If you’re new to real estate investing, you might be wondering about the importance of due diligence and what the process is like. You might even feel a bit intimidated by the process if you haven’t purchased a property before. Due diligence is crucial for any investment acquisition. With time, you will gain confidence and even begin automating each part of the investment process, including due diligence.
In real estate, the period of time known as due diligence is an opportunity for you, the buyer-investor, to receive full disclosure of the facts and conditions of a potential asset prior to completing a transaction with the seller.
The process is your chance to investigate the physical and financial facts of a property, to find out if a prospective property is what the seller claims it is. Due diligence allows you to make an informed decision about whether a certain house or condo is the right investment for you.
What beginning investors need to know
Beginning investors of single-family homes and condos need to know that even though due diligence can be intimidating and stressful, there are ways to mitigate becoming completely overwhelmed. For one, it definitely helps to learn from experienced investors and glean from their experiences.
Here’s what you need to do if you’re a beginning investor. You need to have a process in place, an organized strategy to navigate each step prior to going into contract for a prospective property. It’s not uncommon for experienced investors to streamline the process by having a due diligence binder or digital folders ready at the outset, prepped with blank forms, documents, and checklists organized by area of investigation (physical, financial, and legal).
The reason it’s important to have a process is that due diligence moves quickly immediately after going into contract. The last thing an investor should be doing is scrambling for a due diligence strategy in the middle of the process. A due diligence strategy will save you time, energy, and spare your wallet in the long run.
What’s the timeline, you ask? It varies by state requirements and according to agreements made between the buyer and seller. But, generally, due diligence takes two to three weeks. Be sure to work with your real estate agent or broker and determine your state’s exact laws surrounding due diligence timelines.
Due diligence begins when you open escrow and ends when you close. The entire process begins when a buyer submits a Letter of Intent (LOI) and the property is put under contract after a negotiation of contingencies between the buyer and seller. Closing is complete when the buyer has received all required information and conducts investigations, makes a determination, and either purchases the property or walks away. Due diligence is everything that happens in between going into contract and finishing the close.
Due diligence broadly falls into the realms of the physical, financial, and legal. Don’t skip any of the steps. Doing so could cost you. Consider the following steps when creating a due diligence checklist.
Physical due diligence
The process of physical due diligence involves inspecting the physical conditions of the interior and exterior of the property. At this stage, it is important to examine and document environmental conditions, the integrity of the building, and the electrical, heating, and plumbing systems.
- Conduct a preliminary area analysis before you submit a Letter of Intent to the seller. Check out the property at different times of the day and on different days of the week so you get a sense of the neighborhood. In fact, meet the neighbors! They’ll give you the down and dirty, the history, as well as the excellent qualities of the neighborhood from those who know it best.
- Check the sex offender registry and see how the neighborhood fares. Decide if you are comfortable with the information you find.
- Check crime stats. Local law enforcement agencies will have records of typical crime rates and activities for the area of your prospective property.
- Physical inspections are crucial. After you go into contract, arrange for a formal property inspection conducted by a licensed professional.
- Upcoming developments and building plans in the neighboring area will affect the value of the property. Ask the city’s land and zoning department for the current 10-year plan, so you can anticipate whether future developments will increase or decrease the value of the house.
- Look into zoning. If the property comes up against parcels that can be developed, you will want to know what kinds of development could possibly take place.
- Check for encroachments onto the property, such as sheds, plants from neighboring homes. You might want to have those issues remedied prior to agreeing to purchase the home.
- Arrange for a formal property appraisal. This step will compare your prospective property to similar properties in a certain radius.
- Request an insurance claim report from the seller’s insurance company. The report will discloses if claims were made on the property.
- Get repair quotes during due diligence, before you purchase.This step can actually result in reducing your purchase price. Alternatively, you might get the seller to help you cover repairs or lower the closing costs.
- Account for the weather. If you are buying in a cold weather climate, you will need to factor in the cost of “winterizing.” The concept can be entirely new if you’re from, for example, the Southwestern states but seek to purchase in the Midwest. Buyers from warm states might not realize they need to prep pipes before the winter freeze in colder states!
Financial due diligence
The process of financial due diligence requires studying and verifying financial disclosures provided to you by the seller, including taxes, income, and expenses.
- Prepare to run an in-depth cash-flow analysis by requesting documents for rental income, tax liability, repair quotes, and principle and interest rates on the mortgage loans you are considering. Don’t forget to incorporate landlord tax deductions, if you plan to rent the property out.
- Shop around for financing and avoid the temptation to go with the first lender you speak to.
- Distinguish between capital improvements versus repairs and maintenance expenses. How will each fit into the larger financial picture?
- Use your analysis of financial due diligence to set a rent estimate for your future tenants.
Legal due diligence
Legal due diligence entails examining zoning issues, code compliance, the property’s title, and more.
- Review any and all seller disclosures, which you should get shortly after you open escrow on the house. If your state doesn’t require seller disclosures, create a list of questions and ask your real estate agent to work with the seller and get the questions answered.
- If you’re buying a house or condo with a Homeowners Association (HOA), get a copy of the Declaration of Covenants, Codes, and Restrictions (CC&Rs) that govern the community. States may vary in their requirements about what HOAs must disclose to potential buyers. But, the more information you can get, the better.
- Ask for the HOAs financial statements so you can confirm that the Association is being managed properly, and that money is being spent appropriately.
- Request a preliminary title report from the title company. The preliminary report will disclose who currently owns the property. This is important because you want to make sure the seller has clear title and can transfer it to you upon closing.
- Research homeowners insurance. If you plan to finance the home, insurance is mandatory. So go ahead and begin researching homeowners insurance.
- While you’re looking into insurance, go ahead and shop for landlord insurance.
- Since you might rent the home or condo out, confirm that your intended use of the property follows town and municipal rules.
- If you are purchasing a home in a rural area, look into property rights. Determine the status of water rights and mineral rights. (You never know!)
Close, or walk away
If you discover a major problem during due diligence, you can walk away from the property, just in case the seller can’t–or won’t–fix the issue. This is the point at which you can renegotiate the offer in light of information that emerged during due diligence. This is the value of doing your homework and coming up with an excellent due diligence process: you will save time and money, and feel confident that your new asset will serve your portfolio well in the long run.