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: Financial, Physical, and 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 minimum of a 30 day due diligence period for inspecting smaller properties, and at least 45 to 60 days for the larger properties. Be sure to add extensions in the contract for length of the due diligence period.
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. Once the time period expires, you are in jeopardy of losing your down payment if you do not go to closing.
Let me recap the three types of due diligence:
It’s all about the numbers. Analyze a property based on actual numbers. Request the last twelve months of profit and loss and calculate the net operating income based on this statement. Once the numbers hit your investing criteria, move onto the next step.
Once the numbers work, it’s time to inspect the property. If you don’t have an inspector, visit home inspector to find a professional in your market. Be sure to inspect every unit, and negotiate the price with your inspector. You can expect to pay around 500 for a small multifamily property, and a per unit cost for a larger multifamily property.
Whatever deficiencies you find with the property can be negotiated with the seller. Don’t be cheap!! Inspect every purchase.
When you purchase a property, you want the property to have no encumbrances, or liens, to have good title, and to have a valid certificate of occupancy (C of O). Your title company will provide title insurance to protect you if there is ever any question to the title of the property. Check to see if the property has any type of liens, and have the seller “cure” the liens before you take over.
As far as the C of O, I have been a culprit of this mistake. I once purchased a four family that was zoned as a three family. The attorney and the bank did not pick up on this mistake, and when we went to refinance the property, it took years and thousands of dollars to bring it up to code.
Here is a step-by-step approach to analyzing and purchasing real estate correctly:
- Verify income
- Verify expenses
- Calculate net operating income. (gross income-operating expenses)
- 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
- Submit Letter of Intent
- Negotiate a price
- Fill out Purchase and Sale agreement
- Perform three steps of due diligence
- If property passes due diligence test, then proceed to closing. If not, go back to the seller and negotiate problems discovered during 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 “re-trading”. One does not want to be known as a re-trader 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 re-trading 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.
Create a list of criteria when analyzing a property. We strive for a 10% cash on cash return, 8 cap rate and 1.3 debt coverage ratio. Learn to analyze properties based on current financial numbers. Secondly, visit the home inspector site and choose an inspector for your team. Next, interview title companies and attorneys for your real estate team. It is vital to have a team in place before you start putting offers in on deals.
Once everyone is in place, the process will run much smoother!
I am always curious as to what problems you have run into during your due diligence period. Please leave a comment below and we will compare battle scars. Bet you mine are bigger than yours.