Importance of Due Diligence in Real Estate Investments
A comprehensive due diligence in real estate investments is a necessary risk management strategy that should be considered by all real estate investors. Due Diligence is arguably the most important step an investor would take before closing the deal. Even if a property looks good at the surface level, there may exist reasons why it should either not be bought or not be bought at the stated price.
Why is due diligence necessary?
There may exist potential risks in a seemingly attractive property that cannot be uncovered without thorough investigation. No vendor would be willing to be upfront about the risks, obviously so that he can sell it at a higher price. There may also be a possibility that the vendor is selling off the property in hopes of good riddance as he is aware of the existing risks and defects and is looking for an unsuspecting investor. We do not want to be the victim of this, do we? So, let us now discuss how an efficient due diligence can be done.
How to conduct a due diligence?
Along with the analysis of the physical structure and the exterior of the property, an investor must thoroughly examine the financial, legal and operational histories of the property. In a nutshell, due diligence is the homework that an investor needs to do before saying yes to the property.
● Steps involved-
1. Physical Due Diligence- As the name suggests; this step involves inspecting the physical aspects of the property i.e. the interior and the exterior. An investor must also take into account the environmental conditions, the integrity of the building and the area and the heating and plumbing systems. To do this the investor must get a sense of the neighborhood by checking the property at different hours of the day and different days of the week. The investor can also communicate with the neighbors to get a better idea of what ensues in the said locality. The investor must check the crime stats and make his opinion about how the neighborhood fares. Perhaps, the investor can also try to acquire the 10-year plan to get an idea of the upcoming developments and how they may affect the value of the property.
A quote of repairs, if any are required, must be asked for from the vendor, so that the investor can either get the seller to cover the cost of repair or lower the cost of selling.
2. Financial Due Diligence- With the permission from the seller, the investor can obtain and verify the financial disclosures of the property. Then, an in-depth cash-flow analysis must be done by requesting the documents for rental income, tax liability and the principal and the interest rates on the mortgage loan being considered. The investor must also account for the landlord tax deductions if he plans on renting out the property. It is imperative to take a look at the bigger financial picture by – a) distinguishing between capital improvements and repairs + maintenance expenses. b) setting a rent estimate for future tenants.
Other financial records that need to be vetted are previous owner’s income tax returns that report the income and expenses to the IRS, lease for terms, expiration date, deposit amount, and any other unique agreements.
Apart from all this, tax due diligence can be customized based on the categories and brackets the parties fall into. The taxes involved in the transaction may also have a significant impact on the financial aspect of the transaction and in evaluating the economic viability of the investment.
3. Legal Due Diligence- This entails investigating the zoning, compliance and more. The investor must review all the seller disclosures, or in the absence of disclosures should prepare a list of questions to ask the seller. The investor can request a preliminary title report from the title company to get an idea of who currently owns the property. This is necessary to know that the seller has a clear title that will be transferred to the investor post the closing of the deal. The investor must figure out that upon renting out, the intended use of the property is aligned with the municipal rules. The status of the water rights and mineral rights must be known, especially if the property is in a rural area.
4. Market Analysis- An investor should go over and above when researching everything he can about the market and see if the property in question fits the general idea of things. This can be done by examining similar properties’ location, demand and amenities available in proximity. He can get an estimate of the future earnings by evaluating the future demand of the property and can thereby make a decision on whether to invest or not.
If any issues are discovered that the seller can’t fix or doesn’t want to fix, you can either walk away from the deal, or you can re-negotiate the offer in the light of the information obtained during the diligence.