What to Do When You Acquire Property That Hasn’t Been Submitted for Verification

Sometimes, when one business acquires another, there are illegal properties among the assets of the company being acquired, but by the time the company that has acquired them notices, it’s already too late. You’ve drawn the old maid. What will you do?

May 10, 2018

Stuck with illegal property gained via M&A

In 2014, the Japanese Ministry of Land, Infrastructure, Transport and Tourism released its <i>Guidelines for Investigating the Status of Compliance with the Building Standards Act Using Designated Verification and Inspection Agencies in Regard to Architectural Structures Without a Certificate of Inspection. <i> These guidelines accelerate the progress of legalizing buildings that have not been issued a certificate of completion inspection. Under these guidelines, buildings can be deemed lawful upon investigation by designated private-sector inspection agencies to determine whether they are compliant, and rectification of problems. Upon being deemed lawful, they can be repurposed or expanded. The guidelines are a groundbreaking initiative to encourage the effective use of existing stock, with the ulterior aim of putting properties that are ripe for investment on the market.

There have been some “relief measures” directed at the problem of buildings that haven’t received a completion inspection certificate, but buildings that have intentionally never been submitted for building verification are train wrecks. Going ahead with the construction of a building without getting permission from the relevant authorities is obviously illegal, but when you unwittingly gain ownership of a property with no verification certification, you might not realize that you have a problem until later.

Fumi Ikegami of the JLL Japan Capital Markets Department was baffled by something a client told her on the phone. It was a sudden request for counsel from a long-time client. This is what the client said: “We acquired a company, but some of the real estate that company owned doesn’t have verification certification. What should we do?”

JLL takes compliance very seriously, and strictly abides by the law. Day to day, clients come to JLL with all kinds of requests, but, as far as Ikegami knew, this was a case that “the Capital Markets Department had never seen before.” She continues, with some irritation, “Who doesn’t check for compliance when they’re about to make a deal? It’s unbelievable that someone would neglect to check for verification certification.” Because due diligence in real estate required a high level of expertise, real estate dealings that involve other transactions, such as this one, or property transactions that don’t involve real estate professionals, may end in contracts being signed without sufficient surveying of the property. The client had acquired a company, and among that company’s assets was a warehouse in a local city. They continued to use the warehouse for a while after the acquisition. They then decided to expand the building and inquired at the relevant government agency, and only then did they discover that the building does not have verification certification.

If a building has just never been inspected, there are steps that can be taken

If a building’s previous owner intentionally decided not to acquire building verification, and the building was not verified to begin with, that is an illegal building. The building might not have gone through the necessary procedures, and if the violations were severe enough, it would be impossible to expand or repurpose it, leaving no choice but to rebuild it from scratch. The company that acquired the property mentioned above is stuck in a very difficult situation, and is even considering claiming for damages. The damages include the costs of dismantling the building, constructing a new one, and relocating the users of said building—losses worth more than the value of the property. However, with an investigation following the aforementioned MLIT guidelines etc., they could avoid the worst-case scenario that is having to tear down the building. Ikegami offers her commentary. “Throughout the country, there are countless properties with problems like this one. The MLIT guidelines are an initiative being made in order to effectively use existing buildings with problems like this. If the buildings whose safety and legality are certain are utilized, local governments where buildings are located can also have the advantages that they can secure tax money from fixed asset taxes and corporate taxes and contribute to employment.” She hasn’t given up hope, but it feels like she’s grasping for straws. Perhaps, in her heart, she is not so calm.

No verification certification means a drastic drop in value

If you find yourself unwittingly in possession of an illegal property, you must come to the grave understanding that the value of that property is greatly damaged. Shigekazu Kamiyama of the JLL Japan Strategic Consulting and Valuation Team explains. “Real estate has become more securitized, and cases of income properties with no verification certification are rare, but do exist among those owned by companies. However, they tend to be parts of buildings that were expanded, small storage spaces, or warehouses—not entire buildings. In those cases, the impact on the value of the property as a whole is often limited. When a building is required to have a high level of compliance and rectifying it would be too difficult, an appraisal will be conducted on the premise of rebuilding it. However, in areas where land is cheap, the dismantling costs would completely deplete the value of a property, but rebuilding as a highly profitable and highly marketable property with a different use is also on the table, so it’s even possible for the value to increase.” However, the properties are still illegal. Most funds and investors—including, of course, J-REIT—take compliance very seriously, so acquiring a property with no verification certification is out of the question. An exit strategy would be very difficult to come up with.

The case mentioned earlier in this article may seem like a rare one, but Ikegami says otherwise. “The importance of a CRE strategy—a strategy for using your real estate assets to add to the profits from your main business—is becoming widely known. Following that trend, we’re likely to see an increase in cases in which companies not involved in real estate sell their own properties. That means that a higher probability of properties of questionable legality—for example, properties with no certification of verification or inspection—slipping in,” she warns. Kamiyama is of the same opinion, noting, “The only solution is to thoroughly valuate properties before you acquire them.” When it comes to transferring real estate, even in the context of M&A, having a real estate professional survey the properties in advance is the best way to counter the risks.