Due Diligence – What is important when buying real estate?
When you make a big purchase, or an investment, buy a car, sign up for healthcare, etc. you do you “homework” to hopefully make a sensible decision that gives you good value for the money you are spending.
When you buy real estate, which is likely to be the most expensive, most complex, and riskiest purchase you will ever make, there is an extraordinary amount of due diligence that you should do to reduce your risk and make a smart decision. It’s a time consuming, laborious, and expensive process of which most buyers fail to understand and complete. Most don’t even know many of the steps, or they don’t understand the time and cost required to perform the tasks, steps, procedures, analysis, review, etc. To give you a feel for it, here are the main steps in buying income producing property.
Pencil out your deal. In order to determine whether or not you are buying a fair deal, you must pencil out, or pro-forma, your particular deal. This involves investing rents, expenses, vacancy, financing costs, current leases, capital reserves and replacements and inputting those figures into your pro-forma. And you need to do your own research and use good numbers because if you take the seller’s figures, you’re going to find out quickly their numbers were probably overly optimistic. You might need a C.P.A. or financial advisor to help you.
Financing your property. You must also take the time to get qualified and procure several bids to secure the best financing for their property. Understanding the costs and terms involved in a financing agreement, and how those clauses could impact your investment returns and future financing options on the property is a must. Just accepting the loan documents, without your and/or your attorney’s review, is not prudent practice.
Title Issues, Site and Title Insurance. Title issues, at least expensive ones, are rare. But that doesn’t mean you don’t have to do all the needed review, maybe with an attorney, on every single purchase – because you do. You will have a title insurance policy to review, plus an abstract of title that could list easements, restrictions on use, and a schedule of exclusions related to the title insurance. Reviewing all of these, probably with an attorney, is an absolute necessity. And you probably have to have a survey done to see if there are any encumbrances on the property. You don’t want to discover an issue after you’ve closed escrow.
Property Inspection and Rehabilitation. You will also need to have a professional building inspector review the property and do a report of all the issues. Then have several different contractors to come bid on the work that is needed to get it into the condition that makes sense for your ownership and rental operation. These need to be done within the tight timeframe of your inspection period so you can terminate the contract if you find issues and the costs of renovation are prohibitive.
Dwelling and liability insurance policy. During your inspection period you should also get some bids for properly insurance your real estate. Sometimes there are insurance issues, and you may not be able to obtain a policy or the premiums may be unaffordable. For standard properties in decent areas, like apartments, it should be relatively straightforward and easy. But if you add in fire prone, flood prone, hurricane or high property crime areas, you might find a little more trouble obtaining a reasonably priced policy. Make sure to get some premium estimates early in the due diligence process.
Partnership, LLC, tax and ownership issues. If you are buying with other partners, or raising capital for the purchase, there are a myriad of legal partnership, LLC, and tax issues that need to be reviewed with a professional before your purchase. You need to set up the entity structure and tax items before you close escrow so all investors and partners are satisfied with the agreement.
Those are the main due diligence issues for an already built and operating income producing property. There are many other tasks and procedures depending on the circumstances of your purchase. So talk to your real estate broker, lawyer, C.P.A., escrow agent, title officer and others involved in your purchase for other items that need to be considered. And make sure educate yourself well before the process begins and give yourself enough time to do a good job of completing all these tasks.
Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions.