Legal Due Diligence in Real Estate Transactions: Its Significance and Methodology

Introduction

Real estate is one of the fastest growing sectors in India evidenced by a sharp increase in real estate transactions involving buying, selling, leasing and financing of properties. In addition to transactions in urban areas, we have also witnessed large scale procurement of land from individuals in villages close to the urban, industrial and commercial centres. Similarly, there has also been an increase in leasing (both short and long term) of commercial office space.

The increase in real estate transaction values combined with the growing participation of the organized sector in real estate has resulted in heightened awareness of the risks involved and, consequently, the need for ensuring that the risks are identified and minimized in such transactions. ‘Legal due diligence/ title search’ of real property (be it of vacant tracts of land or of constructed residential/ commercial/ industrial properties) is clearly the mode for achieving these objectives. A due diligence exercise is probably the most important aspect of a transaction involving real estate immediately following a broad understanding of the commercials. This process has the potential of not only impacting the commercials but also determining the feasibility of the transaction itself. While the commercials often pay high importance to expedite the conclusion of a transaction, it is critical in the interests of the players to provide adequate time and attention to a detailed due diligence of the property involved. It is important to realize issues such as title, permitted use, legality of construction, encumbrances and easements which have the ability to impact the very nature of the property and its suitability to the commercial needs of the transaction.

Need for conducting and scope of legal due diligence of real property:

Due diligence is conducted mainly to verify the ownership of title over the property and any encumbrances over the property, so as to protect one against pre-existing claims over the property. Such claims could either affect the ability of the transferor to transfer the property or could attach themselves to the property even after it is transferred. The primary objective of a due diligence is therefore to gather information. The extent and type of due diligence to be undertaken by the purchaser’s lawyer will depend on the following:

  • The risk profile and business objectives of the purchaser/ lessee;
  • The type of real asset involved;
  • Nature of the real estate transaction (i.e., whether it is a purchase, long term/ short term lease, mortgage or financing of the real property,
  • The time frame for completion of the transaction; and
  • Whether the purchaser is looking at obtaining third party financing either pre-transaction or post-transaction.

In case of a prospective purchase, a lease of the property or real estate financing, a title search is performed primarily to answer three questions:

  • Does the owner/ lessor have sufficient authority/ interest/ right to enter into the transaction involving the property in question?
  • Do any liens exist on the property which needs to be discharged before the consummation of the transaction in question? These could be in the nature of mortgages, charges, acquisitions, unpaid taxes, litigation, easements and other assessments.
  • What is the nature of restrictions on the use of the property?
  • Apart from undertaking title search/ due diligences for purchase or lease of properties, a title search/ due diligence is also performed when an owner wishes to mortgage the property with any bank, financial institution or a lender. Such bank/ financial institution/ lender may require the owner to submit a due diligence report of the property or may conduct such diligence on its own.

Type of Due Diligence/ Title Search:

Depending upon the nature of the transaction, the property involved and the objective of the participants, a due diligence can be divided into two broad categories:

  1. Full search; and
  2. Limited search.

Full Search:

A full search is usually done while giving a title certificate of the property in instances of sale/ resale/ long term lease transactions and for transactions that involve obtaining of financing by mortgaging the property in question. In a full search, the search regarding status of ownership of the property is generally conducted for a period preceding thirty (30) years (or more) from the date on which the seller in question came to acquire the property.

It also includes a detailed search of all aspects relating to the history of that property such as the status of encumbrances over the property, the status of disputes relating to the property, the applicable regulations and the status of compliance of such applicable regulations relating to the property in question.

Limited Search:

A limited search is generally conducted in transactions where the property is taken on lease for a short term (usually under 9 years). In such instances, the period for which the preceding ownership of the property is traced is generally restricted to fifteen (15) years (or less) from the date on which the current owner of the property came to acquire the property.

Unlike full searches, in a limited search, the search relating to the history of the property may be limited to restricted aspects such as recent title history, encumbrances on the property, disputes related to the property etc.

Steps involved in conducting such due diligence/ title search:

In order to conduct title search / title verification, the following aspects would require to be examined:

a) Legal capacity of the present owner of the property (whether the person is legally capable of entering into a binding contract for sale or lease of the property or for mortgaging the property);

b) Nature of current owner’s right over the property, and whether such right is transferrable;

c) Source of right or title of the current owner;

d) Legality of the construction;

e) Encumbrances over the property; and

f) Whether the property is a part of any acquisition process.

We shall now elaborate each of the above and highlight the need to examine these aspects.

Step 1: Legal capacity of the seller:

It is necessary to ensure whether the current owner of the property or any of the predecessor title holders of such owner is:

  1. a minor (a person, who is below 18 years of age); or
  2. a person of unsound mind.

In case of minor’s land:

If the current owner of the property is a minor, then the property can neither be purchased nor be taken on lease without prior permission of competent authorities. Who or what shall be the ‘competent authority’ will depend upon the personal laws applicable to the minor. For example, in case of a minor who is a Hindu, permission is required to be obtained from the civil courts under applicable sections of the Hindu Minority and Guardianship Act, 1956 before the guardian of the minor can deal with the minor’s property in any manner.

In case the owner is a person of unsound mind:

Only a person appointed as a guardian, by a competent court under the Mental Health Act, 1987, can sell the property on behalf a person of unsound mind.

Step 2: Nature of current owner’s right over the property:

It is necessary to identify the nature of the right that the current owner has over the property and the transferability of such right. The types of rights that an owner can have over the property can be classified as follows:

  1. free hold or absolute ownership;
  2. right of perpetual lease;
  3. tenancy right; and
  4. land allotted by State Government/ Central Government under various enactments.

