Can You Trust Your Due Dilligence?
When an investor ticks the ‘conditional’ boxes on a sale and purchase agreement for a valuation, building report, finance or other relevant health check, are they really protected from potential risk? What is the minimum due diligence an investor should undertake and can they trust the quality of a given report? Diana Clement finds the answers.
19 April 2016
Lawyers, mortgage brokers, surveyors, architects and other professionals regularly see the fallout from poor or non-existent due diligence. \
The repercussions of a lack of due diligence or of substandard reports can cost investors tens or even hundreds of thousands of dollars. So how do you avoid the pitfalls of due diligence gone wrong?
A Land Information Memorandum (LIM) report and a Certificate of Title are two documents where professional interpretation is paramount.
Callum Lindsay, acting team leader planning at Thomas Civil and Environmental says when it comes to LIMs, council files, and property titles many investors simply don’t understand the information.
The LIM, for example might say there is a road widening designation. When the investor goes to develop the property they find they have to give up the first five metres from the road boundary - or a Certificate of Title might have restrictions such as confining building to a specific area in the site.
Lindsay says one example that he can never forget was the buyer of a Whenuapai section that was zoned residential, but was so close to the military airfield that it was prohibited to build a residential building on the land. The investor only found this out after buying the land, and couldn’t subsequently sell it.
Mortgage broker Jeff Royle arranged pre-approval of a mortgage for one client who had relied on a LIM and other reports from the vendor/real estate agent without showing them to her lawyer. “It turned out that the title was defective due to unconsented works and no bank would touch it.
What she failed to note was that there was a sleepout, decking and new laundry and none of this had any form of consent or approval,” Royle says. “She did not know how to read the LIM so missed all this. It was only when we had a valuation done that this all came out.”
Royle managed to find a finance company to provide a bridging loan, but the sorry saga cost the investor $20,000 in legal work and bridging finance costs. The investor didn’t want to be interviewed because she was still “reeling from her silliness”.
The lesson here is to run all documentation past a lawyer and scrutinise it yourself as a second measure.
Property sales are largely governed by the “caveat emptor” (buyer beware) rules in New Zealand. But the Fair Trading Act of 1986 has eroded that to a certain degree as has the real estate agents’ Code of Conduct, Kevin Lampen-Smith, chief executive of the Real Estate Agents Authority (REAA), says.
The act and code mean that agents must disclose what they know about a property to buyers and cannot circumvent this rule by omission. Suggesting the purchaser get a building report isn’t enough if a previous report by another buyer they’re aware of suggested problems existed. Cases against real estate agents can be taken to the REAA.
Taking a vendor to court is more difficult, but not impossible. There are limited warranties and obligations for vendors, says The Property Law Centre lawyer Guy Seton, and sometimes it’s possible to sue for breach of contract or vendor obligation. If, for example, the buyers’ due diligence didn’t pick up issues with water, sewerage and power they could take the vendor to the disputes tribunal.
Not so common is a “fundamental breach”, Seton says, where the purchaser can argue that the property was so significantly damaged or impaired that it was not what was contracted for. Some examples of this arose in Christchurch where sales were about to go through when the land was severely damaged by earthquake.
A vendor doesn’t generally have to supply information about a property, but if they do, they can be sued for misrepresentation.
Likewise an investor whose due diligence cost them financially may be able to sue the council, building inspector, valuer, or their lawyer for negligence.
Discrepancies in titles can be many and varied. A client of Seton's bought a property not realising a covenant prevented sub-division.
You should be proactive in asking your lawyer to check the title documents and to advise you on any potential problems, ideally before signing an agreement. - Guy Seton
Valuation is considered an art not a science. - Malinda Baird
The covenant was put on the property by the original developer. Had the investor come to Seton before purchase he could have pointed this out.
Bayleys national residential manager Daniel Coulson experienced this with a vendor who hadn’t been aware at the time of purchase that the footprint of the cross-leased property he subsequently wanted to sell didn’t match the flats plan.
Cross lease properties can be problematic for many reasons and require extra due diligence. Investor Ashley Church became aware that he needed his neighbour’s permission to subdivide a cross lease property only after the same neighbour came to him seeking permission to build a carport.
Likewise, Mark Trafford, a project manager who runs Maintain to Profit, eventually had to on-sell a cross-lease property because the overseas-based Chinese owner of the other half of the cross lease wasn’t interested and didn’t reply to Trafford’s requests.
On the other hand, on occasion the information investors discover in their due diligence turns out to be incorrect. Schnauer & Co lawyer Nick Kearney cites a vendor who had bought a property years earlier. At the time of purchase a compliance certificate was on the council file. It transpired the certificate had been put in the file in error and belonged to a neighbouring property in the same complex.
