Get to Know Your Real Estate – Focus on Due Diligence Fundamentals in Tough Times
Urban Land Institute
November 30, 2011
Real estate buyers, sellers, lenders and investors will be coping with the fall-out of the real estate collapse for some time to come. Now, more than ever, professional advisors, real estate investors and lenders need to focus on the fundamentals of due diligence in considering prospective land deals. Whether a property has endured a loan work-out or foreclosure, or has simply sat idle for years, the following tips offer guidance in navigating uncertain terrain in evaluating land investment opportunities.
1. Get a Survey. A lender who has acquired a distressed property through foreclosure may take title only to the land described in its deed of trust. This can be problematic, for example, in large residential subdivisions in which lots were sold to homeowners (or common areas were conveyed to a homeowners’ association) prior to the lender’s foreclosure -- the lender may not know for certain what property it acquired from the borrower. As a result, when the lender tries to sell the property later, the lender may expressly avoid any warranty or representation about the description of the property being sold. This disclaimer is a red flag for the potential buyer, who should obtain a survey to verify the boundaries of the land described in the contract. In addition, a survey is important to confirm that the property conveyed to the lender has legal access to a public right of way. It is not unusual for tracts or lots to have been inadvertently landlocked through re-subdivision, foreclosure or the break-up of a project into smaller components. Even if a prior description in the chain of title refers to a prior recorded plat and/or access easement, the accuracy and validity of the plat and/or easement must be verified.
2. Know What Title Insurance Is and Isn’t. Buyers should not update a title from a prior lender’s title insurance policy. Lender’s policies typically do not reflect all of the title exceptions affecting insured property. Buyers also should be wary of updating from a prior owner’s policy without at least reviewing the prior chain of title to gauge the accuracy of the policy. Title insurance claims abound right now because defective or incomplete title work was relied upon to issue prior title insurance policies. Even if a title insurance company offers coverage from a prior policy, payment on a title insurance policy claim will seldom make an insured buyer whole if a title defect affects the marketability of the property. Despite the extra cost, which may be small, the best advice when there is any doubt is to obtain a 30-year title search on a property.
3. Triple-Check Zoning. A buyer’s title insurance company may issue a zoning endorsement based on a zoning letter from a county or municipal planning department. A zoning endorsement is meant to insure, according to the applicable zoning map and ordinance, the property is classified in a certain zoning district. Buyers should not rely solely on zoning letters or endorsements to evaluate permitted uses on a property. In North Carolina, if a local government mistakenly issues an incorrect zoning letter, the local government may require the landowner, at their own cost, to remove or modify the improvements and cease incompatible uses immediately. While an insured owner may be entitled to some damages under a properly endorsed title insurance policy, those damages may not reimburse the owner for lost revenues resulting from terminating or suspending operations on the property or for correcting the violation. Buyers should have their attorney examine the applicable zoning ordinances and zoning map carefully to ensure the map correctly delineates the property and is up to date. When possible, verify that all applicable rules, procedures and notices were complied with in adopting a zoning change and confirm the expiration of the applicable zoning appeal period.
4. Beware of Stealth Liens. A foreclosure does not necessarily wipe out a mechanic’s lien if the work started prior to the recording of the deed of trust. Many communities and projects are saddled with pre-existing, still valid liens. Also, a foreclosure will not wipe out tax liens and other governmental liens, including liens for governmental assessments and charges for abatement of public nuisances, both of which are treated like tax liens. The title insurance company should list every lien discovered in the chain of title on the title insurance commitment -- the exceptions can be removed later after the buyer and their attorney review the liens individually.
5. Subordinate Deeds of Trust to CC&Rs. When possible, all loans secured by property should be made junior (subordinated) to restrictive covenants, conditions and restrictions (CC&Rs) recorded to benefit the property. Without a subordination, a lender may extinguish the CC&Rs by foreclosing on the property. Because CC&Rs typically benefit more than one owner in a development, a foreclosure will not necessarily disturb CC&Rs in every situation. For example, when a foreclosure does not include all of the property affected by the CC&Rs, the foreclosure will not extinguish the CC&Rs, unless the lender includes all of the property owners benefitted by the CC&Rs in the foreclosure action. A buyer should have their attorney examine carefully the foreclosure file in the public records to determine the current status of CC&Rs or any other restrictions or covenants in the chain of title.
