Real Estate Purchase Due Diligence-Module 3 of 5

Real Estate Purchase Due Diligence-Module 3 of 5


Module 3: Real Estate Purchase Due Diligence

 

Conducting due diligence requires both a seller and buyer to “do their homework.” It will take a considerable amount of time to complete because the buyer and seller must both take necessary steps to ensure that the seller is conveying proper title to a buyer.

Each state has a complex system of rules and requirements for what qualifies as proper due diligence for a real estate transaction.  In every state, the proper due diligence checklist requires title examination, purchasing title insurance, completion of land surveys and writing accurate land descriptions, researching and compiling all encumbrances on the land, and understanding the zoning laws that apply to the property. An encumbrance is any claim on a property that affects the property's value and examples include mortgages, tax liens and easements on the land.


Title Examination & Insurance

A seller must offer proof of good title of ownership in the real property he conveys to a buyer.  This proof of good title is procured after a title examination of public property records and the purchase of title insurance.[1]

In a title search, a title examiner, who usually works for the title insurance company, will scour public records for any defects in the real property’s chain of title. The title examiner will examine title as early as possible in a real estate transaction and will also perform a second examination immediately before closing. Public records consist of chain of title information, mortgages, judgements, tax liens, mechanic’s liens, ongoing suits involving the property and probate records. Properly-executed title searches differ by jurisdiction. For example, in Massachusetts, a buyer must examine only conveyances from the time at which each owner received the property until it was conveyed to another owner.[2]  In New York, a buyer must examine all records made by successive owners, including liens, encumbrances, and easements.[3]

Title can be defective if a minor or a person lacking capacity executes a deed, if there are missing or erroneous public records, if there is deed falsification, there are liens or encumbrances affecting the property such as judgment or tax liens or if another party is making an adverse claim on the property.[4]

Notice of an adverse claim may appear in two ways. First is if a buyer has “actual” notice, where he learns about, or directly observes, facts demonstrating that someone else claims the property.[5]  Second is if a buyer has “constructive” notice. Constructive notice arises if notice of the claim appears in searchable public records.

If there is no actual or constructive notice, the buyer is shielded from any adverse claims. Under the bona fide purchaser for value rule, a buyer purchasing real estate in good faith for valuable consideration without notice of an adverse claim on the property takes ownership of the property free and clear of these other claims. Therefore, unrecorded security interests are at risk of being extinguished by transfers to bona fide purchasers.

Even the most thorough title examiners can fail to discover risks to good title. Therefore, lenders typically require a buyer to purchase title insurance, which indemnifies the purchaser in the event of a title problem.  Title insurance protects the lenders by protecting the value of its security interest against title defects. Title insurance premiums consist of a one-time fee and the policy lasts as long as a buyer and her heirs own it.

Surveys and Land Descriptions

Property deeds must be accurately described to be legally valid.  Every deed, mortgage, lease, easement, or other similar document affecting the property must properly identify the property.[6] While an address might be a sufficient description for legal purposes, more comprehensive “meets and bounds” descriptions are typically included in deeds.

Land surveyors are integral to creating a complete and accurate legal description about a piece of property. A land survey is a data-driven evaluation of real property that shows the physical boundaries of a given piece of land. A surveyor gathers information from field evidence, written records, and physical measurements and prepares a map that becomes the official record of the property’s boundaries.[7]


Encumbrances on the Land

Seldom is any piece of real estate entirely free from any restrictions or encumbrances.  An encumbrance must be recorded to be legally binding so that it can be discovered during the title search.

Property Tax Liens

State and local governments levy taxes on real property within their borders on an annual basis.  These taxes are based on the piece of property’s value as assessed by the governing revenue agency.  If a property owner fails to pay property taxes owed when they’re due, the government may impose a property tax lien, a public encumbrance.

A lien is a right to keep an interest in property belonging to another until a property owner discharges a debt owed. Property tax liens have superiority over most other encumbrances.  If property taxes remain unpaid, the government can collect on the debt by foreclosing on the subject property and selling it at public auction.[8] As a practical matter, when property is sold, the purchaser will always insist that the seller settle any liens at or before closing.

