The Short Answer
When it comes to investing in real estate, due diligence is one of the most important parts of the process for investors to understand and implement during real estate transactions. Due diligence should be done for the physical, financial and legal aspects of the property. The purpose of this is to avoid running into any trouble with the property such as large repairs, liens against the property or low rental income. Doing due diligence is basically doing “homework” on the property, before buying it. This homework is essential to the success of the purchase of investment properties.
One of the biggest fears that real estate investors have, is purchasing a property with costly problems. These problems would require repairs, which would probably need to be done immediately, before the property can be rented out. This would in turn impact the cash flow for the real estate investor and be a major expense that they hadn’t planned for.
A vital tool for real estate investors to use during real estate transactions, to avoid a situation like this, is due diligence. Read on to learn about why due diligence is a key tool for investors, how the process works and get a free due diligence checklist to use for your next investment property purchase.
Table of Contents
What Is Due Diligence In Real Estate?
Due diligence in real estate can be a valuable tool for those looking to navigate the complexities of property ownership. It is essentially the process of researching and verifying all aspects of a potential purchase. This process covers every element of the investment including financial statements, leases, building condition, zoning laws and more.
Due diligence should also extend to tenant laws in the state where the property is located, contract terms and conditions involving any foreclosures or legal action regarding ownership of the property. By going through this process, investors can get peace of mind that their future purchase is fully researched, verified and in full compliance with regulations.
Due Diligence Process
Step 1: Physical Inspections
The first step in the due diligence process during real estate transactions is to get the physical inspections of the property done. A real estate agent may organize some of these, but it’s important to follow up regardless.
These include inspections of the condition of the interior and exterior of the property, the environment, the electrical, heating and plumbing systems and more. The idea is to make sure the property and environment are up to code and in a decent condition.
The types of physicals inspections are:
- Home inspection – including building integrity and structure, both interior and exterior, done by a professional
- Heating, electrical and plumbing systems
- Pests, such as termites
- Environmental research and inspection to determine if the property requires extra insurance (for example if it’s located in an area with a high level of natural disasters) and that the environment is not a health hazard
- Safety inspections for things like lead-based paint, mold and other issues
Step 2: Financial Outline
Doing a review of a property’s financials can be a laborious task, but it’s an extremely important one to determine the potential future profits of the property. The following financial aspects should be reviewed in a real estate transaction:
- Cash flow: The property’s cash flow for the last couple of years is an important indication of its profit potential. To determine the cash flow, the rental income, operating expenses, tax liabilities and mortgage all need to be included in the documents to be reviewed.
- Lease agreement review: An important aspect of financial due diligence for rental properties is reviewing all lease agreements. Not only does this give the investor a look into the rental amounts, but it also indicates the length of the leases, deposits, and more, which all impact the property’s profitability.
- Contracts with service providers: It’s a good idea to get access to any contracts that exist with service providers for the property. Service providers include the likes of landscapers, cleaners and property managers. These are expenses that may need to be revised, so it’s worth knowing the details.
- Property taxes: Getting a look at the property taxes is a vital step to take on the financial due diligence path. This will give investors an indication as to what they will need to pay, and what the increase in taxes may be, once the change of ownership takes place.
- Repairs and maintenance: A detailed financial look at the repairs and maintenance that have been done on the house is important. Any improvements done to the property will impact the value, and it’s vital to make sure that property maintenance has been kept up to date.
Step 3: Legal Review
The last step of the due diligence process is to take a closer look at the legalities of the property. This includes:
- A title search: A look into the public records on the property to check for any liens or issues with it, in a legal capacity. This includes a preliminary title report.
- Insurance: Looking into homeowner’s insurance on the property, and landlord insurance if need be.
- HOA analysis: If the property falls under an HOA, it’s important to check out the rules and restrictions that it may be subject to.
- Property appraisal: Conduct and review the home appraisal to make sure that the property is not appraised at a much higher or lower value than the purchase price.
Due Diligence Period
The due diligence period is typically built into the purchase contract that is signed at the outset. This period can be anywhere between 10 and 30 days, depending on the state. The start date for the due diligence period is typically when the contract is signed by both the buyer and seller, or when escrow begins.
If the buyer or the seller have a specific time period in mind, or cannot stick to the typical time period, then they can negotiate a different arrangement. However, this should be agreed upon at the outset, and not discussed later down the line once the buyer has already run out of time. A good tip for buyers is to do as much research as possible, before making an offer on a home.
Simple Due Diligence Checklist
Ultimately, investors should do due diligence on a property to make sure that they know what they are getting themselves into, and that they aren’t paying too much for their investment. To help simplify the process, we’ve put together a simple due diligence checklist below which investors can use to make sure they’ve reviewed the most important aspects of the property in their real estate transactions.
- Home inspections
- Area population, economic, employment and crime information
- New development activity nearby
- Repair and maintenance details and costs
- Property appraisal
- Operating expenses
- Property taxes
- Title search
- Zoning information
- Environmental reports
- Lease agreements and current tenant information
- Existing contracts with service providers
- HOA rules and regulations
- Insurance details
What Are Due Diligence Documents In Real Estate?
When it comes to real estate, due diligence documents are incredibly important. They help ensure that the seller and buyer have a complete understanding of the property and any issues or risks associated with it. Both the buyer and seller can then be on the same page for the duration of the property sale.
These documents can include titles, zoning papers, disclosures, surveys and environmental reviews. For buyers, these documents can provide the information they need to determine whether they want to commit to the purchase or not. Due diligence documents will also provide insight into how much buyers might need to invest in upgrades or repairs.
For sellers, due diligence documents help protect them against liability claims that may arise after transferring ownership of the property. So, due diligence is important for both buyers and sellers in the transfer of home ownership.
Due diligence is a non-negotiable when it comes to real estate investing. It allows investors to do the necessary “homework”, to ensure that the property fits the offer they’ve made. This means conducting inspections, getting copies of all the important documents, and getting a full physical, financial, and legal overview of the property before going ahead with the purchase.
Whether it’s a residential property or a commercial real estate purchase, due diligence is equally as important. The process will help verify that the property you are purchasing is going to generate the cash flow that is expected. Due diligence encompasses all aspects of the property, further than just the physical condition of it. It should be done extensively, to yield as much detail as possible, so that investors can make the most informed decisions.
A due diligence contract is an important tool used in real estate transactions to establish a standard of care between buyers and sellers before committing to a purchase. This contract sets out each parties’ responsibilities and specifies conditions, such as when the buyer must complete their inspections, and who will be responsible for paying for any repairs that may be needed prior to closing.
It also provides buyers with the ability to back out of a real estate purchase if certain stipulations are not met, or if other unexpected problems arise which would have an effect on the property’s value or condition. Ultimately, due diligence contracts aid in creating an open dialogue between both parties to ensure that everyone’s interests are properly represented throughout the real estate transaction process.
Due diligence is not the same as earnest money. Sometimes a due diligence fee is required, however this is not refundable, and is a smaller amount than earnest money. Earnest money is the payment made by a buyer to a seller to show good faith. An earnest money deposit can be refunded if the buyer changes their mind and decides not to purchase the property once due diligence has been done.
Due diligence fees can be anything from a few hundred dollars to a few thousand, whereas earnest money is a percentage of the property’s purchase price. Earnest money demonstrates to the seller that the buyer is ready to purchase the property. Whereas due diligence is the process of verifying and researching the property, to make sure that the value of property and the deal are fair.