A Primer on Due Diligence for Investment Houses
Due diligence may be one of the least exciting parts of real estate investing, but it is easily one of the most important. Failing to correctly evaluate a property before you buy can cost you dearly down the line. Use this brief guide to help put your mind at ease when making offers and implementing various strategies in your real estate portfolio.
Before Getting a Property Under Contract
Words to live by: “Trust but Verify”
Before getting a house under contract, you should always do a preliminary analysis. That analysis should include:
#1: A comparative market analysis
You or a trusted real estate agent should run “comps” on the property to make sure recent, comparable sales align with your ideas about the value of the property
#2: A walk-through (when possible)
If you have access to the inside of the house and can view it in person, do so. While you are there, estimate the cost of big-ticket items like HVAC, electrical, and appliances, as well as the number of rooms and how much basic updates will cost in those areas. I also like to include estimates for holding costs and a “contingency” estimate (you could call it “wiggle room”) for costs I may have missed or that are higher than I anticipated.
Pro Tip from the Contributor:
I have a standard, one-page analysis sheet that I take to every walk-through. It lists everything I want to be sure I consider so I don’t forget anything!
#3: Rental Documents Review (if applicable)
If there is a tenant in the property, review the operating statement and rent roll before getting under contract.
Terms of the Contract
Words to live by: “Check your dates”
An average purchase and sale (PAS) contract for a house provides 30 days to close with a 10- to 15-day “inspection period.” Commercial contracts are usually longer. During the inspection period, your earnest money is usually refundable, but after that window closes, your earnest money usually “goes hard,” meaning it will be forfeited if you back out of the deal. Always check the dates on the inspection period immediately to make sure you will be able do all of your inspections and decide to either follow through with the purchase, back out, or renegotiate before the inspection period ends.
Financial Due Diligence
Words to live by: “Review and approve”
You hear more about financial due diligence when you are discussing apartments and other large, commercial buildings, but it is important on the single-family side of the equation as well if you are dealing with a rental property. Request and review the following documents:
- Current lease: Make sure the terms are as the seller described and that you are comfortable adhering to them. In particular, determine if the lease is month-to-month and that you find any unusual provisions in the contract, such as the tenant receiving discounts for doing maintenance work, acceptable.
- Updated rent roll & aged receivables report: This will verify that the tenant is habitually current on rent.
- Copies of deposit slips showing the rent was paid: Deposit slips demonstrate that rent was not just delivered, but funds were available for payment. Unscrupulous sellers may show images of checks to show rents paid but fail to disclose those checks were returned.
Property Due Diligence
Words to live by: “Dedicated to the details”
Once you have the property under contract, it is time to do another walk-through. Take note of every fixture, door, and window in every room to identify every single thing you will need to adjust, update, or repair. The general pricing process you used in your pre-contract walk-through where you assigned estimates by category of appliance or room needs a lot more detail now! Here are some of the bigger ticket items you should be evaluating carefully and some “default” assumptions that you can usually make about them:
- Electrical panels should be at least 100-amp service. If the panel is a Federal Pacific or a Pushmatic panel, it likely will need to be updated. Older models may have associated fire hazards.
- Fuse boxes should usually be replaced if the property is getting new electric panels.
- Ungrounded electrical systems need to be grounded. This is a common issue in older houses.
- Older furnaces and A/C units are considered a negative for many buyers since older HVAC units are more likely to give out. Factor this into your strategy and estimates.
- Galvanized pipes rust easily and often have poor water flow, so you may have to replace the plumbing system if it features them.
- Leaks must be repaired. Run the water to check for obvious issues and check the meter to see if the arrow is spinning even though all water is turned off.
- Foundation cracks probably need to be epoxied at a minimum. Have a foundation specialist evaluate the situation if you are concerned.
- Foundation movements are not uncommon but must be remedied. If a wall has moved more than four inches, it will probably need a brace. If it has moved more than two feet, you may have to push it back. These issues can be complicated and pricey, so work with a professional if you have any concerns.
Pro tip from the contributor:
Run your finger along the bottom of the siding on the house. There will usually be enough space to hide the top part of your finger to the first knuckle between the foundation wall and the outside of the siding. If there is more room than that, you may have an issue with the wall moving.
- Roof leaks and damage can be spotted by looking for discolored shingles and those that have “lipped up,” meaning the edges are curled upward. Of course, also look for signs that water is entering the house by way of the roof.
Words to live by: “the more information, the better”
A seasoned investor may be able to skip ordering inspections and simply inspect the property on their own. But I would recommend any new investor get an inspection from a licensed property inspector. You should also get a pest inspection and may want to consider testing for radon and lead as well.
Not only will an inspector often find things that you may have missed, but inspection reports can be very helpful for negotiating. You can simply ask the seller to either fix or offer a discount for whatever items the inspector noted as being in unsatisfactory condition. Having an inspection report to back such a request makes it stronger and more likely the seller will fix the problems or offer a price discount.
Some issues may require a specialist. If you have concerns about the roof or the foundation, consider consulting an expert in that area.
Words to live by: “Close with a title company”
It should go without saying, but you should only close a property with a title company (or attorney, depending on the state). A title company will offer title insurance in case they don’t catch any old liens. There’s nothing worse than buying a property only to find it has a giant unpaid loan attached to it that is now your responsibility to pay!
Thorough due diligence can not only prevent you from making critical mistakes, it can also give you the opportunity to get a better deal by providing leverage for negotiation. Make sure to never neglect it.