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Due Diligence and Real Estate

by Mike Farmer on February 12, 2008 · 5 comments

  

In my last post I talked about how to prepare psychologically for that first plunge into investment. Okay, so now you’re ready, somewhat calm and almost fearless. In this post I’ll drill down from there to one aspect of investing that touches every other aspect and allows you to sleep better at night – DUE DILIGENCE. This simply means investigating the investment from all angles to see if it makes sense. You might find a property that looks promising and want to tie it up before someone else gets it in order to have time to investigate it.

Sale Contract and house by ginkgo2

You’re a grownup taking a risk and no one cares (except maybe your family and friends).

It’s your responsibility to do your homework. You can’t depend on the law of averages that it will probably be okay because it costs too much to break that law. You can’t depend on the good word of the seller, because sellers sometimes don’t know, sometimes don’t care or sometimes don’t tell. You can’t depend on the legal system (many state laws don’t protect an investor from misrepresentation like they protect a homeowner, plus lawyers are expensive). Yes, many people buy investment properties without a hitch, but hitches happen and you don’t want hitches happening to you. There may be places to skimp and save money in the process, but this isn’t one of them.

Due diligence starts pre-contract.

Know the contract. Read the contract. Be one with the contract. The contract should allow you time, from one week to a couple of months, depending on the nature of the investment property, to perform due diligence and be able to walk away for any reason and have your earnest money returned in full. There are other aspects of a contract that are important that I will drill down to in a later post. If you need help with the contract, rely on a real estate professional or an attorney experienced in commercial real estate. If a seller pushes you vigorously to shorten your time-frame, train your mind to hear a warning buzzer.

Not too quickly and not too superficially

If your potential investment property is land outside a busy suburb that you hope can be developed, your due diligence, of course, will be different than if it’s a building downtown that could be used for a restaurant, and different if it’s a quadplex used for rental. Here, we’ll assume it’s not just land. One reason I suggested a first time investor stick with something in an area they are familiar with is that you understand the trends of that area, hopefully know some players there and it’s easier to make assessments on use possibilities. Perhaps you’ve been going to neighborhood planning meetings, you know someone who knows someone who knows someone who works at the courthouse and can help guide you with zoning, to read all the fine print and addendums so that you understand all the possibilities of how the property can be used. If you’ve investigated planning, zoning and city ordinances, you should have a good idea of what is allowed and might even discover possibilities you hadn’t thought about before. If you’re unfamiliar with this process of investigation, ask someone experienced to run you through it – it’s not that difficult, just a little time consuming.

Physical inspection

Make sure you get a certified inspector to inspect the property, and get an environmental inspection for all concerns pertinent to your area. Get an inspector who comes with references and develop a close relationship. Let the inspector know what you expect and find out what they don’t inspect. A good inspector might not know everything, but they should know enough to recommend more in depth inspections of what they notice – for example, a good inspector who notices structural warning signs is not a structural engineer, but they can detect signs and recommend getting a structural letter from a structural engineer. This is another drill down subject I’ll cover later.

Financial Investigation

Let’s say you’re investing in a quadplex. You’ll want to get a rental history, vacancy rates, maintenance fees, property management fees (if property management needs to be hired out), taxes, insurance, leases (read the leases very carefully – Triple net? – who pays what? – who’s responsible for what? ect.) When you made the offer, it was an educated guess based on comparables, cap rates and the like, but now you need to put the green shades on and crunch numbers. The property and the surrounding area might have looked good before, but now that you’re looking with a magnifying glass, it might seem like the area is going down and areas close by are going up which could hurt your bottom line if the trend continues. You’ll want to investigate your financing options, determine your fixed and variable costs, in order to see if your return on investment is in line with what you had in mind.

As you can see, there are many aspects to investing, but with a focused, planned approach you can break it all down and investigate to help make an informed decision. I’ll be writing each week in a series about one of these aspects, drilling down further and further until they’ve all been covered. The most important thing in the beginning is to understand due diligence and make sure it’s thorough.

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{ 2 comments… read them below or add one }

Shawn February 17, 2008 at 9:23 am

Thanks so much for this very informative post! I especially like how at the beginning, you kept emphasizing due diligence and you smashed the excuses people would have given (or would have been thinking). You certainly covered all the thoughts I’ve had when purchasing things without doing my due diligence.

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Bill March 26, 2008 at 2:56 pm

Very good points. A few to add – whether raw land or a previously developed site, we often compare due diligence with digging to the bottom of the details. Although there is ultimately a point of diminishing return, the benefit of knowledge in a real estate transaction as either buyer or seller is usually money. We use GIS for site selection (screening among several candidate properties for clients). Due diligence usually requires in depth work on the site, in the public records and government offices, on the phone, and in person research. If it was easy to do well anyone could do it.

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