In short, due diligence in real estate means “do your homework.”
This goes beyond looking for the “perfect” property, whether for your personal residence or an investment. Due diligence means conducting thorough research to ensure the home is a good investment before you sign on the dotted line.
Millions of homes on the market today don’t live up to their promised returns. Unless you do the work to discover property faults, clouds on the title, weak real estate cash flow, or other reasons not to buy a property, you won’t discover them until it’s too late. If you want to avoid making a bad investment, learn how to do your due diligence.
So how do you do due diligence when buying a house? Keep all of the following in mind before shelling out hundreds of thousands on your next home or investment property.
What is Due Diligence in Real Estate?
You already know the basics of due diligence in real estate: bringing in experts to conduct the appraisal and home inspection. Both reports reveal crucial information about the home you need – its current market value and condition, respectively. If a home isn’t worth as much as you bid, it’s time to renegotiate the contract or walk away.
If the property comes with greater repair problems than you knew, you can of course also negotiate a lower home price, or pull out if you included a real estate offer contingency. In this case you also have a third option: ask the seller to pay for the repairs.
As long as you included a real estate offer contingency, your earnest money deposit is protected during the due diligence period. Wait beyond this period however, and you risk your earnest money.
But the home inspection and appraisal only represent the tip of the iceberg. There is much more to due diligence in property investing.
How Do You Do Due Diligence in Real Estate?
Due diligence is a broad term. It encompasses the vast amount of homework you have before buying a home. Here are the most common steps:
Research the Neighborhood
When you buy a home, you buy the neighborhood along with it.
Find out the local crime rates, the area’s noise level at all times of day, and the area’s demographics (young families, older couples, income levels, etc.). For rental properties, gauge the demand in the area by researching the vacancy rate.
Which will also help you calculate the property’s cash flow, if you’re buying a rental.
Calculate Cash Flow & Returns
Before making an offer, you should know the precise real estate cash flow you can expect to earn on the property.
That starts with pinpointing the market rent for the property. Research rental listings on websites like Craigslist, Trulia, and Zillow.
Then you can estimate expenses to calculate the rental property’s cash flow. These include, but aren’t limited to:
- Vacancy rate
- Property management costs (even if you plan to self-manage – they still represent labor costs!)
- Repairs & maintenance
- Property taxes
- Property insurance
- Rent default insurance
- Monthly mortgage payment
- Travel, bookkeeping, accounting, legal, and other miscellaneous expenses
Note that property taxes could jump up after you purchase, based on the new purchase price amount.
Use a free rental cash flow calculator to run the numbers instantly.
Review Property Loan Options
You may have many financing options when investing in real estate. Compare rental property loan terms here.
Determine the options at your disposal based on your credit score, down payment (LTV), and the programs available in the area. Finding proper financing is a large part of due diligence in property investing.
Financing directly impacts your rental cash flow and returns, so invest the time to develop relationships with several lenders.
Pay for a Home Inspection
This is one of the most important components of due diligence. A professional home inspector peers under the hood at every component in the property, including foundation issues, problems in the mechanical systems like HVAC and plumbing, inadequate roofing, and termite infestation/damage.
Also consider tests for lead paint, radon, asbestos, and mold if you have any reason to believe there’s a risk. You need to know before buying, not after.
As a final thought, attend the home inspection if you can. Ask probing questions and get a sense for the red flags the home inspector looks for, to improve your own eye for problems in the future.
Buy Title Insurance
A title search determines if there are any ownership defects in the chain of title. In other words, can someone come and claim ownership that you weren’t aware of when you buy the home? Undisclosed heirs, contested property lines, and easements on the property can all cost you enormous sums, headaches, and possibly heartache.
A title search also uncovers any unpaid contractor’s liens or other financial liabilities that transfer with the property. In other words, if you buy a home with a lien, the lien becomes your debt. You don’t want any surprises after buying, and to protect yourself spend the few hundred bucks to buy title insurance.
Get an Appraisal
If you need financing to buy the property, lenders require an appraisal. Even if you plan to buy with cash, pay for an appraisal. The inspector tells you in-depth what’s wrong with the home. He doesn’t discuss the home’s value – that’s the appraiser’s job.
