Real estate investors can encounter legal risks that could hinder the transaction. Not all defects can be remedied quickly and cheaply. Some may even be irreparable. In this context, legal risk insurance becomes a useful tool to secure acquisition of real estate and to facilitate closing deals in all real estate sectors.
Due Diligence
Under Polish law, a purchase may become invalid, for example, if a municipality’s right of first refusal is disregarded or no access to a public road is provided when subdividing a plot of land. What should be done in a situation where a due diligence report shows that the seller has acquired the property on the basis of an invalid contract? The title to the property could be challenged despite formal registration in the land and mortgage register. Can such properties be acquired?
A title can be challenged or even lost due to legal problems. The resulting financial loss can be significant. In practice, defects in title often result in long and difficult negotiations between the parties, the financing bank, and/or other interested parties. The parties discuss compensation, price reductions or additional security in case the risk materialises. Sometimes the buyer walks away from the negotiation table. Or an investor sometimes decides to go ahead with the transaction, but later faces problems obtaining a loan, developing the project, or leasing the space.
Risk assessment and solutions
Merely discovering an irremediable and significant legal defect does not necessarily mean that a loss will be suffered. An experienced legal adviser can help to assess the risks and may propose effective insurance solutions to protect against a loss. This will enable the transaction to proceed successfully.
Insurance eases negotiations
If the legal due diligence process reveals a defect in title, the buyer may be advised to take out a title insurance policy. This insurance allows certain risks to be assumed by an insurance company. If the risk materialises, the insurer will cover the costs of defending the case in court (together with lawyers’ fees and other expenses) and will pay a settlement equal to the losses incurred by the insured party.
Hence, taking out a title insurance policy makes it possible to unblock transactions and carry out investments despite risks that otherwise would be unacceptable to the investor.
Other advantages
There are also other advantages:
- Insurance is beneficial for the seller. If a defect is discovered by the buyer’s lawyer, the seller can offer to pay an insurance premium which is much lower than the reduction in the sales price requested by the buyer. The price is maintained at a low cost and the buyer is secured.
- Negotiations take less time and focus on business and commercial matters rather than complex legal issues that are difficult to explain to both parties and the bank.
- The policy is transferable – the bank granting a mortgage can also be protected from the risk, as can the next owner of the property, e.g. an investor buying a completed project from a developer.
Various types of insurance
Certainly, the mere fact of obtaining insurance does not eliminate the insured risk but makes it possible to provide compensation for a potential loss.
At the same time, it is important to remember that the loss may not necessarily be limited to the value of the land. If a buyer incurs significant costs by building a manufacturing plant or a warehouse on the property, the losses will exceed the value of the land by a significant amount. Title insurance policies may be adapted to such specific situations. Insurers can offer an option of insuring up to the full value of the future investment.
These examples are related to defects in title (typically ownership or perpetual usufruct), but title insurance may also cover other forms of legal title to land. A policy can guarantee the validity and enforceability of tenancy or land lease agreements on which, for example, a wind or photovoltaic farm is located.
In addition to risks of defects of title, insurers are willing to underwrite many other specific risks. For instance, if a building permit is invalidated a construction project may be suspended or the use of a building may be prohibited. With some insurers, defects in planning permission can be covered as early as during the construction process. Not only monetary losses incurred on investments but also losses suffered during the suspension period or consequential losses due to cancellation of permits (such as demolition or rebuilding costs) are covered.
For example, a shopping centre could suffer a substantial loss due to a total closure order that lasts many months. It is noteworthy that in such situations, insurers offer a loss-of-rent settlement because a covered risk has materialised.
Conversely, if a tenant of a warehouse or manufacturing space is planning significant capital expenditure on the premises and there is a risk that the building may lose its potentially defective building permit, one solution would be to cover the tenant’s capital expenditure loss under a permit policy.
These are just a few examples. Insurers do not have a finite list of risks; the legal reality is more complex. It is always advisable to ask an insurance company whether a particular risk can be covered.
Looking beyond title insurance cover
Insurance plays an important role in many aspects of property or M&A transactions. Representations and warranties made by the seller in the purchase agreement relate to fundamental matters (incorporation, authority of the company, title to assets, leases, permits, absence of claims, absence of insolvency situations) as well as non-fundamental ones (tax, environmental, intellectual property, etc.).
The seller is bound by these representations for an agreed period and is liable for damages if its representations prove to be incorrect. Therefore, the seller must ensure the existence and solvency of the warrantor for the entire period. At the same time, the seller naturally expects smooth distribution of the profit generated in the transaction and fast liquidation of the selling company, often organised as a special purpose vehicle.
This is where insurance comes in. The insurer covers the seller’s warranties without recourse to the seller. The insurer steps in, and it is the insurer that indemnifies the buyer in the event of a breach of representations. This solution benefits the seller in that it provides for an exit from the transaction regardless of any prior liabilities. The buyer has a highly solvent financial entity as its counterparty instead of an empty SPV, a clear and fast route to indemnification is guaranteed, and the period of cover can be extended.
Conclusion
A professionally conducted real estate due diligence process makes it possible to assess a risk in a transaction and to apply appropriate methods to protect the buyer. An insurance policy is sometimes essential to unlock negotiations and close the deal. Title and R&W insurance can be a win-win solution. It gives the buyer peace of mind and protection against financial losses and enables the seller to redistribute profits quickly.
Co-author Marek Koziarek, business development consultant, XL Insurance Company SE (AXA XL)
Marek Koziarek is a real estate professional with over 30 years of experience. For many years, he has worked in senior positions at financial institutions that lend to commercial and residential property projects. He has been involved in structuring and negotiating the financing of many construction and investment projects that have become icons of the Polish real estate market. For five years he has presented insurance solutions to developers and investors facing legal and administrative challenges in their projects.