Real Estate Due Diligence: 2 Critical Steps You Can’t Afford to Screw Up
One bad deal can set you way, way back. A friend of mine once put it like this: “One bad deal prevents you from doing the next 10.”
Want more articles like this?
Create an account today to get BiggerPocket's best blog articles delivered to your inboxSign up for free
OK, that’s a bit hyperbolic. But if you haven’t noticed, many of BiggerPockets’ most prolific authors have made sure to emphasize their worst deals. I’ve done it, as have Engelo Rumora, Brandon Turner, Mark Ferguson, and many others. The reason is that such deals can break new investors or turn them off from continuing in real estate.
So despite it not being a particularly fun topic to discuss, many of us believe it is essential to do so.
And the No. 1 lesson to learn when it comes to all of our worst deals? In order to avoid such bad deals, you must do due diligence thoroughly and correctly.
Establishing a Process
A while back, I wrote a thorough guide on due diligence and noted the importance of using a checklist. My checklist looks like this:
- Pre-Offer Due Diligence
- Area Analysis
- Value and Financial Estimate
- Rehab Estimate
- Post-Acceptance Due Diligence
- Physical Due Diligence
- Financial Due Diligence
- Legal Due Diligence
- Retrading (if necessary)
- Final Decision and Walking Away (if necessary)
The due diligence that is important to discuss here is part two. Part one is what you do before you make an offer and parts three and four are what to do with the information you’ve collected from your due diligence.
For houses, by far the most important thing is the physical due diligence and inspections. But, of course, the financial component is critical, too.
If the property is currently rented, you will want to get a copy of the rent ledger and the operating statement (profit and loss statement) for the last year. You will also want to get a copy of the lease. Review it to make sure the rent and deposit line up with what the seller said, the utilities are in the tenant's name (unless otherwise stated), all the standard clauses exist (like for late fees), and there's nothing weird in the lease (such as the tenant being responsible for the maintenance or something like that).
I would also recommend getting some sort of proof of deposit. I’ve witnessed several times when sellers have faked rent rolls or just rented the building out to random people regardless of whether they could pay or not to make the rent roll look better. Tax returns, bank statements, or deposit slips all work for this.
But again, with houses, the most important thing is the physical due diligence.
Related: The Ultimate Guide to Due Diligence
Physical Due Diligence
Even if you have already walked the property, I would recommend walking it again. Do it very thoroughly and create a detailed scope of work. And try to get the utilities on if they are currently off. Sometimes, this won’t be possible; for example, if the wiring has been stolen. If that’s the case, make sure to add an extra contingency to your rehab budget.
If you are not experienced with putting together a rehab budget, first and foremost, pick up J. Scott’s The Book on Estimating Rehab Costs. But in addition to that, feel free to ask a contractor or an experienced investor to go by the property and give you a broad estimate. Offering lunch always helps with this.
You can also learn rehab costs by looking over line-item bids from contractors on other rehabs and reviewing your previous projects.
Finally, if the property has a tenant, take careful note of how they treat the place. If they are messy or smoke inside, it’s likely you will have a fairly significant turnover on your hands when they do eventually move out.
For any new investor, I always recommend getting a professional, third-party inspection. First of all, if you want to retrade (ask for a discount), having a third-party inspection report is a great thing to point to. But further, it's always good to have another set of eyes on the property to make sure you didn't miss anything—particularly a set of eyes trained to spot such defects in the property.
Seasoned investors should also usually get third-party reports. That being said, if you do a lot of volume, have a good amount of experience, and put in a solid rehab contingency, you can afford to go without such inspections if you choose.
Finally, if you see any signs of dry rot or termites, you should get a pest and dry rot report. In some areas, you may want to get a radon inspection as well or have particular items looked at by a specialist (roof, HVAC, etc.) depending on the condition of those items.
Whether bad deals cost you the “next 10” or just the next one, it really doesn’t matter. You want to avoid them. And the way to avoid bad deals is to verify what you think you know going in with thorough due diligence. So don’t skimp on it!
What does your due diligence checklist look like? Has it helped you avoid bad deals?
Share your experiences in the comments below.