Due Diligence In Real Estate: A Guide For Homebuyers & Investors

There is one thing every investor should have at the forefront of their mind on any deal: prioritizing due diligence in real estate. Whether you have yet to close your first deal or are a seasoned veteran, due diligence is of the utmost importance. To that end, you need to put in the work to ensure nothing is overlooked. Complacency is the single most dangerous habit an investor can exercise. On the other hand, making due diligence real estate a core principle in one’s professional investing career can lead to unparalleled success.

Due diligence in real estate is invaluable, which begs the question: What is due diligence real estate? Let’s take a closer look at what due diligence really means to a real estate investor and how it can mean the difference between a good career and a great one.

What Is Due Diligence In Real Estate?

Due diligence in real estate is the same as due diligence in any other industry; it’s the practice of taking every step necessary to ensure the job is done correctly. On the surface it’s easy to assume due diligence may be limited to the properties themselves, or perhaps the act of buying and selling, but in reality due diligence in real estate encompasses everything. From overcoming the learning curve to stepping out of your comfort zone; from mitigating risk to overcoming unforeseen obstacles; from building genuine relationships to making success habitual; it’s all necessary.

There is absolutely no reason to limit the practices which receive due diligence. If for nothing else, how you do anything is how you do everything. Investors need to make a habit out of minding due diligence with regard to everything they do. Take the time to master each task associated with real estate investing; then, and only then, will investors realize their true potential.

How Does The Due Diligence Process Work?

The due diligence process works a lot like a mental checklist. In its simplest form, due diligence is essentially the conscious act of making sure every reasonable step is taken to complete a task to the best of one’s ability. At its pinnacle, however, due diligence in real estate is a lifestyle. It isn’t enough to simply work off of a checklist; investors need to simultaneously mind due diligence while striving to iterate and improve on every process in their business.

In minding due diligence, investors must first embrace the fact that they can’t possibly know everything. Even today’s greatest investors encounter obstacles they couldn’t have foreseen. That’s not to say it’s impossible to prepare for the unexpected, but rather that knowing your limitations is actually a strength. In identifying what investors do not know, they are able to improve on current systems and processes; that’s the first step of due diligence real estate: education.

Due diligence is a natural byproduct of education and the desire to learn more. As investors’ knowledge of their particular industries grow, so too does their due diligence. That means due diligence will naturally improve with time and experience, but investors need to be willing to put in the time.

The 4 Key Principles Of Real Estate Due Diligence

Due diligence real estate practices are as comprehensive as they are diverse. Exercising due diligence in the real estate industry suggests investors are leaving no stone unturned. The complex nature of due diligence can leave many real estate investors wondering if they are doing everything they can to succeed. Instead of wondering, however, investors can simply follow the key principles of real estate due diligence:

• Know the area you are investing in

• Familiarize yourself with the property

• Develop a relationship with the seller

• Understand the intricacies of the deal

1. Know The Area

You don’t need to be in real estate to know the importance of location. That said, minding due diligence requires understanding the area you are investing in. It is always better to buy a worse property in a better location than the alternative. A strong area will hold its property value longer, and appeal to a greater number of tenants.

Of course, knowing an area will require a bit of research. You need to find out which way local employment and population numbers are trending. Is a major employer moving out of town, or is a large plant coming in? Look at current comparable listings and everything that has sold in the last six months. Read the listing sheet and find out all the information that is available. Drive by the property at different times of the day and see what the traffic and area are like at night. The more research you can do, the better. It is better to be over prepared than surprised, but don’t suffer from analysis paralysis.

2. Know The Property

Once you are confident that the area is worth investing in, you can focus your attention on the property. Even if you know the listing agent or the seller, you need to do your homework. Inspect the exterior and see if there are any physical defects. Look at the roof, windows, and foundation. If you cannot get to an area, insist that you look at the basement or crawl space with a flashlight or in daytime hours.

