What is Due Diligence in Real Estate?

You’ve probably heard of the phrase caveat emptor, which is Latin for “Let the buyer beware.” 

One of the biggest risks of investing in rental property is that you’re also buying the seller’s problem. Due diligence in real estate helps you to avoid making a big financial mistake by learning everything there is to know about the income property you’re purchasing before you buy.

 

What Does Due Diligence in Real Estate Mean?

Whether you’re purchasing a single-family home or a larger multifamily income-producing property, due diligence should be a time-consuming and in-depth process. 

In short, due diligence means investigating facts about the physical and financial condition of the property and the area the property is located in. A good way to think of due diligence is “doing your homework” both before you make an offer and after your contract is accepted.

As a rental property investor, due diligence helps you to verify that you are getting the property and cash flow that you’re paying for.

 

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How the Due Diligence Process Works

In most residential real estate purchase contracts, the due diligence period is “boilerplate” or pre-defined in the contract. 

Some states have a period of 10 days, others 15 days or more. Sometimes the clock starts ticking on the due diligence period when the real estate contract is executed between buyer and seller, other times the countdown begins when escrow is opened.

Of course, the buyer and seller can always negotiate and agree to a different due diligence period other than the one pre-written in the contract. 

However, if you’re buying real estate, agreeing to a short due diligence period could put you in the position of not having enough time to fully research the property you’re investing in. If you need to extend the due diligence period and the seller refuses, you could be at risk of losing your earnest money deposit if you decide not to proceed with the purchase.

When you invest in income-producing real estate, there’s much more to consider than just the physical condition of the property. Here’s how the due diligence process works if you’re buying or selling rental real estate:

Pre-offer due diligence

There’s quite a bit of due diligence you can do before making an offer on a property. The more information you have ahead of time, the better you’re able to structure an offer that makes good business sense:

1. Area and neighborhood analysis
  • Population and job growth
  • Median household income levels
  • Percentage of renter-occupied households
  • Vacancy rates and median rents
  • Property value trends
  • Neighborhood and school rankings
  • Crime rate
2. Pro Forma financial statement
  • Gross rental income
  • Other income such as application or late fees
  • Vacancy and credit loss
  • Expense items including leasing and property management fees
  • Repairs and maintenance
  • Property taxes and insurance
  • Contributions to a capital reserve account for future major improvements such as a new HVAC or a value-add room addition

3. Review of financing options: based on your neighborhood analysis and pro forma statement, you can now shop around for a loan if you’re financing your purchase. Lenders are in the risk reduction business because they want the loan to be repaid in full. They may spot issues in your pre-offer due diligence that you overlooked and have different ideas of how to structure your potential deal.

 

Post-offer due diligence

After your offer has been accepted, the clock starts to run on your due diligence period:

1. Physical inspections
  • General home inspection covering structural items such as roof and foundation
  • Utilities and mechanical systems such as plumbing and HVAC
  • Condition of each room
  • Outside grounds including driveway, sidewalks, and drainage
  • Wood-destroying organism inspection for pests such as termites wood rot caused by water damage
  • Lead-based paint inspection for residential property built prior to 1978
  • Radon gas and defective drywall inspection (normally done in Florida for property built during the last decade)
  • Flood zone verification may require additional flood insurance coverage.
  • Property purchased in rural or unincorporated areas may also require survey, septic inspection, well water inspection, and a Phase I environmental report for property near commercial or industrial areas.
2. Financial due diligence and review
  • Profit and loss statement for the current year and the last two years
  • Review section of previous owner’s income tax return that reports income and expenses to the IRS.
  • Current rent roll
  • Review lease for terms, expiration date, deposit amount, and any unique agreements such as discounted rent in exchange for tenant doing landscaping.
  • Allowance for pets and additional pet rent, deposit, or other fees
  • Receivables report
  • Detailed list of repairs and capital improvements including invoices and proof of payment
  • Copies of existing service contracts such as landscaping and property management
  • Property taxes (including if they will increase due to the property changing hands), transfer fees, and evidence that any sales taxes on the rental income have been paid in full
  • Compare your proforma from your pre-offer due diligence to what you now have in hand.
3. Legal and loan issues
  • Review HOA (homeowners association) covenants and restrictions to verify that the property can be rented.
  • Analyze the financial strength of the homeowner’s association by reviewing the profit and loss statement and balance sheet.
  • Check for pending litigation or unrecorded worker’s liens by reviewing public records and proof of paid receipts for recent work.
  • Obtain quotes for homeowners and landlord insurance.
  • Review the history of title search provided by your escrow company.
  • Verify the cost of owner’s title insurance.
  • Ensure the property appraisal comes in for at least the purchase price on the contract.