The government can also impose a lien if a property owner fails to pay a special assessment, a one-time bill from the government for costs of upgrades to public infrastructure serving the property, such as grading roads or extending water lines.[9] 

Private Party Liens

In some circumstances, private parties can assess liens against property owned by people who owe them money. For example, a real estate broker with an exclusive listing agreement may establish a broker’s lien on the property for her commission if the listing agreement is breached.[10] Additionally, a court can place a judgment lien on a property if a property owner is assessed a monetary judgment. The judgement lien becomes an official encumbrance on the property once it is properly recorded in the jurisdiction in which the property is located and will remain in place until the judgment is paid.[11]  Most states limit the duration that a judgment lien can be in place, typically seven to 14 years.[12] 

Another common lien is a mechanic’s lien, where a mechanic performs work that improves the value of the property but isn’t paid. Though it’s called a mechanic’s lien, this remedy is available for a laborer, architect or engineer as well.[13]  Any of these parties must file a lien within a reasonable time after the completion of the work or supply of the materials, typically 60-120 days, and it must include information regarding the claim against the property owner. A mechanic's lien can be a serious concern for affected property owners because if unaddressed, it may result in property foreclosure.

 

Interests Involving Usage of Land

Restrictive Covenants

A property owner can reach a private agreement to restrict or expand use of her land.  Certain encumbrances on real property "run with the land," which means that they attach to the property itself and pass from one owner to another.[14] Two types of private encumbrances that run with the property are restrictive covenants and easements.

A restrictive covenant is an encumbrance because it inhibits an owner from using property in a way that she wants to. The restrictive covenant specifies that certain things may not be done and prevents future property owners from using the land for certain purposes.[15]  A restrictive covenant is listed in the deed, generally in the “legal description” portion of the deed. Covenants can also be filed in the local county clerk’s or property records office.

In subdivisions and planned communities, restrictive covenants are manifested in a document known as covenants, codes, and restrictions. They may dictate things like:

·       The size and type of construction that can take place on the property;

·       Permissible colors for exterior house paint;

·       Pets that may be kept or trees that may be planted;

·       Types of fencing allowed; and

·       Limitations on the types of security lights. [16]

Restrictive covenants may be enforced by a homeowner’s association in a planned community. In a community with restrictive covenants, but no homeowner’s association, owners can enforce the restrictive covenants against other property owners by seeking an injunction against the violating use.

Easements

Another encumbrance is an easement, which conveys a legal right to use or enter a piece of property.[17]  Easements are ubiquitous and common easements include rights-of-way (allowing one neighbor physical access across his neighbor’s property), prohibiting excavations and allowing other landowners access to light, airflow, water, or wildlife. 

An easement is an encumbrance because it gives a third party some privilege or liberty over a piece of land that the property owner cannot interfere with.[18] It can be formalized with an express agreement, can be implied, or can arise by prescription.

An express easement is created by a written agreement between landowners granting or reserving an easement. The agreement must be signed by both parties and is recorded with the deeds to each property.

Easements can also be implied. The first example is “prior use” when "an owner of two parcels of land uses one parcel to benefit the other to such a degree that, upon the sale of the benefited parcel, the purchaser could reasonably expect the prior use to be included in the sale."[19] For example, Dana owns a home with an acre of land and her home relies on solar energy. If she subdivides her acre so that another home is built on it, Dana can seek an implied easement to prevent the future buyer from building a tall structure that would prevent sunlight from reaching her house’s solar panels that she used to meet her energy needs prior to the sale. In this example, there was unity of ownership prior to the conveyance of the new parcel, intent among the parties to create an easement, and an apparent need to have an easement for light so that Dana can continue her prior use.

The second way is for an easement to be implied from “necessity,” though necessity means more than mere inconvenience. The most common example of an easement by necessity is with a landlocked property with no access to public road unless there’s a right of way over an adjoining parcel of land. The legal theory is that the landlocked parcel was accidentally created, and the landowner forgot to include an easement or method of access to reach the road. So, a court will find an implied easement over another’s parcel to use the roadway.

A landowner must also be aware of whether there are any easements by prescription. A prescriptive easement grants one landowner the ability to use another landowner’s property if the use is open and notorious, actual, continuous for a state’s statutory period, which can be between five and 30 years, and is without the other landowner’s permission. Due to the unrecorded nature of many prescriptive easements, a title examination will not help a buyer identify this easement. The most effective ways of identifying prescriptive easements are to review photographs of the property to determine whether there is a well-worn path that others may be using, and to interview neighboring landowners and tenants about their use of the property and if any agreements permitting use exist.