Once inside the property, examine the HVAC, furnace, water heater and oil tank. If there is a basement, look at the walls to see any visible signs of mold. Any buyer will notice the flooring and the appliances, but those aren’t the areas that will break your budget. Dealing with foundation or roofing issues can quickly turn a profitable property into one you wish you never get involved in.

3. Know The Seller

Understanding a seller’s motivation is perhaps the best way to facilitate a good deal. If the property is banked-owned, however, it may be worth looking into any previous offers that were made. Check out how long the house has been on the market for. If it isn’t banked-owned, try to gauge why the seller is selling. Are they selling because they have to, or because they want to?

The difference could mean a quicker sale on your end, and at a discounted price. With any short sale, the first thing you should do is find out who your assigned negotiator is. With a little prying, they may be able to give you some idea as to what they may accept. Just making an offer without knowledge of the seller puts you at a disadvantage. Do your homework and get to know your seller.

4. Know The Deal

If everything looks good, you can proceed to make an offer on the property. However, with every offer, you need to be comfortable with the specifics. Trying to back out of a deal after a contract is signed is difficult, if not impossible. Take a few minutes and read the contract. See if there are any contingencies that you may not be comfortable with. If you want a piece of furniture left or removed, make sure it is in the contract.

Understand how much you are putting down, and when you need to close by. You never want to get pressured to move forward unless you are completely comfortable. During this stage you should rely heavily on your attorney and Realtor. They are working for you, not the other way around. If you have questions, now is the time you need to ask them.

Due Diligence Before Making An Offer

Due diligence should be performed during every waking moment of an investor’s career. It isn’t enough to initiate due diligence once an offer is made; investors need to conduct it before reaching out to sellers. Minding due diligence before making a deal will enable investors to maximize both profits and efficiency. Consequently, here are a few things investors need to familiarize themselves with before they even make an offer:

• Area & neighborhood analysis

• Pro-forma financial statement

• Financing options

Area & Neighborhood Analysis

Gaining an in-depth knowledge of the area in which a property is located can give investors invaluable insight into an impending deal. In doing so, special considerations must be paid to the following:

• Positive net migration

• Local employment opportunities & job growth

• The number of households occupied by renters

• Vacancy rates

• Median rental rates

• Property values & current trends

• The quality of nearby schools

• Crime rate

Pro-Forma Financial Statement

It should go without saying, but in the spirit of due diligence real estate practices, investors need to evaluate the numbers associated with a deal. The variables that need to be taken into consideration include, but are not limited to:

• Potential for gross rental income

• Other forms of potential income

• Vacancy trends

• Credit impact

• Operating expenses

• Costs incurred from repairs & maintenance

• Property taxes & insurance

Financing Options

With a better idea of what to expect from a subject property, its location, and the resulting numbers, investors should then turn to financing options. However, it is worth noting that this step can easily come before the two we already mentioned. If for nothing else, receiving approval for financing prior to looking for a property will give investors a better idea of what they can afford.

Regardless of when investors seek financing, the goal remains the same: seek terms and rates that optimize investment returns. At this time, investors will need to decide if they are going to use a traditional loan, a private money loan, or something else. Take a look at interest rates, loan repayment periods, early payment penalty fees, and qualifications. Next, compare the terms of each loan with the impending subject property. Different exit strategies call for different loans, so make sure the financing lines up with the investment. Sometimes, paying a higher interest rate may be worthwhile if the loan duration is short enough.

