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Investing in real estate is an excellent way to build wealth and create cash flow. But it's also a big financial commitment.
And with any big financial commitment, you want to avoid big mistakes.
According to Investopedia, “Skimping on Research” is one of the top mistakes to avoid if you want your real estate investment to succeed.
That's where due diligence comes in.
Due diligence is thoroughly researching a real estate investment before the final sale.
Knowing how to do due diligence reduces the risk of big financial mistakes. And it helps you invest with more knowledge and confidence.
This article discusses why due diligence is essential in real estate. Primarily, it covers how to perform due diligence for real estate investing.
What does due diligence mean?
In simple terms, due diligence is “doing your homework.” It’s confirming the facts and weighing possible outcomes before making a significant decision.
Recommended Reading: What Does “Do Your Due Diligence” Mean?
What is due diligence for real estate investing?
Due diligence for real estate is verifying a property's physical, financial, and legal facts before you buy it.
It's the best way to be confident you get the property – and the income potential – you expect.
The good news is that if you find problems during your research, you can renegotiate the contract or walk away.
So, it's easy to see why due diligence is essential for real estate investing. However, the process can be intensive.
So rather than think about it as a chore, think of it as an opportunity.
Consider it your chance to make an informed decision and avoid big mistakes.
How to perform real estate investing due diligence
Of course, the way you analyze types of real estate investments can differ, but the basics are the same.
During due diligence, you learn as much as possible about a property before the sale is final. And the process begins before you even step into a property.
There are three stages of the due diligence process:
- Pre-offer due diligence
- The purchase offer (contract)
- Post-offer due diligence
Pre-offer due diligence
Before making an offer on any property, save yourself time, money, and energy by doing preliminary due diligence.
Below are some critical steps to take before making an offer on a property:
- Market & neighborhood analysis
- Find financing
- Estimate repair/renovation costs
- Calculate an estimated return-on-investment
- Decide if the property could be profitable based on your investment goals.
Market and neighborhood analysis
An excellent way to understand your real estate market is to analyze properties like those you want to buy – aka “comps” or comparable properties.
Here's how to learn about your target market:
- Track real estate listings, how quickly they sell, and their price.
- Talk to local real estate investors.
- Visit target neighborhoods and talk to residents.
- Talk to a local real estate agent.
- Research key metrics for the city and communities.
To find an area to invest in, look at the local demographics and data. Consider the following:
- Value trends (Are property values rising or falling?)
- Percent of owner-occupants
- School rankings
- Crime rate
- Population growth
- Job availability
- Proximity to shopping and services
- Zoning & future development
- Rent prices
Helpful websites for gathering information:
- United States Census Data
- National Association of Realtors (NAR)
Different financial institutions offer different types of loans. But not all programs, terms, and rates are available for real estate investments.
Also, some banks don't finance particular properties. For example, some won't offer loans on properties needing extensive repairs.
So, it's wise to shop for the best financing for the investment property you want – before you're ready to buy.
It’s also wise to get pre-approved by a lender (not just pre-qualified, so sellers won’t be concerned about your financing falling through if they accept your offer.
The upfront work you put in preparing for financing will pay off when you find the right property and make an offer.
Estimate repair & renovation costs
As you view properties, make a list of repairs needed and estimated costs. Many investors have a pre-made list of typical rehab items for this purpose.
Include things like HVAC, roof, foundation, plumbing, electrical, and windows.
At this point, renovation costs will be a ballpark estimate. Still, it's essential to calculate the potential return to decide if you want to make an offer.
Do the math: Determine the potential return on investment (Flip vs. Rental)
Once you have rehab estimates, do a few quick calculations to see if it’s worth making an offer.
Here's where rental and flip property pre-offer analyses differ.
Still, you might consider doing calculations for both strategies.
Because if both methods have potential, you have a sound exit strategy if one doesn't work out.
For existing rentals, use the rental information from the seller to evaluate the property's potential.
Typically, the seller provides a pro forma statement listing rental income and expenses.
Just keep in mind pro forma is an estimate based on the seller's report – and can leave out vital details.
In other words, it needs to be verified during more in-depth due diligence after a contract is in place.
If the property isn’t an existing rental, estimate the potential expenses and rental income.
For a conservative approach, underestimate rent and overestimate costs.
Next, make some calculations to evaluate the property's potential, including Net Operating Income (NOI), Cap Rate, and Cash on Cash Return.
- Net Operating Income (NOI). NOI figures income minus expenses.
Net Operating Income = Gross Income – Operating Expenses
- Cap rate. This calculation is a ratio of NOI to property value and a good way to compare investments.
