What is due diligence in real estate?
Due diligence in real estate is basically determining whether the property is going to fit your needs. If you're buying residential property to live in, you need to know that the house isn't ready to fall down or that you won't have unexpected expenses piling up. If you're buying real estate as an investment, you want to make sure that it's actually going to make you money before purchasing it. Buying real estate is a big financial commitment, so you should also be investing some time in making sure you know what you're buying and that you're getting a fair deal.
While you can never know exactly what you're getting into until you've bought it, there are steps you can take to limit the number of surprises you get after picking up the keys. The due diligence process may be quick and simple if you're buying a single-family home, or it could be a really time-consuming process if you're buying a 50-unit apartment building. Either way, there are a few things you'll need to learn about the property no matter what, including the physical condition of the property, the local market, and whether the property will work for your intended use.
When should you do your due diligence on a property?
You'll most likely do some surface-level due diligence before making an offer on a property. This will usually involve looking at the property itself and the neighborhood it's in. If it's an investment property, you'll probably want to see at least some basic financial information. These things help you determine whether the property is something you want to move forward with, as long as everything is what it seems.
When you make an offer on the property, you'll set a certain number of days for your due diligence period. On purchase agreements for residential real estate, due diligence is usually referred to as an "inspection period." The language in the purchase agreement regarding due diligence usually allows you, as the buyer, to terminate the agreement during the due diligence period if you determine that the property doesn't satisfy your requirements.
Since you only have a certain amount of time to do your due diligence, it's best to get started right away. You'll want to request any information you'll need from the seller about the property and schedule any physical access to the property that you'll need. You should also request to see any HOA documents as soon as possible to have adequate time to have them reviewed.
What kind of due diligence should you do?
The type of due diligence you do will depend on the type of property you're buying. We're going to cover the most common types you should know about.
No matter what type of property you're buying, you need to know what kind of condition it's in and whether it will be needing any significant repairs. To do this, you'll hire a qualified inspector to look at several aspects of the property including:
|Property feature||What it includes|
• Door frames.
• Air conditioning.
• Interior rooms.
The inspector will provide you with a report of their inspection. This report will list any issues, big or small, that they find. This will tell you whether there are any major repairs you can expect to make in the near future or any safety issues you should be concerned about.
Before buying a property, you need to make sure it has a clean title. This means that there are no outstanding liens on the property and that no one else has a claim to its rights. For example, if you bought a property without realizing there was a tax lien, you could end up with an unexpected foreclosure notice.
Being protected from title issues is why most sales involve title insurance. The title insurance company will check the chain of title to make sure that any liens have either already been released or will be at the time of the sale. The title insurance policy will then cover you from losses as a result of any unresolved liens or claims.
The title search will also find any deed restrictions or restrictive covenants on the property. These restrictions can limit the use of the property by not allowing certain uses or even prevent future construction on the property.
Property taxes can be a major expense. They can be the difference between a house being affordable or not, and between an investment being profitable or not. Knowing what you can expect to pay in property taxes is an important step in the due diligence process.
You'll want to find out how the sale of the property will affect the property taxes. In some cases, the property taxes may increase after a sale, so find out what the laws are on tax assessments in your area.
You also want to check for any special assessments being charged against the property. Depending on what the special assessment is paying for, it could be a significant added expense for several years.
Local zoning ordinances dictate which types of uses are allowed in which areas. Simply owning a property doesn't mean you can use it for whatever you want. The property has to be zoned for your use. Checking a property's zoning and its allowed uses is especially important with commercial real estate. If you want to convert a property into an office building but the zoning is strictly residential, you could end up with a piece of real estate you have no use for.
Just as important as the property itself is the neighborhood it's in. How are property values in the neighborhood trending? If they're going down, you could start off losing money right away. If it's a high-crime area, you may have a difficult time selling it later, or it might be difficult to find tenants if you're buying a rental property.
An environmental study is a very common part of the purchasing process for commercial real estate. By having an environmental study done before buying a commercial property, you'll not only find out whether there is any contamination affecting it but also protect yourself from any liability that could result from contamination by previous owners.
If it's bad enough, some contamination might require expensive cleanup. A contaminated property may also have restrictive covenants placed on it, limiting what can be done with the property, and may be subject to ongoing testing.
Real estate investing is all about making a return on your investment. If you're doing due diligence on an investment property, you'll want to look at the property's financials for the past three years. When reviewing financials, you'll want to look at:
- Gross rent collected.
- Vacancy rate.
- Maintenance/repair expenses.
- Utilities expenses.
- Marketing expenses.
- Insurance expenses.
- Property taxes.
- Net operating income (NOI).
This is how you will determine whether the investment will give you a big enough return on the price you pay for it. It's usually a good idea to review these financials with your real estate broker or a CPA with real estate experience.
Homeowners insurance doesn't typically cover flood damage without specific flood insurance. If the property is in a flood zone, you'll not only have the additional expense of flood insurance, but there's also a greater likelihood that the property will suffer from flood damage at some point. If it is in a flood zone, talk to a homeowners insurance company agent to find out what the cost will be for flood insurance.
Due diligence on a residential property vs. a commercial property
The intended uses of a residential property and a commercial property are obviously quite different. With a residential property, you'll mostly be looking for things that will affect how you, or your tenants, will be able to live in the property. With a commercial property, you'll be more concerned with how the property will support the business, or businesses, that will be occupying it.
When buying as an investment, the value of a commercial property depends greatly on its current leases. Some common questions you'll want to ask are:
- What's the current vacancy rate?
- What is each tenants' lease rate?
- How much time is remaining on each lease?
- What are their renewal options?
You'll also want to take a close look at who the tenants are. Are they businesses that are doing well and are likely to stay, or are they at risk of closing?
Due diligence on commercial real estate usually involves a lot more research into the local market and its demographics. The success of most businesses depends greatly on their location, so you want to be sure the location is right before buying a commercial property. When studying the market as part of your due diligence for commercial real estate, some common things you'll want to look at are:
- Population changes.
- Household income trends.
- Crime rates.
- Public transportation.
- New developments.
- New businesses.
- Businesses closing.
- Unemployment rate.
- Property value trends.
Proper due diligence is one of the most important pieces of purchasing real estate. If the property isn't what you thought it was, it may suddenly be worth a lot less than what you paid for it, and you will have a hard time selling it to somebody else. You can't return it, so be sure that you're making a well-informed decision when you decide to close on a property.
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