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What is Due Diligence in Real Estate?

What is Due Diligence in Real Estate?

One of the potential risks of investing in rental property is that you’re also buying the seller’s problem. Due diligence in real estate helps you to avoid making a big financial mistake by learning as much as possible about the income property you’re purchasing before you buy.

Due diligence means investigating facts about the physical and financial condition of the property and the area the property is located in. A good way to think of due diligence is “doing your homework” both before you make an offer and after your contract is accepted.

Whether you’re purchasing a single-family home or a larger multifamily income-producing property, due diligence should be a time-consuming and in-depth process.

As a rental property investor, due diligence helps you to verify that you are getting the property and cash flow that you’re paying for.

 How the Due Diligence Process Works

In most residential real estate purchase contracts, the due diligence period is pre-defined in the contract. The due diligence period starts when the real estate contract is executed between buyer and seller, other times the countdown begins when the bond is opened.

 The buyer and seller can always negotiate and agree to a different due diligence period other than the one pre-written in the contract.

However, if you’re buying real estate, agreeing to a short due diligence period could put you in the position of not having enough time to fully research the property you’re investing in. If you need to extend the due diligence period and the seller refuses, you could be at risk of losing your earnest money deposit if you decide not to proceed with the purchase.

When you invest in income-producing real estate, there’s much more to consider than just the physical condition of the property. Here’s how the due diligence process works if you’re buying or selling rental real estate:

Pre-offer due diligence

There’s quite a bit of due diligence you can do before making an offer on a property. The more information you have ahead of time, the better you’re able to structure an offer that makes good business sense:

Area and neighborhood analysis: This involves taking in to count the Population and job growth, Median household income levels, Percentage of renter-occupied households, Vacancy rates and median rents, Property value trends, Neighborhood and school rankings, Crime rate

Pro Forma financial statement: Gross rental income and Other income such as application or late fees

Vacancy and credit loss, expense items including leasing and property management fees, Repairs and maintenance, Property taxes and insurance

 Review of financing options: Based on your neighborhood analysis and pro forma statement, you can now shop around for a loan if you’re financing your purchase. Lenders are in the risk reduction business because they want the loan to be repaid in full. They may spot issues in your pre-offer due diligence that you overlooked and have different ideas of how to structure your potential deal.

Seller disclosures

A seller has the obligation to disclose material facts and known defects about the property in writing, usually in the form of a seller disclosure statement. Sellers who are long-distance real estate investors may ask their property manager to provide certain information, since the owner may honestly not know much about the property. Examples of material facts and defects include noise pollution from a nearby highway, if and when the property was last treated for termites, or if the neighbor’s fence is encroaching onto the seller’s backyard. Sellers also need to disclose if there have been any insurance claims over the last few years because too many claims can make the property difficult and more expensive to insure.

Homebuyer rights

If you discover something about the property during the due diligence period that you don’t like, you have the right to ask the seller to remedy the issue or you can cancel the contract and have your earnest money fully refunded.

There are some issues a seller can solve, while other problems may be physical defects that can’t be fixed.  For example, solvable issues may include a roof leak or missing information in the tenant’s file. On the other hand, the vacant lot on the corner that is quiet during the week may be the site of dirt bike races on the weekends. While both sets of issues can lessen the value of the property, one group of problems can easily be solved while the other cannot.

If the seller does agree to requests you’ve made as a result of your due diligence, make sure that the purchase contract is amended to include those agreements as a condition of closing contract and reinspect if necessary. Never take the seller’s word that a problem will be taken care of.

 

Source: Reuben Affum-Ankamah(Real Estate Times Africa)

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