The Biggest Advantage of Doing Due Diligence Well
At this point, you’ve probably got a handle on due diligence. And if not, check out my “Ultimate Guide to Due Diligence” and examples of how to do due diligence right and what happens when it goes wrong.
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Once you have the process down, you can start using all the information you’ve gathered to your advantage—for instance, to renegotiate.
The Due Diligence Process
First and foremost, here’s the due diligence checklist I’d like to hammer into every newbie’s head:
- 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)
Now, here’s how to use due diligence to renegotiate a deal.
Details About the Property
In this example, the property in question was in an area that my company and I knew well and had several rentals. Therefore, we were quite comfortable with the location and felt we could easily estimate the rent price.
But as I’ve noted before when discussing our BRRRR strategy, we strive to be all in on a property for 75 percent of its market value in order to refinance out our entire investment. So, the big thing to us was the ARV.
This house was a 4-bed/2.5-bath. It was bank owned and in rough shape. Just about everything needed redone. There was an additional half bathroom in its finished basement; however, as I’ve said before, finishing your basement almost never makes sense. But if it’s already done and dry when you buy it, it’s a bit of a bonus.
Here’s what the house looked like:
As you can see, it needed a bit of work. The property was listed for just $49,000 though.
As for comps, here's what our real estate agent sent me regarding nearby houses with three to four bedrooms and two to three bathrooms that were built between 50 and 75 years ago. All the properties had sold in the last six months.
Prices ranged widely to say the least! So, while this type of list from the MLS is helpful, it’s far better to export the list into Excel and then manually go through and make adjustments.
For example, we bought this property several years ago when the market still had a lot of foreclosures. There were several real estate owned properties (REOs) on this list, and each was in terrible condition.
They would not be comparable to our finished product. Neither would houses that were much worse, better, smaller, or bigger.
I went through the list and removed anything that shouldn’t be there. Then, I calculated the average of those that were left, along with average price per square foot, and compared that to the subject property’s square footage.
It looked like this:
Let me be clear, this is only the start of an analysis. It should also involve taking a closer look at each of the comparables (especially the pictures on their listings) to see what kind of shape they were in when they sold.
You should also make adjustments for basements, finished basements, garages, carports, fenced yards, central A/C, style and age of construction, and perhaps the subdivision (nearby properties may still be in better or worse subdivisions). You want to make sure each property is, if possible, in the same school district, too.
The point is to think like an appraiser and try to turn each comparable property into an exact replica of what your subject property will be when you’re finished with the rehab. That means you take money off the price of comparable sales if they have an added benefit and add money to it if they are deficient in some way.
For example, if a comparable sale is identical to yours except it has an extra bathroom, take off maybe $5,000 (depending on price and area) from its sale price, because that’s what the comparable house would have sold for if it was absolutely identical to your subject property.
In this case, a closer analysis didn’t change my conclusion much from the original. I decided the property was worth approximately $120,000 fixed up. We offered $42,000 and came to terms at $45,000.
Once we had it under contract, I painstakingly went through the property and put together a scope of work. The scope had over 300 line items on it, just to give you an idea of how much there was to do.
To avoid repeating due diligence errors I’d made on previous properties, this time I added a contingency for unforeseen issues and accounted for holding costs.
My rehab estimate came in at just over $40,000. But in my thorough analysis, I noticed something else…
Signs of Termite Damage
During my initial walkthrough (when I only put together a one-page sheet with a quick estimate), I hadn’t noticed that some of the joists in the basement had been chewed up. However, on my thorough walkthrough after we had it under contract (which lasted over two hours), I found ample evidence that wood-devouring termites had been there and done what they do.
I knew banks wouldn’t simply take my word for it though. Plus, I wanted to make sure I understood the full scope of the problem. Therefore, I ordered a termite inspection. These images were included with the inspection report:
Fortunately, the damage was mostly isolated to a few spots in the basement and one side of the house, so the repairs would be tolerable. Also, termite treatments themselves are pretty inexpensive. But still, the property was not in the condition we initially expected it to be.
With this new knowledge, we decided to “retrade.” In other words, we would renegotiate the purchase price (or terms) based on what we found during due diligence.
This is single-handedly one of the biggest advantages of doing due diligence well.
We asked for $3,500 off; the bank immediately agreed. It was one of the easiest negotiations I’ve ever been through! That being said, I probably should have asked for at least $5,000 off.
My new rehab budget came in at just over $44,000. We did end up going slightly over that budget, but fortunately, it wasn’t too bad. We finished all in on the property for just over $88,000.
Given that I believed the property was worth $120,000, that put us all in for 73.39 percent. So, even with loan fees, we could refinance out just about everything we put into the property. That meant we pretty much bought that puppy for free!
And in the end, it turned out to be a nice little home:
Bringing tired, old properties back to life is one of the most enjoyable parts of real estate investing to me. Although, I have to say, it’s that much better when you have almost 27 percent equity in the property!
Do your due diligence, folks. Don’t skimp, and don’t get lazy. Not only can due diligence prevent you from buying a bad deal, it can also save you money on the good ones.