Due diligence is something all investors have heard about, but very few investors really understand.
It is one of the most important things you must do before closing on a property. During the due diligence period it is imperative that the buyer identifies and evaluates any and all potential problems. You must thoroughly research, evaluate, and confirm all information and representations made about a property. If you do your job correctly then you will buy properly and make a lot of money avoiding expensive mistakes.
As a new investor I was afraid to make mistakes, so I’d do my due diligence to make sure I was completely comfortable with the transaction BEFORE making an offer. Three times another buyer showed up and put the property under contract while I was out doing my research. That’s very frustrating, especially after researching everything and learning I had found a gem.
If you find a property that looks good at first glance, then get it under contract. Just be sure to put contingencies in place that allow you to get out of the contract if you find something unacceptable during your due diligence period. This way you’ll have the opportunity to ask the seller to either solve the problem, reduce the price, get other concessions, or if needed cancel the contract.
Many times you have much more negotiating power when the property is under contract then when negotiating to put it under contract. Once under contract the seller mentally thinks the deal is done. Usually the seller doesn’t want to lose you as a buyer and is many times much more flexible then they’d otherwise be, especially when you bring them legitimate issues that need to be resolved.
Unfortunately, in this day and age you can’t trust what people tell you. One of the most important things I tell other investors is “don’t trust anyone. This is your business and you must be responsible for it.” People misrepresent the facts and sometimes down right lie. It doesn’t matter who it is, including nationally respected real estate gurus. You must verify everything! Do not ever just take their word for it.
There are people out there looking to take advantage of the uniformed out of state investor. Don’t let that stop you, just be sure to implement your due diligence. Keep searching for new information up until the day you close. There have been times I’ve found something that killed the deal the day before I was supposed to close.
Know your exit strategy up front. Are you planning to buy and hold the property making it a rental? Or do you plan to fix it up and sell it right away through lease/option or seller financing? If you plan to sell it right away then be sure that there won’t be any seasoning issues with the buyers lender. Always have back up exit strategies because things don’t always go as planned. I always look at the best case scenario and the worst case. If I can live with the worst case then I’ll move forward.
I’ve purchased many properties sight unseen, however when possible it is always best to do everything mentioned in this article yourself. If you’re not in the area then you must have someone you trust see the property inside and out. If you’re being represented by a real estate agent then they should not only see the property but also take pictures of everything including the neighborhood. You want to see and evaluate as much as possible. It’s also important to drive the neighborhood at night because many times it becomes very different when the sun goes down.
There was a property in South Carolina I had under contract. I was in California and not using an agent, so I contacted a local investment club and asked investors if they’d help me out. I also called a couple of local real estate agents and property managers. I’d need both an agent and property manager in the future and so it was mutually beneficial for them to help me. I had them all go by and give me their opinion on the property and the area it was located in. It was very informative hearing what they all had to say. They not only sent me pictures but also gave me an idea of what damage there was and what needed to be fixed.
Another great tool is Google Earth. This allows you to see an aerial view of the property. This can be very useful seeing what’s around the property. I had a property I was buying in San Antonio, Texas and using Google Earth saw railroad tracks not just near the property but right next to it. I could have pretty much reached out of the property window and touched the train as it went by. Then there were other times I found a dump nearby, or an airport, or a treatment plant! You never know what you’ll find and having this aerial tool is very beneficial.
After someone you trust has seen the inside and outside of the property and everything looks reasonably good, then next you would hire a home inspector. Be sure the home inspector is licensed and insured. If possible be present when the inspection takes place; if not just be sure to discuss with them that you want them to be very detailed. You want them to write down anything and everything they see, and the more pictures the better. Once you get the report look it over and make a list of questions, then call the home inspector to clarify anything that is needed. Many times what I thought was a big problem ended up being minor after discussing it with the inspector.
Don’t be alarmed when the inspector finds problems, they can be fixed. I’d be more nervous if they didn’t find problems because that means they probably didn’t do their job correctly. Even brand new homes should be inspected.