Step 3: Source of right or title of the current owner:

In India, a person can acquire right or title over the property in following ways:

By Purchase:

In case the title was acquired by purchase, then one needs to examine the registered1 sale deed/ conveyance deed along with the title documents of the predecessors’ title holders of the property.

By inheritance (by virtue of entries in mutation2 register/ jamabhandi3 [which are maintained by Revenue Office for every village] and/ or court orders):

If the title was acquired by inheritance, the basis of such inheritance would require to be determined, i.e., whether by way of a will or applicable laws of inheritance. It would also require to be determined whether there is any other person(s) who would have a similar claim of inheritance over the property. An understanding of the personal laws would also be required in this analysis. If the owner claims inheritance jointly with other persons, then it should be checked whether there was any partition.

Also, in rural properties, the Jamabhandi/records of rights need to be examined to check if the current owner’s name is reflected as owner in possession of the land. The Jamabhandi/record of rights would disclose the name of the recorded owner, name of the person in possession, nature of right, nature of land, and also encumbrances, if any. For urban properties, the records of the municipal authorities should be inspected.

By Partition:

If the current owner has acquired title over the property by way of partition, then one needs to examine the deed of partition to ascertain whether there were any conditions or restrictions in the deed which may affect the enjoyment/ transferability of property.

By Gift:

If the title was acquired by way of gift, then the registered gift deed needs to be examined to check if there are any conditions, like reservation of life interest, restrictions for alienation, payment of maintenance, pre-emption etc.

By Will:

In case, the title has devolved upon the current owner by virtue of a will, it is advisable to examine the will as well as the order passed by the probate court granting probate/ letters of administration of the property, if any.

By Perpetual lease:

If the title was acquired by perpetual lease, then the deed of lease has to be examined to determine the transferability of the right and the conditions to such transfer. The extent of the rights of the lessor should also be examined.

Step 4: Legality of the Construction:

If the property involves a construction on the land, it also becomes necessary to examine the legality of the construction. Each State government (and the relevant local authorities) lay down their own rules and regulations which govern the manner in which civil constructions need to be carried out in that particular State. Therefore, a lawyer, undertaking a due diligence of land having a structure on it, needs to first get familiar with the local construction laws applicable in the region in which the building is situated, and then, to determine whether these have been complied with, in undertaking the construction of the building in question. The aspects which would need to be examined in this process would be the footprint area (including set-backs), the extent of constructed area, the number of units constructed, the height of the construction and such other aspects.

Step 5: Encumbrances over the property:

It is necessary to verify whether there are any encumbrances, charges, or mortgages on the property in question. The records of the concerned Sub-Registrar of Properties should be examined to ensure that the property is free from all sorts of registered encumbrances or charges or mortgages. It is also advisable to obtain an encumbrance certificate issued by the concerned Sub-Registrar of Properties which would detail the registered encumbrances, if any, on the property. This certificate may be obtained from the office of the Sub-Registrar for Properties, where the property is situated. In addition, since a mortgage could also be created over the property by way of deposit of title deeds, the original title documents of the property should be inspected to ensure absence of such unregistered mortgages. Further, if an encumbrance is created over a property which belongs to a company then such encumbrance needs to be registered with the Registrar of Companies. Therefore, if we are conducting due diligence of a property where the current owner is a company then the records of Registrar of Companies need to be inspected in order to ascertain absence of encumbrance over the property in question. If there is an existing encumbrance, charge or mortgage over the property, it should either be cleared prior to the purchase or provided for in the consideration.

Step 6: Whether the Land is a part of any acquisition process:

It is also important to know if the property is under the process of acquisition by any government authority. If the property has been acquired by the government, then the property ceases to belong to its original owner and becomes the property of the acquiring authority. Thus, the property so acquired cannot be sold or alienated further by the original owner of the said property, unless the property has been released from the acquisition process.

Constituents of a valid title certificate:

Based on the information collected by following the steps enumerated above, the report/ title certificate is issued. The question as to what would constitute a valid title certificate under Indian laws has been examined by the Bombay High Court in Ramniklal Kotak Tulsidas & Others Vs Varsha Builders & Others (AIR 1992 Bom 62) which lays down some of the principles for issuance of a title certificate. Based on the observations in this case and other relevant matters, in our view, an advocate needs to undertake the following before issuing a title certificate:

  1. Peruse the title-deeds in original.
  2. Undertake searches in the offices of the sub-registrar of properties. This search should cover a period of at least the last 30 years. In case of agricultural land, search should also be undertaken at the local Patwari/Tehsildar’s office. In case of companies, a search of the records of the Registrar of Companies should also be undertaken.
  3. Obtain an encumbrance certificate.
  4. Make enquiries on title and obtain satisfactory answers.
  5. Obtain declarations on oath from the relevant persons regarding the factual position before issuing the certificate of title.
  6. Public notices should be published in at least two newspapers (one in vernacular and the other in English circulating in the area where the property is situated) inviting claims of members of the public against, or in respect of, the property in question.

Conclusion:

The significance of a due diligence exercise lies in following each of the above detailed steps, the absence of even one of which could render the process inadequate to address the concerns of the participants.

Footnotes:

  1. Registered with the Sub-Registrar of Properties/ Assurances appointed under the [Indian] Registration Act, 1908.
  2. Mutation indicates the changes that have to be brought about in ownership and title of the land. The order directing/ allowing a mutation is called a mutation order.
  3. A document prepared as part of record-of-right in every revenue estate. It contains entries regarding ownership, cultivation and up-to-date of various rights in land. It is revised every five years when a Jamabhandi is prepared by a Patwari (A village accountant or registrar) and attested by revenue officer.

Written By : Krishna Kumar Mishra

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