Capital construction projects (referred to below as CCPs) are a distinct legal category in the regulation of immovable property and hold a special place in civil circulation. The legislator has therefore laid down a number of special rules.
Yet, despite the abundance of Russian rules on how rights in a CCP arise and pass, and on how encumbrances over a CCP are created and removed, many hidden risks remain in practice. If those risks are left out of account, they can affect the liquidity and the market value of the property, and they can lead to its loss in whole or in part.
The point is especially relevant when risk is assessed in the performance of obligations under loan agreements concluded with banks and secured by a pledge.
In precisely those cases, what matters most to a credit institution is comprehensive monitoring of the characteristics of the property, among them:
- the actual use of the land plot and of the CCP, and whether that use matches the permitted use;
- the lawfulness of construction and reconstruction works carried out on the CCP;
- whether the cadastral records are complete and up to date.
Risks that are left out of account can, in the end, lead to:
- total or partial loss of the collateral, and a fall in its value;
- a deterioration in the borrower's financial position and the loss of the ability to service the loan;
- difficulty, or impossibility, in realising the collateral if enforcement is sought against it.
Banks' collateral departments carry out their own checks of both the borrower and the collateral as early as the stage at which the characteristics of the property are analysed. The main risks connected with the property are therefore taken into account at the initial stage of the credit relationship. Some hidden and less obvious risks can still be missed by the bank's staff, for various reasons.
Drawing on our own legal and valuation practice, we have identified the breaches of the law by borrowers that occur most often. They are not always among the obvious risks that a valuer may detect when determining the value of the collateral, but they can affect a bank's decisions.
The legal risk factors that materially affect a change in the value of the collateral and the possibility of registering a transfer of rights to it, and that worsen the borrower's position, are as follows:
- the property being held to be an unauthorised building;
- a finding that the actual use of the land plot does not match the permitted use;
- a refusal to register a transfer of rights to the property because its technical characteristics were changed unlawfully by replanning and refitting.
We consider the main risks in detail below.
Treating the property as an unauthorised building
An unauthorised building is a structure erected on a land plot that was not granted in the prescribed manner, or whose permitted use does not allow such a structure to be built on it. The category also covers structures erected without the necessary approvals or permits, or in breach of urban-planning norms and rules.
Owners of commercial property who try to increase cash flow by means of extra floor area they have built often disregard the need to obtain permits. In those situations they rely either on obtaining the necessary documents in the course of construction or reconstruction, or on unlawful schemes connected with state registration of rights and with cadastral registration of the changes.
Although Federal Law No. 218-FZ of 13 July 2015 "On State Registration of Real Estate" guarantees that the particulars of a property entered in the Unified State Register of Real Estate (EGRN) are reliable, practice looks different: particulars entered in the EGRN may have no lawful basis.
Typical breaches by property owners include added storeys, extensions and other changes to the parameters of a CCP.
If those breaches are found, a public authority may apply to a court either for demolition of the property as a whole or for the property to be brought back into line with its previous condition (loss of part of the property).
A mismatch between the actual use of the land plot and the permitted use
The permitted use of a land plot is one of the key factors that determine the value of the land plot. That parameter is the basis both for the cadastral value and for the market value, and it determines the amount of property tax or of the rent for the land plot, which are calculated from the cadastral value. Because a land plot and a building share one "fate", every building on the land plot must be used in accordance with the permitted use established for the plot.
In practice, holders of land plots granted to them for particular purposes often begin to use the plots in an entirely different way.
For example, in Moscow, until a certain time, a state programme provided for land plots to be allocated to interested persons so that car-wash bays could be built. Once they had received the plots for use, the holders often disregarded the stated purposes and built retail properties.
It is also common for industrial buildings, standing on land plots intended for the operation of industrial facilities, to be converted into office buildings and for the office premises then to be let.
Today, because of the land-use and development rules of Moscow adopted in 2017, the public authorities are seeking to bring all current types of permitted use into line with Order of the Ministry of Economic Development of Russia No. 540 of 1 September 2014 "On Approval of the Classifier of Types of Permitted Use of Land Plots".
On that basis, the State Inspectorate for Control over the Use of Real Estate of the City of Moscow, which is subordinate to the Moscow Department of City Property, has a number of powers to control the use of real estate, including compliance with the types of permitted use.
If, following an inspection, the State Inspectorate finds that the actual use does not match the permitted use, it issues an act containing an order to remedy the breaches. That means either restoring the building to its original condition or demolishing it. Where the land-lease agreement provides for penalties for use of the land plot other than for its intended purpose, the person in breach is also obliged to pay a fine (in Moscow, up to 100% of the annual rent).
Those sanctions can come as a complete surprise to owners of buildings or premises whose land relations are governed by a land-lease agreement with several persons on the tenant's side. A breach of the land-use conditions by one tenant of the land plot which has led to a change in the permitted use, an increase in the cadastral value of the land plot and, as a result, an increase in the rent, extends to all the tenants of that land plot.
In addition, since 2017, cases of an "unexpected" change in the permitted use have become frequent. The consequence is an equally unexpected increase in the cadastral value of the land plot (often several times over), which brings an increase in the rent (land tax). The cause is those same inspections of the actual use of the land plot carried out by the State Inspectorate.
