Due diligence is the nitty gritty part of real estate investment that is often overlooked, but only at a real estate investor’s peril. Last week I gave a brief guide to due diligence for apartments. This week I’ll focus on houses and small multi-family properties. For both, proper due diligence is absolutely vital to avoid making huge mistakes.
Unfortunately, I learned this the hard way. I’ve bought more than one house with a broken sewer line, once I bought a property with no plumbing in the basement, another time the electrical had been so completely scrambled by some Do-It-Yourself-er with a bit of a meth problem that flipping the bathroom light switch turned on the porch light. It only takes a few of these mistakes before you realize that due diligence needs to be a top priority. So why wait? They say the wise man learns from his mistakes, but the wiser man learns from the mistakes of others. Be the wiser man.
With houses and small multis, you will generally have 30 days to close and 10 to 15 days to inspect. If you back out of the contract during the inspection period, you should be able to get your earnest money back. This is negotiable and varies, so make sure you are aware of what your time table is up front. But regardless, you definitely want to complete your due diligence in the time allotted. For example, Fannie Mae requires 10 percent down for cash purchases, which will all be lost if you choose to drop the deal after the inspection period expires.
The Goldilocks Zone
With apartments, I said, “It’s hard to do too much due diligence,” which is completely true. With houses, there probably is a point of diminishing returns. For example, if you are in a volume business and buy five to 10 houses a month, missing something here or there from time to time during due diligence can amount to just the cost of doing business. You should still do thorough due diligence, of course, but if it’s so thorough as to slow down or interfere with acquisition, it may become counterproductive.
On the other hand, if you buy one house a month or one a year, there is absolutely no messing around. That one house has to be good, so very thorough due diligence becomes nonnegotiable.
In other words you want your due diligence to be in the “Goldilocks Zone” — not too hot and not too cold. But err on the side of too much.
What to Look For
You will need to get the water, electricity and gas turned on if they are off. Sometimes this isn’t possible (say if the property is winterized or the furnace is missing), but for the most part, you want to check the utilities. By getting the utilities turned on, you can make sure the HVAC system and electrical work and that there are no plumbing leaks.
Other key things to look for:
- Old Furnace or AC: It is probably near the end of its useful life, even if it is still working.
- Fuse Boxes: You will probably want to replace them.
- Electrical Panels: You don’t want to have a Federal Pacific panel in your house because they’ve been recalled and are basically useless. You also want to make sure you have at least 100 amps of service coming into the house. Some old houses only have a 60 amp service. Upgrading the electrical service can be done, but it isn’t cheap. An inspector should be able to tell you this if you can’t figure it out from your own inspection.
- Ungrounded Electrical: You can easily tell if the outlets have only two prongs instead of the usual three. But be forewarned, some people put three prong outlet covers over ungrounded outlets. Having ungrounded outlets is not the end of the world, but if you do choose to ground it, it will cost a good amount.
- Plumbing Leaks
- Galvanized Plumbing: This plumbing often rusts and will likely need to be replaced, but not always. If it has galvanized plumbing and the pipes don’t look corroded, check the water pressure and make sure it is sufficient.
- Condition of the Appliances: Can they be cleaned or do they need to be replaced?
- Dry Rot or Signs of Pest Damage
- Large Cracks in the Foundation Wall or Movement: If it is more than three inches (you can check this by running your finger along the siding outside and seeing how far the back of the siding is from the foundation wall), this is very concerning and you should get an expert out there to inspect it. If it is moving at all, there should be vertical braces or deadmen in the basement. If there aren’t, you’re going to want to put them in and epoxy any notable cracks. If you are concerned at all about the foundation, it’s worth getting a foundation expert to inspect the property.
- Roof Leaks or Substantial Roof Damage: This often requires getting on the roof to verify. But if you see any discoloration in the ceiling, this means there was probably a roof leak (or plumbing leak).
For new investors especially, it is all but mandatory to get a licensed inspector to inspect the property and then review the inspection report thoroughly. You should have them do a pest and dry rot inspection too. Not only will this help you avoid mistakes by catching things you may have missed or are not qualified to evaluate, but it can also help you renegotiate the price if you do find problems. Never be afraid to walk away or renegotiate if you find something that makes the deal not work anymore.
Also, I highly recommend scoping the sewer line on any property that is more than 30 years old. Broken sewer lines usually cost $3,000 to $5,000 to replace so you want to know about them up front. You should be able to find a plumber to scope them for around $100 to $200.
Pricing it Out
Most investors — and almost all new investors — think things cost less to repair than they actually do. You should absolutely have a repair estimate going in, but you want to verify your estimates after you get the property under contract. Especially if you’re new, get some bids from contractors on the major work to be done and then update your estimate to be in line with the bid you’re likely to use. And add an extra contingency to your budget for unforeseen expenses and knick-knacks (around 25 percent).
Make sure your updated repair estimate is still in line with your expectations when you made the original offer. It’s better to find out you were wrong at the beginning and back out than at the end when you already own the property.
Finally, always close at a title company or with an attorney. If you don’t, you may find yourself with a huge tax lien attached to your new property.
Due diligence may be tedious, but it is vital. Any problem you find before closing can be used to renegotiate or back out. If you find it after you close, good luck getting the seller to pay for it. In other words, due diligence can save you a lot of money so don’t let it fall to the back burner. Make due diligence a top priority.
What would you add to my list of due diligence? Have you ever been burned by not scoping out a property thoroughly?
Leave a comment, and let’s discuss!