The Big Picture Due Diligence in Real Estate:
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- Due diligence ensures real estate buyers thoroughly assess a property’s condition, neighborhood, financial potential, and risks, preventing costly surprises after purchase. This involves property inspections, title checks, insurance assessments, and reviewing loan options.
- Key steps include evaluating rental income potential, tenant screening for investment properties, and ensuring the property aligns with zoning rules or HOA guidelines. Buyers must also verify flood risks and insurance costs, which impact profitability.
- Completing these checks protects the buyer’s investment, ensuring they make informed decisions and enabling strategies like BRRRR (buy, renovate, rent, refinance, repeat).
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In real estate, due diligence means “do your homework.”
This goes beyond looking for the “perfect” property for your personal residence or an investment. Due diligence means conducting thorough research to ensure the home is a good investment before signing 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? Consider the following before spending 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 has 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.
Your earnest money deposit is protected during the due diligence period as long as you include a contingency in your real estate offer. Wait beyond this period, however, and you risk your earnest money.
However, home inspection and appraisal only represent the tip of the iceberg. There is much more to due diligence in property investing.
Critical Areas To Consider
Although home inspection and appraisal are as important, thorough due diligence extends to several other important areas.
Due Diligence Area | Key Considerations |
Legal Review | Property liens, easements, encroachments |
Financial Analysis | Property tax history, potential future assessments |
Physical Inspection | Foundation issues, roof condition, HVAC system age |
Environmental Factors | Soil contamination, flood zone status, radon levels |
Market Research | Neighborhood development plans, local market trends |
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.
This will also help you calculate the property’s cash flow if you buy 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
Property taxes could increase after your 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 your options 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 in real estate. A professional home inspector examines every component of the property, including foundation issues, problems in the mechanical systems like HVAC and plumbing, inadequate roofing, and termite infestation/damage.
If you have any reason to believe there’s a risk, you should also consider tests for lead paint, radon, asbestos, and mold. 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 of the red flags the 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 bought 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 a 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, 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
Know the HOA rules, whether the home purchase is for your primary use or an investment. 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 special assessments are assessed. 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. Of course, if there’s anything else that concerns you, you should look into the situation before committing to buying 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. However, 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 vacant and destroyed property?
The last place you want to find yourself is locked in a year-long legal battle to remove professional tenants who may damage the property out of sheer spite.
Tenant due diligence is essential to the real estate investment process when buying a property with inherited tenants.
Disclosure Requirements
Never overlook seller disclosures when it comes to due diligence. But what are those? Well, those are legally required documents that can save you from nasty surprises and costly oversights.
You see, sellers are typically obligated to reveal known defects and issues with the property. This isn’t just a courtesy – it’s often the law. Disclosure requirements vary by state, but they generally cover:
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- Structural issues
- Water damage or mold
- Pest infestations
- Environmental hazards (like asbestos or lead paint)
- Neighborhood nuisances
- History of property crimes
- Deaths on the property (in some states)
However, although sellers must disclose what they know, they are not required to hunt for problems. That’s where your due diligence comes in.
Review disclosure forms carefully, but don’t stop there. Use them as a springboard for further investigation. If a disclosure mentions past water damage, for instance, that’s your cue to scrutinize for mold or structural issues during the inspection.
A lack of disclosure doesn’t necessarily mean a lack of problems. Some sellers may conveniently “forget” certain issues. Others genuinely might not know about hidden defects. That’s why combining seller disclosures with your own thorough due diligence is as important.
Word to the wise: Ask for utility bills and repair records. These can reveal ongoing issues the seller might not have explicitly mentioned.
And, if you discover the seller withheld information they were legally required to disclose, you may have grounds for legal action even after the sale. But prevention is always better than cure – so leave no stone unturned in your due diligence process.
Is a Turnkey Property Worth It?
In your search for real estate properties, you may come across several rent-ready or turnkey properties that require no work 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 it; don’t hesitate to negotiate with the seller if you need more time. While the law is the law, there are ways you can ask for more time if something isn’t adding up or you run 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.
You’re stuck unless your real estate contract has contingencies that give you more time to back out. If you back out after the due diligence period without a valid contingency, you give up your earnest money. The seller keeps the funds to compensate 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 portfolio quickly. Essentially, you get your down payment back quickly, which opens up the possibility of buying another property and starting 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 bad investments and increases your chances of a profitable real estate investment.
Final Thoughts on Due Diligence in Real Estate
You can’t afford to make mistakes when you buy an asset worth hundreds of thousands of dollars.
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?
Really liked this article! Where can i find a trustworthy appraiser, please?
Thanks a lot.
Hi Theo, lenders will often require you to use their own appraiser. But if you’re not getting a loan, ask your real estate agent for a referral for a great appraiser.
Hello Theo, Check with a few Realtor’s in your area. They often have some great appraiser referrals.
Also, check zoning regulations, they change so often. They can become a real pain and can randomly bring you down. This coming from experience haha.
Great point Jeff, thanks for mentioning zoning, can wreak havoc on otherwise enticing deals!
Well, investing in properties is a good idea but to know about how it works there are many things to consider. I totally agree that one should do homework before committing hard-earned cash!
Very true Adam!
A great post – quality commercial property maintenance service will keep your tenants happy.
I only invest when my checklist are all marked ✔. Otherwise, I will negotiate with what I think should be done or I will turn away from it complete. That’s how I do my due diligence.
Definitely helps to use a systematized approach to real estate investing and due diligence!
Due diligence is indeed a part of a recipe called success!
Absolutely!