6. Know Your Declarant Rights. Special development rights reserved for the benefit of a developer in a planned project are commonly referred to as “declarant rights.” North Carolina law is unclear on whether declarant rights automatically transfer with title to property, whether through foreclosure or another type of conveyance. Often a deed of trust will not include declarant rights as part of the secured collateral. If a lender acquires property through a foreclosure, deed in lieu of foreclosure or in a bankruptcy sale, the lender may not automatically acquire the declarant rights without a separate assignment from the borrower. If the public records do not reveal a transfer of declarant rights, a prospective buyer may consider requiring the lender to obtain an assignment of declarant rights from the former borrower. If an assignment can’t be obtained (e.g., the former borrower cannot be located), consider whether the declarant rights created in the original CC&Rs or by statute are still relevant to the project. The buyer may have substantially the same control over development decisions in the project through voting rights in the property owners’ association (e.g., by electing a majority to the board).
7. Investigate Property Owners’ Association. With many distressed properties caught in limbo after a borrower’s default, the management or administration of property owners’ associations may fall by the wayside. Declarant control periods and other deadlines may not be extended automatically as a result of a loan default or subsequent workout, foreclosure or bankruptcy proceeding. If the declarant control period expires, the borrower may no longer be obligated or entitled to exercise declarant rights to appoint board members, sign management contracts or approve architectural requests. No interim arrangements may have been made for the election of new board members, and it is unclear, particularly in bankruptcy situations, who and what authority the borrower or lender has to call meetings and carry out association business. Thus, a prospective buyer should obtain assurances from the seller about the status and organization of the association at closing and should review operating budgets and reserves, pending architectural requests, bank accounts, service and management agreements and common area ownership.
8. Check Public Infrastructure. Many large projects typically include obligations by developers to install public infrastructure, such as roads, water, sewer and/or stormwater facilities. When a developer defaults on loan obligations, a default on public infrastructure obligations usually follows. When security bonds or letters of credit were issued to secure completion of public infrastructure, a prospective buyer should contact the beneficiary(ies) of the security to determine the status of the improvements and whether the posted security is still adequate. If additional security is required, the buyer should inquire whether the municipality or county can withhold building permits and/or certificates of occupancy in a project until the security is provided. The buyer also needs to coordinate the replacement of security with the public agency and seller to avoid any lapse in coverage during the project’s change in ownership.
9. Review Development Agreements. A development agreement with a local government commonly addresses, among other things, a phased build-out of a project, water and/or sewer capacity allocations, public infrastructure improvements, stormwater compliance and performance deadlines. These agreements often require local government approval before they can be assigned to new developers. Lenders who have acquired property through foreclosure or deeds in lieu may have to renegotiate agreement terms to secure the local government’s approval for an assignment or to preserve or enhance the value of the property for sale later. Such renegotiation may result in tighter development standards (in exchange for extended deadlines) or higher impact fees for the buyer of the property. Since many development agreements are tied to planned unit development (PUD) approvals, the PUDs also may require amendment.
10. Take Assignment of Plans & Construction Contracts at Your Own Risk. Clauses in development requiring the assignment of architectural/engineering designs and specifications and/or construction contracts in the event of default by the developer should be scrutinized. Typically, a client does not own intellectual property rights in plans or specifications and is not authorized to assign any rights in these materials to a third party without the preparer’s involvement. As a result, anyone taking an assignment of plans or specifications without the preparer’s signature should be warned they may not be acquiring any rights in the materials at all. A prospective buyer also needs to review default clauses in development agreements requiring assignment of a construction contract without the consent of the contractor. Such an assignment may be unenforceable against the contractor, particularly if the assignor has defaulted under the construction contract (which is likely if a default has occurred under the development agreement). Further, the assignee may not want to continue the project. An effective construction contract assignment provision in a development agreement will require the developer to name the property owner as a third-party beneficiary to the construction contract. It also will permit the contract to be assignable to the owner at the owner’s election, subject to limitations on the owner’s obligation to continue construction on the project.
If ignored, any of the above issues could sink a deal at the last minute or create problems later for an owner or their tenants. The property owner who performs proactive due diligence at the beginning of a project seldom regrets the time and cost invested.