It happens more than you might think. Developers and investors find an excellent commercial property with tons of potential. They go through their due diligence checklist and move forward with purchasing the property. The problem is: they didn’t have a commercial real estate attorney go over the title documents to check for any encumbrances. Or, if they did, they glazed over a portion that might not have been a common encumbrance in real estate.
What does this mean? It means the new commercial real estate ownership might not be able to use a portion or all of the property they just purchased in the manner they set out to.
What Is an Encumbrance in Real Estate?
An encumbrance is a claim against a property that inhibits it and can affect its ownership, value or the ability to transfer. Most properties sold come with some form of encumbrance.
It might seem like an encumbrance is a bad thing, but they’re actually designed to protect the property and benefit the owners/buyers. Encumbrances generally only hurt sellers who don’t disclose them to buyers, which can result in costly legal action.
For buyers who fail to consider encumbrances early in the due diligence process, the result can be the need for additional capital to be raised to resolve the encumbrance. This financial strain can negatively affect calculated rates of return for developers and investors.
Types of Encumbrances: Private vs Governmental
Encumbrances can be broken down into two primary categories; private and governmental. These encumbrances differ by nature depending on if they are financially driven or set up around zoning ordinances.
A private encumbrance can be placed upon a property by an individual or company and is usually financial.
A lien is one of the most common types of encumbrances. For example, a mortgage is a lien set up by a lending institution. A lien grants rights to a portion or all of the property until the debtor repays them. Judgment liens are another form of lien where legal action is taken against a property owner for goods or services unpaid.
A lease is another common form of encumbrance. For commercial real estate, leases are a critical encumbrance for potential buyers of multi-unit residential and retail properties. Just because a building is sold doesn’t mean the new buyer can change the existing terms of a lease. Commercial real estate investors should factor in all aspects of these encumbrances. Otherwise, it could significantly affect their income projections.
Easements are slightly more complicated encumbrances that generally affect the current or future use or development of a property. The most common types of easements are easements in gross and negative easements.
Easements in Gross
An easement in gross is bought by a person and allows them to use or develop a portion of the property. Typically these easements exist between owners of neighboring properties. An example would be an easement for property owner B to make a driveway through property owner A’s land due to impeding natural structures.
However, this isn’t always the case. Property owner A could grant Mr. Brown the right to hunt on his land. The critical fact to remember is these easements attach themselves to the person who owns them for their lifetime. If a new property owner wants out of these easements, it could mean buying them out of the agreement to develop or change the property’s usage.
Negative easements outline changes new property owners can’t make with a property. Many times, utility companies place negative easements on portions of a property to prevent owners from developing on areas they need to run utilities such as power and gas lines. There can also be negative easement agreements with neighboring properties, so one doesn’t expand a building to block a view or sunlight. An overlooked negative easement can completely derail the development plans of a commercial property.
Restrictive covenants are similar to negative easements but differ slightly. A covenant usually places restrictions on a general area and is enforced by a community, like a homeowners association. While restrictive covenants are typically limited to residential usage, commercial developers who intend to repurpose residential areas should be on the lookout for any attached to their prospective property.
Many mistake encroachments for easements. A good way to remember the difference is that an easement is an agreement, while an encroachment is someone illegally claiming someone else’s property for their own.
This problem can happen in CRE when an owner builds on their property without getting a survey. If a buyer neglects to get a survey, these encroachments can be passed to them. This risk is why getting a survey should always be on a due diligence checklist.
The most common encumbrances imposed by municipalities are city zoning laws. These laws outline land use regulations and protect other residential and commercial landowners. It’s essential that CRE developers and investors are knowledgeable of all zoning laws before buying a property. While zoning laws are not “set in stone,” and variances can be filed, it’s much better knowing that going into the deal than after the purchase.
Building codes are enforced by the city and apply to residential and commercial properties. They’re designed to provide a record of safe building practices and help with the standardization of construction. Most of the time, these encumbrances are not an issue.
But, like with zoning, commercial developers want to go outside of these guidelines in certain instances. They also have to get a building variance approval from the city in these cases.
Of all the encumbrances imposed on a property, environmental protections are the hardest to overcome and most unpredictable when it comes to land development. Factors like native lands, endangered wildlife habitats and preserved ecosystems all come with strict development regulations. While most environmentally protected lands are clearly outlined on maps, protected areas are always subject to change.
For example, if a property is near a freshwater source, it could potentially become a protected water source in the future. If there is an endangered bird species that nests in a specific tree prevalent on the property, it could become a protected habitat.
There are also public health encumbrances that come with environmental protection. Environmental surveys are also helpful in detecting any hazardous materials left over from previous ownership that can be a detriment to human health, like asbestos or contaminated groundwater within the property. These liabilities are often overlooked during property appraisals and can be transferred to the new owner if not mediated.
How to Know If Your Property Has an Encumbrance
There are three easy steps to understand the encumbrances tied to your property.
1. Do a Title Search
By paying a title company to perform a chain of title search, you’ll be able to dig up most financial encumbrances associated with the property. This research should include liens, leases and easements.
2. Have a Real Estate Attorney
Having an excellent real estate attorney on your side will help dig up any encumbrances that aren’t provided through a title search. These obstacles can include restrictive covenants, zoning laws and building codes.
3. Get Surveys
Surveys will turn up records that might not be associated with a title search. Surveys should always ferret out any encroachment issues, whether with other properties or environmentally protected lands. It’s always a good idea to do an environmental survey to prevent purchasing a contaminated property.
How to Handle Encumbrances
While some encumbrances such as environmental protection or zoning laws might be challenging to overcome, they’re not impossible. It’s all about the time and money you’re willing to spend to overturn them. However, simply repaying a loan or restructuring a lease agreement can solve an encumbrance in most cases.
Be Aware, But Not Afraid of Encumbrances
For the most part, encumbrances are designed to help people make the right real estate decision and act as a speed bump to prevent people from entering into deals too hastily. They become troublesome for sellers who choose not to disclose them and buyers who don’t perform the proper due diligence.
Following a due diligence checklist that includes performing title searches and purchasing surveys will protect buyers from most encumbrances. Having a real estate attorney on your side to guide you through the process and advise you when uncommon encumbrances surface is always a good idea as well.