One important skill to develop as a real estate investor is the process of due diligence.
Due diligence is the in-depth research you will do on a property you've contracted to buy. Your purchase-and-sale agreement should provide for a period of time to study the propertyto determine if it makes sense to move forward to closing. Terms can vary from market to market and property to property, but generally speaking, most sellers will agree to provide a purchaser with 30 days to 60 days to go through the due-diligence process at no charge.
There are two main goals in due diligence. The first is to verify the information you receive from a seller on a property to determine if the information is accurate and reliable. Your second goal is to gather additional information about the property that will help you determine if the property is one you want to purchase. You want to gather all the information on the property you can so that you clearly understand everything there is to know about it.
How in depth do you need to go? Try to find out more about the property than the seller knows. Property owners tend to get complacent as the years pass and can lose touch with how their properties are operating. You want to get all the skeletons out of the closet and uncover as many problems as possible. In some ways, purchasing an existing building can be like buying a used car. Some blemishes are visible, but some are not so apparent.
The tasks involved in due diligence fall into four basic categories: physical, financial, technical, and practical.
Physical inspection
To perform the physical part of due diligence, you need a good team of specialistsroofers, plumbers, and electricians, among othersto study a property. A general contractor experienced in the type of property you look to buy is helpful as well. Some professionals might charge fees to do an inspection, but talk to a broker before shelling out cash. He or she might have relationships with contractors who will do the workin the hope of getting your business in the future. You also can ask for bids for work that needs to be done on the property.
Keep this in mind: No matter how well you do your homework, there often will be a few physical details about a property that are tough to detect.
A client once bought an office building and hired a heating, ventilation, and air-conditioning expert to inspect the HVAC system. The inspector checked out the four rooftop units, and he deemed them to be in good working order. All else looked good, so my client bought the building that fall and moved in.
The next summer, he called me and said he couldn't get one part of the building to stay cool. The HVAC contractor came back out and took a more thorough look at the building. With this second inspection, he determined that the building had an addition that wasn't readily apparent. The HVAC system from the original structure had been extended into the addition, but the ducts in the addition were too small to carry an adequate amount of air to that space. Another cooling unit had to be added to the building.
Clearly, buildings are unique, and there often are a few surprises here and there.
Crunching numbers
While the physical-inspection process is important, a working knowledge of the financial aspects of a property arejust as crucial. If you aren't a financial whiz, a broker or an accountant can assist you in analyzing a property's math.
Keep in mind that the key is to start with real numbers. What were the actual income and expenses for the property during the last three years?If those numbers seem fuzzy, askthe seller for the last three year's income-tax information that relates to the property.Don't consider purchasing a property based onprojections or proformas provided by an owner or listing broker.Work hard to put together your best assessment of a property's current and future income and expenses.
Do some research on market rental rates. Are the current rents at market? Are they above market or are they under market? In this economy, it's not uncommon to find tenants who have been on long-term leases with built-in rental increases who are paying above-market rents. When their leases expire, they are likely to request a rent reduction. At the appropriate time, it is helpful to interview the tenants and determine if they have been happy with their premises. What are the odds that they will remain in the building long term?
Technical, practical
The two other areasof due diligence are technical and practical. A few highlights of this portion of your due diligence would be verifying the property's zoning to confirm the types of tenants that can use the property. Having the ability to lease your property to a wide variety of tenants over the life of your investment is important. Also, look at other public records, such as county assessor notes, boundary line surveys, and municipal sign regulations.
One key practical component of a property is parking. The more parking a property has, the more attractive it is to a wide variety of tenants.
Other practical questions to answer involve whether a property's building design is timeless and whether it's safe and well-lit at night, among several others.
Once due diligence is completed, you can determine if you are ready to move forward with the purchase. If substantial, previously unknown or undisclosed issues that have arisen during the due-diligence process might lead you back to the seller to try to remedy those issues.
The most common issues that I have encountered during the years are related to unexpected repairs and environmental issues, but it's important to make sure each fact about a property is verified.
Many years ago, a partner and I had tied up a piece of land on which we planned to build an office building. We completed our due diligence on the property, and we were ready to remove our contingencies and move to closing. At the last minute, my partner thought he should go down to the city to verify the listing assertion that city sewer service was in the street in front of the property, something we hadn't verified yet.
It was a good thing he did. He found out the sewer line ended in solid rock 150 feet from our property. As I recall, the estimate we obtained to extend the sewer to the property was about $25,000.
We went back to the listing broker and let him know we weren't happy about his negligence on the facts. The seller was upset but agreed to giveus a discount on the price at closing in consideration of the error.
So, to become a successful real estate investor, it's important to do your due diligence and to consider the physical, financial, technical, and practical aspects of a property. Doing the property due diligence can help you avoid many problems and unexpected expenses. It also will help insure that you have selecteda well performingproperty that will meet your investment goals.