Cap rate = Net Operating Income (NOI)/Total Purchase Price
- Cash on Cash return. This calculation is the rate of return on the actual money you invest.
Cash on Cash return = NOI/Cash Investment
Most flip properties need more than a little TLC and get priced under market value. So, a critical estimate is the After Repair Value (ARV).
To find ARV, first, you need the estimated rehab costs from when you walked through the property.
(Note: You might want to overestimate expenses to account for surprises.)
Also, find the average value per square foot for comparable properties.
Then you can figure out the value added by the renovations.
- Look at recently sold similar properties. Note how much they sold for and compare them to the property under consideration.
- Find an average price per square foot for comparable properties.
- Use that average price per square foot to determine the market value of renovations on the property under consideration.
Calculate the estimated ARV
After Repair Value (ARV) = Purchase Price + Value Added by Renovations
Then, you can use the ARV to decide the maximum purchase price. A common rule of thumb is the 70% rule:
Maximum Purchase Price = (ARV x 0.70) – Estimated Repair Cost
The purchase offer: Understand the contract
The purchase offer defines the due diligence timeline and conditions for the final sale.
For example, residential contracts often have pre-defined timelines of 10 to 21 days. But you can negotiate different timelines.
The offer should also say that, as the buyer, you can cancel the contract if you find unexpected physical, financial, or legal issues during due diligence.
Once you and the seller sign the offer, it becomes a legally binding contract.
Next, you make an earnest money deposit. Then, the timeline for completing due diligence begins.
Things move quickly! So, gather information, request documentation, and schedule inspections right away.
At the end of the timeline, the earnest money deposit can become non-refundable. You can request an extension, but it’s usually better to stick to the original timeline.
Owners may just move on to a different offer in a competitive market if you can’t close on time.
An excellent way to ensure you complete everything is to have a set due diligence process.
For example, have an outline for each step with blank forms and checklists.
Post-offer due diligence
Post-offer due diligence confirms a property's physical, financial, and legal facts.
As you go through the process, be open to finding problems.
You're in negotiations until the final settlement papers get signed. So, it's your chance to avoid a risky investment.
Physical due diligence
Physical due diligence examines the property's condition and clarifies rehab costs and market value.
It includes an appraisal, property inspections, walkthrough, and repair/renovation list.
Appraisal. A professional appraiser evaluates the property's quality, condition, and size.
Then they compare it to similar properties and establish fair market value.
Bank financing requires an appraisal. But even if you don't have bank financing, consider getting one.
Property inspection. Hire a qualified home inspector to check for interior and exterior flaws, building code issues, and hidden problems.
Doing a walk through with the inspector to see the problems and ask questions is a good idea.
The inspection should look at the following:
Walkthrough. It's critical to walk the entire property, even if you have a professional inspection.
And if the property has several units, look at each one.
A walkthrough is ideal for making a detailed list of repairs and renovations and noting issues on the grounds and neighboring properties.
Here are some things to list:
- Clean out and demo (before repair work can begin)
- Electrical, plumbing, roof, & HVAC
- Construction projects (structural; projects for a contractor)
- Blinds, painting, appliances, countertops, etc.
Other Inspections. A regular property inspection doesn't cover everything.
Depending on the property's age and condition, consider these extra inspections:
- Termite & Pest (banks require a termite inspection)
- Lead-based paint
- Radon gas
- Septic system
- Water well
- Sewer line (scope older properties)
- Environmental study (typical for commercial real estate)
Financial due diligence
Financial due diligence helps you decide if the property is a sound financial investment.
Of course, the more accurate the information, the better. But sometimes, you have to make assumptions.
Below are common financial due diligence items. Following that is specific information for rentals versus flip properties.
Estimate repair & renovation costs.
Use the list of rehab items from your walkthrough to calculate repair costs.
Try to find actual costs for materials and labor. And don't forget fees for municipal inspections and permits.
If you hire a contractor, ask them to view the property and give you an estimate.
If that's not possible, provide them with the repair and renovation list to get a ballpark figure.
Once you have a rehab cost, compare it to the estimate you did before making an offer.
Do the costs align?
Insurance. Get quotes from a few insurance companies for the correct insurance coverage.
The type of insurance can depend on whether you're renting or flipping.
For example, you might need home renovation insurance, landlord insurance, or vacant property insurance.
If the property is in a flood zone, add flood insurance to the list.
Many landlords also purchase umbrella insurance as an added layer of protection.
Property taxes. Public property tax information is often available through local government agencies.
Check the property tax assessment and see if taxes are current.