Post-Offer Due Diligence

Not surprisingly, due diligence real estate practices don’t end once an offer is made. Due diligence should be ramped up the further an investor gets into a deal. With that in mind, these are the steps investors should take to comply with due diligence following an offer:

• Inspect every aspect of the property

• Go over the numbers again

• Take every legal precaution

Physical Inspections

Physically inspect the property and all of its attributes, not the least of which include:

• General home inspection items (from the foundation to the roof)

• Utilities like plumbing & electrical

• Mechanical systems like HVAC units

• The condition of each individual room

• Exterior inspections to account for foundation & drainage

• Termite inspection & wood rot

• Toxic elements that include lead-based paint, radon gas, & asbestos

• Flood zone verification

• Septic & water well inspections

• Anything else regarding the physical condition of the property

Financial Due Diligence

Each financial variable contributes to a deal in one way or another. As a result, investor will want to make sure they check the following

• Profit & loss statements from current and previous years

• Previous owner’s income tax return

• Current rent

• Previous lease terms

• Potential pet allowances, deposits, and fees

• Receivables report

• Detailed accounts of past repairs & maintenance (including invoices & receipts)

• Detailed accounts of existing service contracts

• Property Taxes

Legal Due Diligence

No due diligence is complete without accounting for the following legal issues:

• HOA rules and fees

• Title discrepancies

• Pending litigation

• Homeowners insurance

• Confirm appraisal prices

• Any legal issues that may arise over the course of ownership

Seller Disclosures

Sellers are obligated to disclose material facts and known defects regarding a subject property. In what’s known as a seller disclosure statement, sellers must identify the defects they are currently aware of. Examples of line items that may be included in a letter include, but are not limited to:

• Local noise pollution

• Termite damage

• Encroachment discrepancies

• Sewer and water well issues

• Foundation issues

Seller disclosure statements are an important tool that investors can’t overlook; they can identify serious issues that impact the deal’s future. Perhaps even more importantly, disclosures can identify issues that are likely to arise sooner rather than later. Either way, seller disclosures must be considered when minding due diligence in real estate. In fact, ignoring these disclosures is the opposite of due diligence; it’s exercising ignorance.

Real Estate Due Diligence Checklist

Minding due diligence in the real estate industry can get complicated quickly. Fortunately, we have developed a checklist that can help every investor, from the inexperienced to the seasoned. Investors may use the following checklist to make sure they check everything they need to with a subject property:

• Pull comparables from the MLS and other websites: Study local comparables to get a better idea of what to expect from the subject property. Comparables can give investors insight to everything from sales prices to acceptable accommodations. If for nothing else, comparables will set the bar for what the final product should look like.

• Find a contractor and bring them to the property walkthrough: It is entirely possible to evaluate a property on your own, but it’s a good idea to walkthrough a house with a licensed contractor. Not only will contractors be able to identify potential issues, but they will also be able to provide an estimate as to how much a rehab will cost. Their knowledge, combined with an inherent ability to set a budget, will provide valuable insight into the overall project.

• Bring essential tools: Minding due diligence will require investors to have the right tools. At the very least, coming equipped with the appropriate tools will make minding due diligence a lot easier. That means investors should go to each property prepared, with essentials like cameras and flashlights in hand. With tools in hand, be ready to look at and evaluate every aspect of the property.

• Review the exterior, paying careful attention to structural issues: Evaluate the exterior. Everything from the foundation to the roof needs to be checked. Take not of any serious issues and the condition each line item is in.

• Check interior for layout, structural, and cosmetic changes: At this point, investors will take their evaluation skills to the interior. Following the same strategy as they used on the exterior, investors should evaluate every aspect of the interior. This will give investors an idea of what to expect moving forward and how much to budget for.

• Review the condition of the electrical, plumbing, and HVAC systems: Evaluate the mechanical systems which enable the house to function. Take note of what needs to be fixed or replaced or which units can be left alone.

• Stage the property and get ready to sell:  Hire a staging company or set up the property yourself (if you think you can) and create an atmosphere that feels like “home” to anyone that walks through the doors.

Summary

Due diligence real estate practices are invaluable from an investor’s perspective. Nothing else, for that matter, will take an investor further than educating themselves on every process and learning how to execute them efficiently and successfully. With due diligence, investors will run a more competitive business that’s capable of taking things to the next level. With the steps outlined above, there’s no reason any investor shouldn’t be able to improve their own business.

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