Due Diligence

Rules of Thumb, Part 4.

Any experienced investor will tell you that due diligence are two of the most important words in investing.  Due diligence is defined by Investopedia as the care a reasonable person should take before entering into an agreement or a transaction to another party.  I learned the importance of due diligence soon after my first real estate blunder.

There are 3 types of due diligence:

  1. Financial

  2. Physical

  3. Legal

As a rule of thumb, always perform the financial due diligence first.  If the numbers don’t work out, then you didn’t waste any money or time on the property inspection or legal work.  The majority of deals that don’t go to closing are because of the financial due diligence.  We recommend a 30 day due diligence period for inspecting smaller properties, and at least 45 to 60 days for the larger properties. The due diligence period should not commence until you’ve received ALL the requested financial documents. This will motivate the seller to turn over all the records in a timely fashion so you can perform an accurate analysis of the property’s performance much more quickly.

Here is a step by step approach to analyzing and purchasing real estate correctly

 

  • Verify income
  • Verify expenses
  • Calculate net operating income
  • If property meets your criteria, then proceed to the letter of intent.  If not, then start the process over and continue your search for other properties.
  • Draft Letter of Intent
  • Agree on a price
  • Fill out Purchase and Sale agreement
  • Perform due diligence

Here is a list of problems that can occur during the due diligence phase:

  • Repair costs/larger capital improvement
  • Poor tenancy with low security deposits
  • Leases don’t match lease schedule
  • Run out of time
  • Property owner not cooperative

All of these problems can be addressed with the seller.  If you turn up unseen repairs, such as replacing a roof, or a damaged foundation, you can go back to the seller and ask for a price concession to fix the damage.  In real estate, investors refer to these price concessions as “retrading”.  One does not want to be labelled as a retarder because most brokers will be unwilling to work with you if you constantly want to lower the price once you have gone to contract.  Once you sign the contract, most brokers have already spent the commission.  Can you imagine their anger if you jeopardize the deal and threaten not to close.  Only consider retrading when there are legitimate repairs that were uncovered during the inspection phase.

If the leases do not match the schedule, then you can either have the owner produce the leases or adjust the income according to what the leases show.  If the property contains poor tenancy, then this should be reflected in the price with lower occupancy figures and lower rent collections.  As an investor, my number one rule is to buy a property on actual numbers.  So go back to the seller if there are any discrepancies in either the income or expense figure and reduce the price accordingly.

If you run out of time, you may be at risk of losing your down payment.  We always ask for an extension of time to perform and close on the deal.  It is a bit more difficult to deal with an uncooperative seller.  Some sellers are a pain in the butt, and some are just simply disorganized.  Have patience in both situations and keep your eye on the prize. 

Let us know what problems you’ve turned up while performing due diligence on your investment deals.

Gino

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