Real estate title is often misunderstood and overlooked but is one of the highest risk areas of real estate acquisition; potentially resulting in a catastrophic loss of an entire investment that may not be covered by a title insurance policy.
Priority of interests.
Real estate buyers purchase title policies to protect themselves from loss arising out of prior interests on title. Many real estate practitioners don’t truly understand real estate title or the function of a title policy that insures the buyer’s interest. A real estate buyer purchases real estate subject to the rights of parties that acquired interests in the real estate before them, regardless of how minor that interest may be. A $5,000 lien could wipe out a $5,000,000 loan if that lien has priority. Any discussion on real estate title or title policies must start with priority.
A person whose real estate interest has priority supersedes other junior interests. Priority is based upon the time at which a party’s interest in the real estate is created, so long as that party does not have notice of prior interests. Basically, the party that gets there first without notice of competing prior interests wins. In California, unless your chain of title originated from the state or federal government (or in some cases, believe it or not, Mexico or the Queen of Spain), prior owners or users of the real estate may have retained an interest in the land and any subsequent buyer takes subject to those interests.
General Rule: race notice.
To have priority in California over another, a party must both be the first to record their interest with the county recorder and not have notice of any prior interest (this is called a “race-notice” system of priority; some states have a “pure-race” system where first to record with or without notice attains priority). Notice means having either actual or constructive knowledge of a prior interest. Actual notice/knowledge is when we actually know (or should know) someone else has (or may have) an interest, even if it isn’t recorded with the county. For example, if we know (or would have known by an inspection of the real estate) that someone other than our seller or its tenant occupies (or uses) a property, we have notice/knowledge of that interest even if a lease or a memorandum of lease isn’t recorded with the county. This is also true of prescriptive easements (like a neighbor driving a path across a property for years). Constructive notice/knowledge is when something is recorded with the county recorder; even if we don’t have actual knowledge of it, we are deemed to have knowledge by virtue of the fact it is recorded and can be investigated by the public.
We often hear a real estate buyer say “no one told me about that before I bought the property” when referring to an easement or HOA restriction. The seller didn’t have to if it’s a recorded title matter; the buyer has constructive knowledge and their real estate is bound by it.
Purpose of a title policy.
A title policy is an indemnity (insurance) contract whereby the title company agrees to pay your covered losses for any matters they fail to identify in the policy as an exception to your ownership interest. Most common policies are either owner’s title policies (insuring the owner’s interest) or lender’s title policies (insuring that the lender’s deed of trust has a particular lien priority position). A title policy is not a representation of all prior interests that affect the title to your property; just what the title company identifies as an exception to their obligation to indemnify you. In effect, by issuing an owner’s title policy, the title company is promising to pay the buyer for insured losses covered by the policy and not excluded as an exception to the policy which have priority over the owner’s interest. It protects the buyer by insuring that its ownership interest is free of unknown prior interests (liens, easements, CC&R, past due taxes, and other matters) not shown in the county recorder’s records and listed as a title exception. The title company conducts a search of the county records and any interests they find and wish to except from the title policy coverage is listed as an exception to the title policy. These policy “exceptions” are a critical component of the title policy and often overlooked.
Read the exception documents!
Buyers have the opportunity to review these exceptions in advance (by a process usually stated in the purchase agreement) by obtaining a preliminary report or title commitment prior to purchasing the property and obtaining a title insurance policy. One of the biggest mistakes a buyer can make is not properly addressing title by following the title review process in the purchase agreement and not obtaining copies of the exceptions and reading them in their entirety. Reports and commitments list the recording information of the exception and its title or name but they frequently incorrectly state what they are. Because these exceptions were recorded before the buyer obtained its interest, the buyer has constructive knowledge and takes title subject to the rights of the holder of the exceptions. In this fashion, the basic policy covers the insured for matters not shown in the public record (i.e., constructive notice), but what about matters revealed by an inspection of the real estate that the buyer would have actual notice of?
Actual notice and the survey exception.
