Due diligence is something all investors have heard of, but very few investors really understand.
This is one of the most important things you should do before closing a property. During the due diligence period, the buyer must identify and evaluate any and all potential issues. You must thoroughly research, evaluate and confirm all information and representations made about a property. If you do your job right then you will buy right and make a lot of money avoiding costly mistakes.
As a new investor, I am afraid of making mistakes, so I will do my due diligence to make sure that I am completely comfortable with the transaction BEFORE placing an offer. Three other times another buyer showed up and put the property under contract while I was doing my research. It was 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. Be sure to place a possibility that will allow you to exit the contract if you find something unacceptable during your due diligence period. This way you will have the opportunity to ask the seller to solve the problem, reduce the price, get another concession, or if necessary cancel the contract.
Often you have more negotiating power when the property is under contract than when negotiating to put it under contract. Once under the contract, the seller mentally thinks the deal is done. Usually sellers don’t want to lose you as a buyer and are many times more flexible than they need to be, especially when you bring them a legitimate issue that needs to be resolved.
Unfortunately, in this day and age you can’t believe what people tell you. One of the most important things I say to other investors is “don’t trust anyone. This is your business and you should be held accountable.” People misinterpret facts and sometimes lie. It doesn’t matter who it is, including a nationally respected real estate expert. You have to verify everything! Never just take their word for it.
There are people out there who want to take advantage of uniformed state investors. Don’t let that stop you, be sure to apply your due diligence. Keep looking for new information until your day closes. There have been times I found something that turned the deal off the day before I was supposed to close.
Know your exit strategy up front. Are you planning to buy and hold property for rent? Or are you planning to repair it and sell it immediately through leasing/option or seller financing? If you plan to sell it soon, make sure there won’t be any spice issues with the buyer’s lender. Always have a backup exit strategy because things don’t always go as planned. I always look at best case and worst case scenarios. If I can live with the worst case then I will move forward.
I’ve bought a lot of unseen properties, but if possible, it’s always best to do everything mentioned in this article yourself. If you are not in the area then you should ask someone you trust to look at the property inside and out. If you are represented by a real estate agent then they must not only look at the property but also take pictures of everything including the surroundings. You want to see and evaluate as much as possible. It’s also important for driving environments at night because it often becomes very different when the sun goes down.
There is a property in South Carolina that I contract. I was in California and didn’t use an agency, so I contacted a local investment club and asked investors if they would help me. I also called several local real estate agents and property managers. I will need agents and property managers in the future and so it is mutually beneficial for them to help me. I asked them all to go and give me their opinion on the property and the area it is in. Very informative hearing what they all had to say. They not only sent me pictures but also gave me an idea of what the damage was and what needed to be fixed.
Another great tool is Google Earth. This allows you to have an aerial view of the property. This can be very useful to see what is around the property. I have a property I purchased in San Antonio, Texas and using Google Earth saw railroad tracks not only near the property but right next to it. I could have reached out of the property window and touched a passing train. Then there are other times I find a landfill nearby, or an airport, or a processing plant! You never know what you will find and having this air tool is very useful.
Once someone you trust looks inside and outside the property and everything looks pretty good, you’ll next hire a home inspector. Make sure the home inspector is licensed and insured. If possible be present at the time of the examination; otherwise 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’ve got your report, go over it and make a list of questions, then contact the home inspector to clarify anything needed. Often what I thought was a big problem turned out to be a minor one after discussing it with the inspector.
Don’t worry when the inspector finds a problem, it can be fixed. I would be more nervous if they didn’t find the problem because that would mean they might not be doing their job properly. Even new homes should be inspected.
Often something serious comes up that may require additional examination by a specialist. If there is a potential problem with the foundation, contact a foundation specialist. Perhaps the inspector finds evidence of environmental pollution so you will contact a contamination specialist.
Remember, with the right possibilities, you can cancel the contract if a problem arises that is too big or too expensive to investigate further. Before contacting a specialist, see if the owner will pay for the additional inspection or at least share the cost with you. If not, you have to decide whether you want to go ahead or not.
Once the inspection is complete and any repairs are needed, ask the contractor to come out and give you an estimate of the cost needed to fix everything. Then take it to the seller and renegotiate. You have many options, the seller can pay to solve the problem, reduce the price, or give you other concessions. If you are unable to reach an agreement with the seller, then you always have the option to cancel the contract.
I bought a 4-plex in Arkansas one Spring. One of the units had an AC unit which looked very old. The last thing I want is to close escrow and stop working next Summer. The seller assured me they have never had a problem with the unit. Just to be safe, I asked the seller to leave money in escrow for one year. If there is a problem the money will be used to repair or replace the unit.
Get a company that verifies that the property is worth what you paid for it. Comps must have equivalent properties (room, square feet, lot size, etc.), and you should direct comps to verify that they are indeed comparable to your property. See the most recent sale date, properties closest to you, and how many days on the market.
Be sure to get a copy of the assessment for review. I have one property that I almost bought from a builder and the only company in the valuation is the same property that the builder has sold to someone else. No other company comes close to what I paid for. Turns out I overpaid but was smart enough to notice it and walked out of the deal. Other overseas investors were not so lucky!
Read the title of the report, this is something many investors fail to do. If you need help understanding it, contact the title company and if necessary an attorney. Verify that the person you are dealing with is the owner. Twice I signed the contract only to find out that the seller is not the owner. You should also check for liens against the property. Once the owner unknowingly sold me a property for less than he owed. Instead of closing in 30 days as planned, we needed to make a short sale with the bank which can be a very lengthy process.
Ask the seller in writing if any additional rooms are made and if it is allowed. If permission is not obtained then this will be your problem later. Before closing I would request that all work done previously be approved by the city at the seller’s expense.
Check to see if the city is growing and has high employment. Visit the city’s website and look at the following: demographics, growth, crime, is there any revitalization going on in the area, are major stores/chains coming to the area, is there a cultural center nearby or coming soon, what is the nearest airport and big city, etc. Another place to get information is local newspapers online. There are plenty of online resources to take advantage of, so anything you can think of will suit Google.
Often with smaller communities I can get someone on the phone who will give me lots of unknown facts/gossip about the area which can be very informative. After talking to locals including property managers, agents, other investors, even the police, I discovered that I purchased two duplexes on the worst street in that South Carolina city’s worst neighborhood. Glad I asked.
Another important part of due diligence is verifying the rent you expect to collect. Talk to a local property manager to see if there is a need for a lease and what rent you should accept. Don’t just take their word for it, have them prove it with the rental company. Verify all expenses including how much your mortgage costs each month, insurance by contacting an insurance agent, taxes by calling the county, what property management will do, if there is a HOA, etc. Once you verify your income and expenses, you’ll have a better idea of where your cash flow is going.
If the property comes with tenants then you should check everything about the tenants. Be sure to get a rental copy as soon as possible and read it. If it’s legal in your area, get a copy of their credit report, background check if done, tenant application, and other agreements. Verify that the deposit has been paid, the amount and where it is deposited. Twice I had to back out of the deal because the tenant was living in the property I was about to buy.
I can’t stress 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