Regardless of the easement’s formation, it will encumber the land until termination. The legal requirements for termination of an easement vary by state, but certain principles exist everywhere. First, there can be an express termination agreement. Second, an easement holder can abandon an easement if he neither uses the easement nor intends to use it in the future. The easement can also be terminated by merger of the properties involved in the easement transaction. Here, the owner of the property encumbered by the easement acquires the property benefiting from the easement, so there’s no longer a need for it.


Zoning Laws

Geographic areas are typically divided by local authorities into "zones," and the local government will designate allowable land uses in each zone.  The city or county regulates land use by enacting and enforcing zoning laws that protect property owners and ensure that the people living in an area use their land in a manner consistent with their neighbors’ uses of their lands.[20]  The local government can initiate legal action to stop a landowner from violating the zoning laws and can even levy monetary penalties on a landowner.  

In some cases, a piece of property is used for a method that predates zoning rules restricting that use.  When this occurs, the preexisting nonconforming use is often allowed to continue. The use is referred to as having been “grandfathered.” Grandfathering is not always allowed, and even allowed grandfathered usages usually cannot be expanded or stopped and restarted.[21]

Should a landowner want to use his property in a way that is not permitted by zoning laws, he can apply for a variance. A variance isn’t a change in zoning laws but is a waiver of zoning ordinance requirements for a defined and limited purpose. The process of obtaining a variance differs by area, but the landowner must typically demonstrate that existing zoning regulations present an unnecessary hardship. First, he must submit a request to a zoning enforcement officer who then decides whether to grant it after holding a hearing and meeting with him and his neighbors who would be affected by the variance.  If the enforcement officer denies the variance, the landowner can appeal this decision to the local zoning board of appeals.

Cities may also pass building code regulations to prescribe rules for the materials and methods used in construction projects. In most U.S. cities, a building cannot be constructed and occupied without a permit certifying that it was inspected and found to be complaint with all applicable building codes. Local governments also commonly create and enforce subdivision laws that require advance approval for the construction of new infrastructure, like streets or sewers.

Purchasers of real estate can inspect properties with the property’s certificate of occupancy to determine whether there are any nonconforming or illegal usages of the property. If a search determines that there are zoning violations, many contacts require that the seller remedy the violations or obtain the needed certificates of occupancy or variances as a precondition of the buyer’s duty to close the sale.

Conclusion

          Real estate title searches and inspections can be complex and time-consuming but are important for purchasers to ensure that the properties they purchase are free of title defects, encumbrances and nonconforming usages. Failure to give due effort to these searches and inspections can cause the purchaser to be subjected to nasty surprises after closing, when the seller is no longer around to help remedy problems.



[1] Kelley v. Leucadia Financial Corp. 846P.2d 1238 (1992); Madbeth, Inc. v. Weade, 204 Va. 199 (1963) (holding sellers or real estate legally responsible to demonstrate merchantable title to real property). See also Chavez v. Gomez, 423 P.2d 31 (N.M 1967).

[2] 93 M.G.L. § 70 (2017).

[4] American Land Title Association, What is Title?, Course 1 Chapter 1 (2001) available at https://www.alta.org/media/pdf/CH01.pdf

[6] Hilbert v. Hough, 969 P.2d 836 (Idaho Ct. App. 1998) (denying specific performance for buyers when seller voided real estate agreement upon discovering southern boundary line of the subject parcel was unclearly defined).

[7] Hinkel, D., Essentials of Practical Real Estate Law 34-35 (6th ed. 2016).


[8] United States of America v. Towne, 406F. Supp. 2d 928 (N.D. Ill. 2005), aff'd, 467 F.3d 655 (7th Cir. 2006).

[9] McLaughlin, C., The Property Tax Lien, UNC Property Tax Bulletin No. 150 (Oct. 2009). Available at http://sogpubs.unc.edu/electronicversions/pdfs/ptb150.pdf

[12] Hinkel, D., Essentials of Practical Real Estate Law 77 (6th ed. 2016).

[13] See e.g. Glasser & Glasser, PLC v.Jack Bays, Inc., et al., 285 Va. 358 (Feb, 28, 2013) (discussing the requirements for securing and enforcing a mechanic’s lien under state law).

[15] See Hutchens v. Bella Vista VillageProperty Owners' Ass'n, Inc., 110 S.W.3d 325 (2003); Cunningham v. City of Greensboro, 711 S.E.2d 477 (2011).

[16] Hinkel, D., Essentials of Practical Real Estate Law 79-80 (6th ed. 2016).

[21] See e.g. Shackford & Gooch, Inc. V.Town of Kennebunk, 486 A.2d 102 (1984)