Title policies also list as an exception any matters that would be disclosed by an accurate and complete survey of the real estate (the “survey exception”). Why? Because a person’s title to real estate is also affected by what a visual inspection of the real estate would reveal (“actual notice”). If a buyer wants to be insured for matters that would be disclosed by an inspection of the property (i.e., protected from both actual and constructive knowledge), it may obtain an extended coverage title policy that deletes the survey exception if the buyer provides an acceptable survey of the real estate. The details shown on the survey include buildings, roads, driveways, parking areas, utility structures, fence lines, walls, and other such improvements. It should also show improvements that encroach onto, or from, adjacent properties. For example, if a neighbor’s block wall (or worse, building) encroaches three feet onto a buyer’s property, if it is shown on the survey and called out as an exception, it would be excluded from coverage. In addition, to the extent exceptions can be shown on the survey (like utility easements), the area affected is depicted. Not only does a buyer need to know where these easements are located, but it also needs to know if there is something shown on the survey that does not have a corresponding easement, like a path running across the property from an adjacent parcel. Not all buyers want survey coverage, as surveys are expensive; however, surveys are critically important if the buyer intends to develop the property. A utility line running in the middle of an area where the buyer intends to construct a building could kill a construction project unless the owner of the easement is willing to release it.
Examples of prior interests.
There are several critical implications of prior interests:
Leases. If a lease has priority (often indicated by a recorded memorandum of lease), then there may be terms in the lease (rights of first refusal or options to purchase an ownership interest in the property) that can affect the new owner’s interests. In shopping centers, it’s common to have title restrictions (such as another tenant’s exclusive use) that may impair or restrict another person’s ability to operate from a property within the shopping center. Just because a memorandum of lease hasn’t been recorded doesn’t mean the real estate is free and clear of a tenant’s interest; if an inspection shows a party in possession other than the owner, then a purchaser could be subject to that party’s interest.
Easements. Ownership in land is often subject to a variety of easements; either recorded separate documents, or easements granted on parcel maps. Carefully review any easements and make sure they are plotted on any survey you obtain; the title report/commitment’s list of easements as exceptions should also be listed and depicted on the survey. If a survey depicts an item that doesn’t have a corresponding easement (like a manhole cover or a light pole), further inquiry is necessary. If an easement is necessary to obtain access to the property, it should be added as a part of the insured legal description.
Rights of first refusal/options to purchase. A right of first refusal or an option to purchase gives the holder (e.g., tenant or prior owner) the right to purchase the property at some time in the future (option) or if the owner decides to sell the property (right of first refusal). If the holder of the right purchases the property, the purchase extinguishes any interests (including ownership and liens) created after the right was given, and the holder receives title to the property in the condition it was in at the time the right or option was granted. These rights are often hidden in leases, deeds, franchise agreements, and other exception documents.
Liens. Lienholders (creditors) with a prior interest in a property can foreclose on that property and extinguish (wipe out) the interests of a subsequent purchaser or junior creditors, taking the collateral free and clear of later (junior) interests. Liens are typically from financing, but in some cases may be from taxes, judgments, mechanics, or owners’ associations.
Subordination. Priority can be changed where one creditor agrees to be subordinate to the other, usually by a subordination or intercreditor agreement. The creditors don’t swap positions; they just agree one will be senior to the other. Intervening creditors that do not sign the subordination are not affected by a subordination agreement. For example, if creditor 1 agrees to be subordinate to creditor 3, creditor 3 will still be junior to creditor 2 unless creditor 2 also agrees to subordinate.
TIPS
- Ensure you obtain and review all exceptions/leases, in full, with all exhibits and any amendments (e.g., “Ground Lease dated October 1, 2015, as amended by that certain First Amendment to Ground Lease dated November 5, 2016 (collectively, the “Lease”)”.
- Check title to ensure there aren’t any use restrictions or exclusives granted to tenants that may conflict with your intended use of the property (usually in CC&Rs or lease memorandums).
- Make sure that the party you are dealing with is reflected on the title documents (either as fee owner if you are buying from them or landlord/tenant if the interest is a lease). If not, there should be assignment documents where you can confirm that the person you are dealing with is the current owner of the interest.
- Obtain estoppel certificates from third parties (like tenants) if possible to confirm their interests. If from a tenant, make sure any estoppel certificate describes the full lease, with amendments, and it addressed to the party who requested it and states the requesting party is entitled to rely upon it.