 

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Seller disclosures

A seller has the obligation to disclose material facts and known defects about the property in writing, usually in the form of a seller disclosure statement. Sellers who are long-distance real estate investors may ask their property manager to provide certain information, since the owner may honestly not know much about the property.

Examples of material facts and defects include noise pollution from a nearby highway, if and when the property was last treated for termites, or if the neighbor’s fence is encroaching onto the seller’s backyard. Sellers also need to disclose if there have been any insurance claims over the last few years because too many claims can make the property difficult and more expensive to insure.

Homebuyer rights

If you discover something about the property during the due diligence period that you don’t like, you have the right to ask the seller to remedy the issue or you can cancel the contract and have your earnest money fully refunded.

There are some issues a seller can solve, while other problems may be physical defects that can’t be fixed. 

For example, solvable issues may include a roof leak or missing information in the tenant’s file. On the other hand, the vacant lot on the corner that is quiet during the week may be the site of dirt bike races on the weekends. While both sets of issues can lessen the value of the property, one group of problems can easily be solved while the other can not.

If the seller does agree to requests you’ve made as a result of your due diligence, make sure that the purchase contract is amended to include those agreements as a condition of closing escrow and reinspect if necessary. Never take the seller’s word that a problem will be taken care of.

 

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Real Estate Due Diligence Checklist

The purpose of performing real estate due diligence is to make sure you’re getting what you are paying for in the real estate transaction. If you don’t like what you see, you can try to renegotiate terms and conditions of the purchase contract, or walk away from the deal and have your earnest money fully refunded.

Here’s an exhaustive list of items to include on a due diligence checklist. But, depending on the property you’re buying, you may not need to review every single one of these (this is where a real estate agent or broker can be helpful as well):

  • Population and job growth
  • Household median income trends
  • Access to public transportation and amenities
  • Neighborhood and school rankings
  • Unemployment rate
  • Crime rate
  • Business openings and closings
  • New development activity that could help or harm your intended investment
  • Property value trends
  • Fair market rent trends
  • Percentage of renter-occupied households
  • Market vacancy trends
  • Gross rent collected
  • Maintenance and repair expenses
  • Utility expenses
  • Property management, leasing, and advertising fees
  • Insurance expense including past insurance claims, need for flood insurance, and the cost of homeowners and landlord insurance
  • Property taxes and potential increase due to change in ownership
  • Proof that any sales tax collected on rent has been remitted and is up to date
  • Physical property inspections including structural and mechanical, wood-destroying organisms, radon, and lead-based paint
  • Title commitment on the property and legal description
  • Most recent ALTA (American Land Title Association) survey
  • Zoning or use certificate for property in rural or unincorporated areas
  • New survey, septic report, and well water report for rural properties
  • Phase I environmental report for property near industrial areas
  • HOA covenants, conditions, and restrictions
  • HOA financial reports including P&L and balance sheet
  • Review of seller financial statements including a copy of the seller’s tax return to verify income and expenses are true as reported to the IRS going back two or three years
  • Review of tenant file including the lease terms and conditions, deposit amount, tenant application, and background and credit checks
  • Copies of existing service contracts such as landscaper or current property manager
  • List of all outstanding invoice and proof of payment for all work recently done
  • Lien search to verify there are no existing worker’s liens
  • History of insurance claims on the property going back three years
  • Verification that property appraisal is for at least the contract purchase price if not more
  • Compare your pre-offer pro forma analysis to the seller’s reports to make sure the deal still makes sense

 

 

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Jeff Rohde

Author

Jeff Rohde

Jeff has over 25 years of experience in all segments of the real estate industry including investing, brokerage, residential, commercial, and property management. While his real estate business runs on autopilot, he writes articles to help other investors grow and manage their real estate portfolios.

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