"You should be proactive in asking your lawyer to check the title documents and to advise you on any potential problems, ideally before signing an agreement,"advises Seton.
Hidden Enviromental Hazards
Methamphetamine contamination and the resulting costly clean-up is an ever-present risk for investors. It’s relatively cheap to test for, however, and it’s something that investors should do in homes that have been let to tenants in the past.
What’s more, the mention of “potential” environmental risks on a LIM should be a red flag, Richard Thomas, of Thomas Civil & Environmental Consultants, says.
A significant number of properties in New Zealand are listed on council hazard registers. The greater Wellington Regional Council has, for example, over 2000 residential and commercial sites registered as contaminated or at risk. The properties are or have been polluted with heavy metals, asbestos, DDT, solvents, chemicals, fertilisers and even munitions. Not all are private dwellings.
We think an enviromental risk assessment report is something really worthwhile. - Richard Thomas
The Greater Wellington Regional Council now lists information about hazardous actives on its site and has a Contaminated Site Enquiry available on a web-based GIS viewer. Investors doing due diligence on properties can also use council GIS viewers to find out a wide range of information such as water quality and flood risks.
Simply being on the register doesn’t make the site contaminated. But the cost to prove that it’s not could outweigh the profits.
Thomas’ clients don’t want to admit their mistakes publicly, but one recent case involved an investor who bought a property with a “potential” contamination issue intending to subdivide. The LIM referred to a potential risk of soil contamination. That might not have been a problem had the investor wanted to let the house to tenants on its current footprint.
Instead he had to pay thousands of dollars for reports, remove tonnes of soil that might be contaminated with arsenic, pay to dump it and buy new fill, which added unexpected costs to the subdivision.
The very act of applying for resource consent triggered demands for a full environmental risk assessment simply because the property was on the council hazard register. Even building a driveway or garage could have triggered the same nightmare with the council.
Thomas says his company often sees cases of investors who have bought properties with asbestos and other hazards and have to pay to have it removed.
It's crucial to be informed says Thomas, "We think an environmental risk assessment report is something really worthwhile for people."
Choose Professionals Carefully
Investors should view all professionals with scrutiny when choosing who to trust with their due diligence. Valuers, engineers and lawyers need a high level of education and belong to professional organisations from which they can be ejected. Nonetheless, they are not all as good as each other.
Someone who is not qualified and experienced may not know what to look for in terms of a defect or understand how the defect has arisen. - Martine Fernandez
Getting a valuation can be particularly invaluable but sometimes isn’t as accurate as investors might expect.
Reader Warren Johns contacted NZ Property Investor magazine with a tale of three widely differing valuations on the same property. The valuations, all done within one day of each other, had a difference of $220,000 in value, which Johns believes is unacceptable.
In theory there should be no more than 10% variation in valuations from different valuers, according to the Consumer’s Institute. In Johns’ case, it was 13%.
But Valocity senior valuer Malinda Baird says valuations will vary in the assessment of market value, from valuer to valuer. “Valuation is considered an art not a science,” Baird says. “A valuation will provide insight into evidence used to arrive at the assessed market value and this can be weighted in your decision when purchasing a property.”
Valuers come up with their figure based on their visit to the home as well as sales of similar properties in the area. Johns suspects that in his case the wrong homes were compared.
Owners can have an impact on a valuation by suggesting local and recent house sales they would like their property valuer to consider. Valuers don’t have to use this information but are likely to if they believe you know your market.
It’s in the area of pre-purchase building reports that investors need to be most careful or risk buying a lemon.
In reality anyone can hang his or her shekel up and start offering pre-purchase building inspection reports. Former real estate agents and police officers with no formal training in building have set themselves up as building inspectors.
The lack of regulation over who can provide pre-purchase reports makes consumers susceptible to bad or even negligent advice, Martine Fernandez, member relationship executive, at the Royal Institution of Chartered Surveyors (RICS), says.
Fernandez says that there is a big difference from a $1,200 report from a member of her organisation and a $400 one from a fly-bynighter. "Someone who is not qualified and experienced may not know what to look for in terms of a defect or understand how the defect has arisen, how serious the issue is and what the necessary remedies might be."
She adds that just because an inspector is using the NZ Standard template doesn’t mean they know what they are doing and it’s a good idea to get a sample report.
Investors should always check that the professional/company has good insurance cover that will pay out if you take a claim against them for negligence.
And they should beware of real estate agents who aren’t that keen on reports that could hamper sales and point buyers to tame inspectors.
The title was defective due to unconsented works and no bank would touch it - Jeff Royle