Many times something serious shows up that may need additional inspections by a specialist. If there are potential issues with the foundation then call a foundation specialist. Maybe the inspector found evidence of environmental contamination so you’d call a contamination specialist.
Remember, with the right contingencies you can cancel the contract if something comes up that is too big of a problem or too expensive to research further. Before calling the specialist see if the owner will pay for that extra inspection or at least split the cost with you. If not, you’ll have to decide if you want to move forward or not.
Once the inspection has been done and there are repairs needed, have a contractor go out and give you an estimate on the cost involved to fix everything. Then take it to the seller and re-negotiate. You have many options, the seller can either pay to solve the problem, reduce the price, or give you other concessions. If you can’t come to an agreement with the seller then you always have the option to cancel the contract.
I purchased a 4-plex in Arkansas one Spring. One of the units had a very old looking AC unit. The last thing I wanted was to close escrow and it stop working the upcoming Summer. The seller assured me that they had never had any problems with that unit. To be safe, I asked the seller to leave money with escrow for one year. If there were any problem that money would be used to fix or replace the unit.
Get comps that verify the property is worth what you’re paying for it. The comps must be of equivalent properties (rooms, sq. ft., lot size, etc.), and you must drive the comps to verify that they are indeed comparable to your property. Look at the most recent sale dates, the properties nearest yours, and how many days on the market.
Be sure to get a copy of the appraisal to look over. I had one property I almost bought from a builder and the only comps in the appraisal were the same properties that builder had sold to others. There were no other comps anywhere near what I was paying. It turned out I was over paying but was smart enough to realize it and get out of the deal. The other out of state investors weren’t so lucky!
Read the title report, this is something that many investors fail to do. If you need help understanding it then contact the title company and if necessary an attorney. Verify that the person you’re dealing with is the owner. Twice I’ve entered into a contract only to find that the seller was not the owner. You should also check the liens against the property. Once the owner unknowingly sold me a property for less then what he owed. Instead of closing in 30 days as planned, we needed to do a short sale with the bank which can be a very long process.
Ask the seller in writing if there were any room additions done and if they were permitted. If permits were not acquired then this will be your problem later. Before closing I would require that all work previously done be approved by the city at the seller’s expense.
Check to see if the city is growing and has high employment. Go to the city website and look at the following: the demographics, growth, crime, is there a revitalization happening in the area, are major stores/chains coming to the area, are there cultural centers nearby or any coming soon, what’s the nearest airport and big city, etc. Another place to get information would be the local newspapers online. There are many online resources to take advantage of so Google anything you can think of that would be appropriate.
Many times with smaller communities I’m able to get someone on the phone that will give me many unknown facts/gossip about the area which can be very informative. After talking to the locals including property managers, agents, other investors, even the police, I found out I was buying two duplexes on the worst street in the worst neighborhood in that South Carolina city. Glad I asked.
Another important part of due diligence is verifying the rents you expect to collect. Talk to local property managers to see if there is a need for rentals and what rents you should receive. Don’t just take their word for it, have them prove it with rental comps. Verify all expenses including what your mortgage will cost you each month, insurance by calling an insurance agent, taxes by calling the county, what property management will be, if there’s an HOA, etc.. Once you’ve verified your income and expenses you’ll have a better idea of where your cash flow will be.
If the property comes with tenants then you’ll need to check everything regarding the tenant. Be sure to get a copy of the lease as soon as possible and read it. If it is legal in your area, get a copy of their credit report, the background check if done, the tenant application, and any other agreements. Verify that a deposit was paid, the amount, and where it’s being held. Twice I’ve had to back out of deals because of the tenant living in the property I was about to buy.
I can’t emphasize enough how important your due diligence is, but have fun with it. Make it a game. Be a detective looking to uncover whatever you can. By making this an important part of your business you will create wealth through real estate.
Copyright 2010 / Michael Gier & MHVProperties.com
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