An appraiser does a high-level property inspection. But he also looks at the property and lot size, location, and the home’s condition. The appraiser takes note of any upgrades and compares the home to the area’s most recently sold comparable homes. It helps ensure you don’t overpay for the property.
Evaluate the Homeowners Association
Whether the home purchase is for your primary use or an investment, know the HOA rules. Can you rent the property out? How many units can you own?
Also, evaluate what the HOA requires. Get into the nitty-gritty details. Can you paint the condo? How many cars may park at the condo? What property changes require HOA approval?
Finally, evaluate the HOA’s finances. Look closely at reserve funds, the association’s budget, and how often they assess special assessments. Is the association often subjected to litigation or do they have any pending litigation right now?
These fees can wreak havoc on your cash flow.
Confirm Flood Risk
Properties in a flood plain require special flood insurance, adding to your annual ownership costs.
If you take out a mortgage or rental property loan to buy the property, the lender will run a flood search, but you should know the answer before then. Ask the seller, and consider running your own flood search. Leave yourself a real estate contingency to renegotiate pricing if you discover the property needs flood insurance.
Price Out Insurance
Flood insurance isn’t your only potential insurance premium. You’ll need homeowner’s or landlord’s insurance to protect the property itself from fire, storm, and other types of damage.
If you’re buying a rental property, also consider buying rent default insurance. If the tenants stop paying, the insurance company pays the rent until you finish the eviction process and replace them with a paying tenant.
Insurance costs factor into your ROI, so evaluate it carefully.
These represent the basic (and most common due diligence steps). If there’s anything else that concerns you, of course, look into the situation before committing to buy the home.
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Screen Inherited Tenants
When you buy a rental property already occupied by tenants, you need to screen them as if they were submitting a rental application for the first time.
Start by requesting copies of the rent roll to review their payment history. But keep in mind that unscrupulous sellers may not provide an accurate rent payment history, so return to the source and request copies of the original tenant screening reports.
Credit reports, eviction history reports, criminal background checks, identity verification, and personal references are all key factors in the tenant screening process. Even if potential tenants have excellent credit, that doesn’t mean they make great tenants. How do you know they’ll take care of the property, treat the neighbors with respect, or not leave you with a vacant and destroyed property?
The last place you want to find yourself is locked in a year-long legal battle trying to remove professional tenants, who may well damage the property out of sheer spite.
Tenant due diligence is an essential part of the real estate investment process, when you buy a property with inherited tenants.
Is a Turnkey Property Worth It?
In your search for real estate properties, you may come across several turnkey properties or rent-ready properties with no work necessary on your end.
Should you buy a property sight unseen? As with any property, do your due diligence in property investing first. Look at the basics – the home inspection, title report, and appraisal. Then consider the rental possibilities (financially and physically speaking). Don’t overlook the pros and cons of turnkey properties, especially any long-distance properties you may consider.
Can a Buyer Back out After the Due Diligence Period?
Each state has different due diligence periods. Know how long you get and if you need more time, don’t be afraid to negotiate with the seller. While the law is the law, there are ways you can ask for more time if something isn’t adding up or you ran out of time.
Once the period ends, you have limited options. Can you back out? Yes. But will you keep your earnest money? Probably not.
Unless you have contingencies in your real estate contract that give you more time to back out of the contract, you’re stuck. If you back out after the due diligence period and without a valid contingency, you give up your earnest money. The seller keeps the funds to make up for the time and money lost while taking the property off the market.
Doing Due Diligence in Property Investing Makes the BRRRR Process Possible
Are you a serious property investor? If so, you likely want to include the BRRRR process in your strategies – buy, renovate, rent, refinance, and repeat.
This tried-and-true real estate concept helps you grow your real estate portfolio quickly. Essentially, you get your down payment back quickly, which opens up the possibilities to buy another property and BRRRR all over again.
Due diligence in real estate is the smartest way to invest. With the right steps, you know all aspects of the property, its finances, and whether it’s a good investment. While no process is fool-proof and there’s always a ‘lemon’ in the group, using the right steps limits the bad investments and increases your chances of a profitable real estate investment.
When you buy an asset worth hundreds of thousands of dollars, you can’t afford to make mistakes.
Do your homework before committing your hard-earned cash. Get it right, and you’ll never make a bad investment again.♦
What steps do you take when conducting due diligence in real estate transactions?