Understanding the due diligence process for buying real estate is critical. Throughout the process, the responsibility is on you to do your homework before closing on the purchase. If you walk through this process correctly, you could save yourself many headaches.
Today we will take a closer look at the due diligence process for buying real estate.
What is the due diligence process for buying real estate?
Once you have a property under contract (meaning both parties have agreed to terms in writing), you begin the process of performing due diligence on the property you’re buying. That might include reviewing the documentation of the property, finding insurance, and performing inspections to make sure the property is up to your standards.
Although real estate laws vary by state, you are typically able to negotiate a period of 3-4 weeks to inspect the property in exchange for an initial “due diligence” deposit.
If a major issue comes up during the inspection and you’re still in your due diligence phase, you can back out of the deal and just lose the due diligence deposit rather than being forced to buy the house with these major issues. Many states are considered “caveat emptor” states which mean “buyer beware.” Essentially, the responsibility to thoroughly examine the property rest on the buyer. With that, the due diligence phase is crucial.
The due diligence process as an investor
As an investor, the due diligence process looks slightly different than it would for someone purchasing a primary residence. You’ll have to go beyond the traditional inspections to ensure that buying the property is a good financial decision.
Investigating the financials
The primary goal of purchasing an investment property is to generate income. With that, one of the most important things for an investor to do during the due diligence phase is to verify the financials of the property. This means reviewing existing leases (if the property is already rented), verifying rent rolls, and if possible, talking to other owners/investors in the community and seeing what they charge (to make sure you are charging market rent).
Most property management companies have software that can produce written verification of rental income pretty quickly. But if the property is managed by the owner, you may have to ask for bank statements or some other proof that the property is indeed generating the income that they claim it is.
If the property is governed by a homeowners association (HOA), they will have their own set of financials (as well as covenants and by-laws) that you need to review. Make sure you go over the balance sheet, budget(s), and statement of reserves on a line-by-line basis. The balance sheet will give you a snapshot of the HOA’s financial status. Hopefully, you’ll find that the HOA has more assets than liabilities. The budget should forecast income and expenses for the upcoming year, but be careful to also pay attention to the variance between what was budgeted and what was actually spent. If there are any large discrepancies, ask the company managing the HOA the reason behind that. Lastly, the statement of the reserves will show how much the HOA has set aside for a “rainy” day. This amount has to be enough to also cover deferred maintenance, such as day-to-day repairs or roof replacements in the case of a condo or townhome HOA.
Evaluating the condition of the property
Besides the financial health of the property, it is also important to inspect the major systems. Take a close look for anything in poor shape that could affect your bottom line down the road. Everything has a life cycle, so verifying the age of the hot water heater, HVAC system, and roof and comparing it to its average life span will give you a rough idea of how much more use you can get out of it before a full replacement is needed.
This is a step that both investors and primary home buyers should consider because the replacement of the aforementioned big-ticket items can be costly. You want to know ahead of time if a repair that could cost you thousands is imminently approaching. When it is an expected expense that you are able to save for, it is much easier to deal with rather than being hit with a large, unexpected expense down the road.
Once the inspection is completed, the home inspector will provide a report detailing problems with the house that need to be corrected, both large and small. Depending on your timeline to closing, the seller may offer a credit for repairs to be done or complete some of the repairs themselves. For any repairs that you as the buyer will be responsible for, it is a good idea to contact multiple contractors for estimates. Bidding the work out will ensure that you are not overpaying for any repairs.
Also during this time, if the home inspector has uncovered any larger issues that are structural, plumbing, electrical, etc. in nature, they will recommend that you consult a contractor in that specific area of expertise. This is because the home inspector is a generalist while for example, a structural engineer, is a specialist. You want to be sure that you get the seal of approval from as many qualified, experienced tradespeople as possible.
The bottom line
Throughout the process, keep in mind that everything in real estate is negotiable. If you find something that doesn’t sit well with you, then consider backing out or asking for a reduced purchase price.
Many buyers who are not as experienced are hesitant when it comes to negotiating, as they think it comes across as tacky. However, real estate is the one industry where negotiating is expected. Don’t let the opportunity to negotiate pass you buy. Otherwise, you could be passing up thousands of dollars in savings.