Understanding due diligence means the difference between success and failure.
Many real estate investors dread doing due diligence. Considered dull and boring.
However, proper due diligence for real estate investments leads to success.
Understanding Due Diligence
Always start with the definition of any terms you don’t understand.
Definition of Due Diligence
In real estate, due diligence means verifying what an investor believes about a property under a purchase contract.
Due Diligence Steps
Follow these steps to perform due diligence on any real estate investment:
1. Pre-Offer Due Diligence involves:
- Location Analysis;
- Financial and Value Estimates; and
- Estimating Rehab Costs.
2. Post-Contract Due Diligence involves:
- Due Diligence of the Property;
- Due Diligence of the Financials;
- Legal Due Diligence; and
These fundamentals cover apartments, houses, and commercial properties. Now, let’s look at each step.
Pre-Offer Due Diligence
The first step requires verifying that the area meets your client’s criteria. Things to consider include:
- Occupancy Rates;
- Median Income;
- Population Growth;
- Crime Rate; and
- School Rankings.
In a nutshell: Your ideal clients seek high occupancy rates for elevated median income renters in an area experiencing population growth with low crime and good schools.
Unless your clients seek low-income housing investments, you should focus on the above-mentioned features.
Resources for Area Demographics
As for schools, try GreatSchools.org which evaluates the schools in each school district across the U.S.
On the other hand, find advanced and more expensive demographic sources for U.S. neighborhoods listed Here.
Financial and Value Estimates
Basically, this type of due diligence determines a property’s After Repair Value (ARV). Accomplished by analyzing comparable sales (comps). Lack of space here prevents a detailed explanation of ARV. However, BiggerPockets published a detailed guide for quickly estimating an ARV Here.
Income and Expense Items
Pro formas estimate future income by looking at these three income categories and 10 expenses categories:
- Gross Rental Income;
- Additional Incomes (late fees, utility chargebacks, laundry, etc.); and
- Vacancy Loss (includes economic vacancy and vacant units).
- Property Taxes;
- Repairs and Maintenance;
- Property Management Fees;
- Contract Services (snow removal, lawn care, pool cleaning, etc.);
- General Administration (eviction process, phone lines, etc.);
- Recurring Capital Improvements (HVAC replacements, roof replacement, etc.); and
- Payroll (for large properties with on-site staff).
Simply subtract the gross expenses from the gross income to get the net operating income. After this, subtract any debt service to estimate the cash flow.
Apartments and commercial properties require using a CAP Rate to compare with other similar properties sales. Learn more about CAP Rates Here.
The best way to estimate the costs to rehab any structure involves using a general contractor to evaluate the property.
Important items to consider when estimating rehab costs include:
- Fuse Box – If they exist, replace them with an electrical panel.
- Electrical Panel – Unless in a small apartment, look for at least 100 amps. If either a Pushmatic panel or a Federal Pacific panel exists, replace them.
- A/C and Furnace – Replace if old and rusty.
- Plumbing Leaks – Look in the basement for leaks. Run the water to see how the faucets work.
- Underground Electrical Outlets – Use a plug tester from Lowe’s or Home Depot to test these.
- Foundation Cracks – Shows signs of roots pushing the wall or bad grading requiring epoxy or shoring up with braces.
- Galvanized Plumbing – Look for rusty steel pipes.
- Mold – Inspect the basement for mold. Also, the bottom half of the drywall. Not difficult to remove mold, but locate where the water gets in to prevent new mold.
- Foundation Movement – Wall movement requires expensive solutions.
- Leaking and Damaged Roof – Unless it’s raining allowing you to observe the roof leaking, look for damage on the roof. The more layers added on over the years, the more labor to remove and fix the leaks. From a side view, see if the shingle edges lip up which means an old roof needing repair. If you see small discolored craters on the roof with missing granules means hail damage.
Post-Contract Due Diligence
After the purchase contract signed by all parties, due diligence comes under a deadline.
While purchase contracts remain negotiable, most residential agreements contain a 30 day period to close with a 15 day period for inspections before your earnest money becomes “hard” and no longer refundable. That’s why working with a contractor becomes essential.
Apartments and commercial properties usually allow more time. Such as 60 days to close with 30 days for inspections. Negotiating additional time or extensions for more time could occur.
Problems discovered during your due diligence gives you negotiation power by threatening to walk away unless the seller resolves the problems.
Due Diligence of the Property
Always walk through the entire property. You never what hidden problems exist in any area of the property.
Make sure the utilities turn on if shut off. The only way to know if everything works require the utilities to function during your inspection.
Scope of Work
Four major categories determine the scope of the required work after the closing:
- Pre-Construction – Done before the main construction starts. Like repairing electrical problems and removing all trash.
- Construction – The work performed by your contractor.
- Sub-Contractors – Labor and supplies provided by vendors other than your contractor. Like flooring, painting, plumbing, etc.
- PunchOut – Last things done to finish the property. Like Installing blinds, appliances, outlet covers, etc.
Take photos of all before and after work.
Due Diligence of the Financials
Apartments and commercial properties need financial due diligence.
Most of the time, the seller won’t provide you with all the financial information about the property until after you sign the purchase agreement. Read them carefully. The most important documents include:
- Current Rent Roll;
- T-12 Operating Statement – Covering the past 12 months at a minimum. Ask for the last three years;
- Aged Receivables Report – Find out which tenants behind in rent and how much; and
- List of Recent Capital Improvements.
Watch out for:
- Misallocated Capital Expenses – Capital expenses misallocated means the owner placed operating expenses (turnovers, maintenance, repairs, etc.) under capital expenses not showing up on the operating statement making the property performance looking better than in reality; and
- Bad Debts – Properties using an accrual accounting system deems all rents received until the bad debts (uncollected rents) become charged off. Verify that all debts charged off so you won’t see phantom income.
Legal Due Diligence
First, review the Homeowner Association (HOAs) rules and bylaws for condo apartments.
Make sure they won’t interfere with your plans.
Verify that the HOA maintains enough funds in reserve for capital improvements. Otherwise, the homeowners will pay for future improvements.
The bylaws reveal the HOA fees for homeowners. See if any restrictions prevent pets or other things. Make sure the bylaws allow you to rent the unit.
Any conversion of the property for different usage requires a visit to the local Zoning Department.
Verify the property taxes on the county’s website or in person.
Read the title report obtained by the closing officer to verify a clear title. Verify no liens or unpaid loans remain.
Make sure your title insurance policy covers all liens, encumbrances, and clear title issues.
Besides your contractor, hire a professional property inspection company to make a complete property inspection. Read the inspection report carefully.
Always do a complete personal walk through the entire property.
Things to look for with inspections:
- Asbestos, lead and Radon – Only needed if the property built before 1978;
- Termites – They destroy wood and damage joists and create mud tunnels;
- ALTA Survey – Large properties with unclear boundaries, easements, etc.;
- Environmental Survey – Required for apartments and commercial properties; and
- Roof Inspection – Older, apparent damage, or just not sure about it.
- Plumbing – Hire a plumber to scope the plumbing.
- Sewer – Properties over 30 years old need a sewer line scope because replacing a sewer line become expensive. Find out before closing if the line contains lots of roots or collapsed.
Understanding due diligence prevents trouble with a property purchase before closing.
Hire an escrow company which knows what due diligence entails.
Steven Rich, MBA – Guest Blogger
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