Lately the Moscow State Inspectorate has been testing its own "know-how": if buildings and structures that can be assigned to a "more expensive permitted use" (retail, catering, consumer services) are found on an industrial land plot, a claim is filed in the arbitrazh court.
At present the principal claim1 is for recovery of unjust enrichment that arose for the tenant of the land plot because the plot was used for purposes other than those stated in the lease and because rent was underpaid. That rent is calculated from the cadastral value and depends directly on the permitted use. To date, the Arbitrazh Court of Moscow has granted one such claim.
In any event, breaches found in the use of land entail, at a minimum, monetary losses in the form of fines and a heavier burden of rent (land tax) and, at a maximum, loss of the property, partial or total.
A refusal to register a transfer of rights to the property because its technical characteristics were changed unlawfully by replanning and refitting
So that a building can be used more efficiently, the configuration of the premises inside it may be changed to suit the needs of the letting business.
Sometimes those changes sit on the boundary with reconstruction works. That calls for state registration of the cadastral record, for which the relevant supporting documents are required.
If the documents are drawn up improperly, or if they are missing, obstacles arise to state registration of a transfer of ownership of buildings and premises in which such replanning was not approved. That will make it impossible to realise the collateral without financial cost and delay.
If the risks set out above materialise, the consequences for the pledgee are as follows:
While the borrower is servicing the loan:
- total loss of the property deprives the borrower of the ability to service the loan if the collateral is the borrower's only source of income;
- partial loss of the property reduces the borrower's rental income because the lettable area shrinks, and because of downtime while dismantling works are carried out. That increases the burden on the borrower and, if the income from letting the remaining area is not enough, makes it impossible to service the loan;
- a breach of the land-use rules, and equally of the terms of the land lease, leads to a demand that the breaches be remedied (total or partial loss of the property) and to a fine on the tenant (in Moscow this is often 100% of the annual rent). The one-off burden on the borrower increases, with no right to be released from the duty to remedy the breaches.
While the debtor's property is being realised:
- partial loss of the property leads to a material fall in the realisation price and to a longer exposure period for the property;
- an unlawful change in the characteristics of the property makes it impossible to sell the property, because registration of a transfer of rights to it is refused.
When determining the market value of a property, a valuer has no duty, and by no means always has the means, to analyse whether the actual characteristics of the building or premises match those that are permitted. Not every valuer has knowledge of related fields (land law, urban-planning legislation, cadastral registration).
Even so, given the main significance of a valuation report for a bank, which is to collect information on the collateral in aggregated form, a valuer's identification of potential risks in the property can substantially strengthen the informative function of that report.
We have identified a number of markers that a valuer may detect when inspecting the property at the stage of preparing the valuation report:
- the permitted use does not match the actual purpose of the building (for example, an office building converted from an industrial building stands on a land plot with the permitted use "for the operation of industrial facilities"), which is a breach of the land-use rules;
- the actual space-planning characteristics of the building or premises do not match the technical-inventory documents (part of the load-bearing walls shown on the floor plan is in fact absent; elements of the building, such as stairs or window openings, are absent from the floor plan; or there is floor area that has not been recorded), which is a breach of the rules of cadastral registration and a risk that the property will be held to be an unauthorised building;
- a material discrepancy between the total area of the CCP according to the technical-inventory documents and the data in the EGRN.
A separate checking tool is Rosreestr's Public Cadastral Map. It can show the boundaries of land plots overlapping neighbouring plots, for example the street and road network. If the boundaries of the plot as actually used do not match the Public Cadastral Map, those breaches must be removed. That, in turn, may lead to a material reduction in the total area of the land plot.
The Public Cadastral Map may also show that part of a CCP stands on a neighbouring land plot. That threatens a potential conflict with the holder of that plot and indicates that construction of that CCP was unlawful.
In addition, the absence of data on the Public Cadastral Map (the link between the CCP and a land plot, or the boundaries of the land plot) indicates that the EGRN does not contain complete and up-to-date data on the property. That may cause difficulty when registration actions are taken in respect of the property.
Although a valuer has no direct duty, and no task, to carry out a legal examination of the property being valued, circumstances that have been identified and that point to possible breaches may be set out in a separate section of the valuation report. That section then serves as an additional source of information for the bank's staff.
A thorough analysis of the collateral, both by the bank's staff and by the valuer, therefore helps to take the full range of potential risks into account at the stage when it is being considered whether the property can be accepted as security for the borrower's obligations. At the same time, a legal assessment of the risks by the bank's staff, placed at the valuer's disposal, will allow the valuer to assess the degree of their effect on the collateral in terms of value.
In light of what is said above, we recommend that credit institutions, when working with valuers, give them the fullest possible information on the collateral, including a legal assessment of the regime governing its use, and that they also take into account the facts of potential breaches identified by the valuer.
For prospective borrowers, the main recommendation is to own and use the property in accordance with the requirements of the law, to monitor changes in those requirements regularly, and to hold a complete set of current and reliable documents for the property.
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