmental Contamination, owners and operators of contaminated property are liable for remediation expenses under state and federal law. Lenders foreclosing on contaminated property have potential liability as an owner following completion of the foreclosure. The primary federal law, CERCLA, and Washington law, the MTCA, have exemptions available to secured 12

13 Law and Practice WASHINGTON lenders. The ability of a lender to qualify for these exemptions depends upon the factual circumstance surrounding the lender s involvement with the contaminated property and lenders should not assume the exemption will apply. Prior to foreclosure, lenders typically engage in independent investigations of the condition of the property if there are grounds to believe contamination may exist. Borrowers and guarantors normally indemnify lenders against any loss arising from the presence of hazardous materials or property contamination. This indemnity is an independent obligation from the security instrument and is structured to survive foreclosure. 3.9 Effects of Borrower Becoming Insolvent The failure to record properly a real property security instrument or file properly a financing statement under the UCC for personal property security interests can result in the lender s loss of priority in a borrower s bankruptcy proceeding and the lender becoming an unsecured creditor. Security interests may also be attacked in bankruptcy as fraudulent conveyances or preferences. The rules concerning these concepts are complex, but as a general statement, loans made within one year of the commencement of the insolvency proceeding and loans to entities secured by real property owned by the borrower s subsidiaries present the fact patterns most often giving rise to these challenges. Washington allows the lender to seek the appointment of a receiver to take control of encumbered property following default but prior to foreclosure. A receiver has the power to sell the encumbered property. It is unclear whether this power includes the ability to sell property free from all liens. However, with the co-operation of borrowers, senior lenders can utilise receiverships to dispose of secured property over the objection of junior lien holders. The general reorganisation of debts and restructuring of secured debts in bankruptcy is governed by federal law. 4. Planning and Zoning 4.1 Legislative and Governmental Controls Applicable to Design, Appearance and Method of Construction Design and appearance are governed by zoning controls that vary from local jurisdiction to local jurisdiction. Each city and town has exclusive zoning authority over the property within its boundaries, while county zoning authority extends only to unincorporated areas of each county. Different jurisdictions choose to exercise different levels of control over design issues. Some, such as the City of Seattle, have a design review process for projects above a certain size or residential yield. Applicants for larger projects must present their designs to a design review board comprised of volunteer architects, landscape designers and others with experience in property development. The board recommends design changes to bring the project more in line with the city s adopted design guidelines. Other local jurisdictions rely on zoning development standards (ie, height, floor area, or lot coverage limitations) to govern the size and shape of buildings. The State Environmental Policy Act provides local governments an additional source of authority to govern design issues. If the local government has adopted relevant SEPA policies, it can require changes to design to mitigate environmental impacts such as height, bulk, scale and even the aesthetics of proposed buildings. Property within 200 feet of the ordinary high water mark of larger water bodies is also subject to the relevant jurisdiction s shoreline management programe, which is a shoreline-specific zoning code adopted pursuant to the state SMA. Each local master programme is adopted by the local jurisdiction and approved by the state DOE, and contains shoreline-specific development standards that may further constrain the height, bulk and scale of structures. These standards are in addition to zoning standards and, typically, the more restrictive standard applies. Methods of construction are governed by building codes. The State Building Code Council revises and adopts codes propounded by the International Code Council to apply state-wide. Although each jurisdiction has the authority to amend the state code, many do not or make only minor process changes. 4.2 Regulatory Authorities Local governments are responsible for the majority of development regulations. They have exclusive jurisdiction to regulate zoning within their boundaries, although the exercise of the zoning authority is guided and constrained by state law, chiefly the Growth Management Act (GMA). Local zoning codes establish permitted and prohibited uses, and set development standards (restrictions on height, lot coverage, building floor area). Local permitting departments manage permitting within their jurisdictions, including (at applicant expense) environmental review of proposed projects. The GMA requires most jurisdictions in the state to adopt comprehensive plans that establish generally how the jurisdiction will direct growth, then to adopt development regulations, such as zoning, consistent with the comprehensive plan. However, where zoning conflicts with a comprehensive plan, the zoning controls. State agencies will become involved in local permitting matters only in special situations. For example, if a project requires a shoreline variance, the state Department of Ecology issues the final decision after local review. 13