Financial due diligence unique to rental properties
For existing rental properties, collect and analyze current rental information.
If the property is not an existing rental, use estimated financial data based on market information.
Once you confirm the details, re-run calculations for NOI, cap rate, and cash on cash return.
For existing rentals, ask for seller documentation to verify the pro forma statement.*
Data collected can reveal financial issues with the property, taxes, leases, etc.
Also, you can use it to find the Net Operating Income (NOI), cap rate, and cash on cash return.
Documentation for a long term rental:
- Profit & Loss statement (current year, plus last two years)
- Seller’s business bank statements, tax returns, and balance sheets
- Rent roll (gross rent collected for each unit, deposits, and lease terms)
- Expenses (utilities, maintenance, property taxes, insurance, service contracts, marketing)
- Vacancy rate
- Copy of service contracts, like property management or lawn care
- List of repairs and capital improvements, with invoices
- Copy of rental certificate
- Current property tax information (is it paid? Are there special assessments?)
- For multi-family property, request a T-12 Operating Statement (last twelve months of financials)
*There's a lot to analyze when buying a rental property. Consider hiring a real estate attorney and CPA to help you.
Estimating income & expenses
If the property isn't an existing rental, you'll forecast income and expenses to get NOI, cap rate, and cash on cash return.
For accuracy, use market rent prices for similar properties.
Then figure anticipated expenses, like marketing, maintenance, property management, lawn care, and repairs.
Financial due diligence unique to flip properties
You’ll focus on rehab costs and after repair value (ARV) for analyzing a flip.
So, accurate renovation and resale estimates are crucial for a successful flip.
It's often wise to overestimate costs to lower the risk of losing money.
Use the list of repairs and renovations from your walkthrough to get repair costs.
Be sure to research the value of comparable properties to find ARV.
Keep in mind flips have real estate commissions and building permit fees on top of rehab expenses. Plus, holding (carrying) costs can add up during renovations.
If you don't have experience, consider hiring a contractor for a detailed estimate.
Legal due diligence
Legal due diligence deals with title issues, zoning, covenants, etc. So, hiring a real estate attorney or title company is recommended.
Homeowner’s Association (HOA). Review the HOA rules, regulations, and financials if the property is part of an HOA.
- Read the HOA Declaration of Covenants, Codes, and Restrictions. This information can affect your investment. For instance, some HOAs restrict parking and don't allow units to get rented out.
- Verify HOA fees.
- Review the HOA's financial statement. Does the HOA have extra money for extensive repairs? If not, they can impose a special assessment, where owners get charged a (large) part of repairs.
Zoning. Could zoning impact your investment or property value?
Look for things like future development and occupancy restrictions.
Title search. An attorney or title company does a title search to look for liens or significant legal issues.
Here's what they look for:
- Liens (a lien attached to the property must get paid before a sale)
- Deed restrictions
- Deed omissions, like unreported heirs, name changes, or fraudulent activity
Title companies also have title insurance for issues missed in the title search. (Lenders and some states require title insurance.)
Property survey. You might want a survey if there's a discrepancy over property lines. That said, surveys are most relevant for commercial or multi-family properties.
Due diligence on commercial property
The due diligence discussed so far also applies to commercial real estate, but there's more to it.
Legal issues, location, zoning, environmental matters, and leases are more critical. So, hiring a team of pros is often worthwhile when considering commercial real estate.
Recommended Reading: Commercial Real Estate Investing: Build a CRE portfolio
Renegotiate or cancel the contract
If you uncover unexpected issues during the due diligence period, you can
1) renegotiate the contract, or
2) cancel the contract.
If you find a problem the seller can fix, you can ask them to fix it before closing. Then, if the seller agrees, verify they did so before signing settlement papers.
Sometimes the seller can't or won't fix issues.
But if you still want to buy the property, you might ask the seller for a price reduction (called retrading) or other financial concessions.
If a seller refuses to negotiate further, the contract gets canceled, and you get your earnest money refunded.
Also, if you find too many unexpected problems, you can cancel the contract and walk away.
If it’s before the due diligence deadline, you get your earnest money back. If it’s after the deadline, it’s possible to lose your earnest money deposit, but it depends on the circumstances.
Performing due diligence is time-consuming and often costs money. Still, in the long run, performing your due diligence is a vital step for successful real estate investing.
Not only does it help you understand potential risks and benefits, but it saves time, money, and headaches down the road.
Don’t skip performing due diligence in a hot real estate market just to land a deal.
When you cut corners to beat out the competition, the income-producing rental property of your dreams could quickly turn into a nightmare money pit.