The Ultimate Due Diligence Guide for Buy & Hold Properties

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Hey All!

As you might already be aware, our primary focus is buy-rehab-hold. Many times over the years, deals have looked great on the first walk through, and the numbers have come up solid, but upon further inspection, we have found issues that caused us to change our minds about the deal.

It’s important to do a thorough physical and financial inspection of a deal to make sure the deal will meet (and even exceed) your expectations. You also want to make sure that the data the seller gives you to evaluate the deal is correct. This includes everything from the rent tenants are paying, the utility expenses and even what use the property is zoned for.

Discovering that a piece of data you used to evaluate the deal is incorrect can kill a deal. Discovering it too late can be much worse.

When we buy a property, every one of our agreement of sales includes two clauses around inspections. One clause allows us a phase called the Due Diligence phase. This phase typically takes 15 to 30 days and is the time period when you can do all inspections. The second clause allows us to ask the seller to make repairs, request a discount in price (called a re-trade) or exit from the deal altogether as a result of what is found during the inspections.

Related: The Importance of Doing Your Due Diligence: A True (and Almost Disastrous) Story

This article is dedicated to the Due Diligence phase and what we typically do to make sure the deal will meet our expectations.

The level of detail you will go into during due diligence will vary depending on the size of the property. You should do some level of all the inspections below, even for a single family home.

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3 Crucial Inspections to Make During Due Diligence

1. Document Inspection

This is the first and typically the most straight forward part of due diligence.

In the agreement of sale, we ask for specific documents to review. Most of these are readily accessible by the seller, and we just want to make sure they have them on hand. Some of the easy ones include the deed to the property, a copy of their insurance policy, copies of all tenants’ leases and a recent real estate tax bill.

If the seller can’t produce one of these things, it’s a red flag that deserves further examination and may uncover more data. Perhaps the tenants living in the building don’t actually have written leases. Perhaps the property is in a flood zone, which would become evident on their insurance policy.

Another document that the seller may or may not have on hand is a land survey of the property. If the owner doesn’t have a survey, you should consider having one performed on your own to confirm that things like fences, driveways and utility poles don’t cause a boundary issue between you and a neighboring property.

The last stop on your document inspection should be to the local municipality. There, you want to confirm that the property is zoned for its current use, that it is registered as a rental property (if that’s required in your area), and that there are no violations filed on the property.

Document inspection/review should take you no more than a day once you have everything in hand.

2. Physical Inspection

Just like a homeowner’s inspection, when you purchase a home, the physical inspection of a rental property is dedicated to uncovering things that may become a problem down the road.

For every deal we do, we perform a detailed walk through of the building.

We look for two things: upgrades we want to make and safety concerns. Upgrades usually include the things that make a unit rent easily, like new kitchens and baths, new light fixtures and appliances. Safety concerns include things like missing smoke detectors and undersized electrical breakers. In New Jersey and Pennsylvania, the local township performs a Certificate of Occupancy inspection on every sale, which focuses on safety.We typically rely on their inspection to uncover safety code violations.

We do all of the above for just about every purchase. As the deals have gotten larger, we’ve implemented some of the following additional physical inspections:

  • Roof inspection: For mixed use or multifamily buildings, we have a roofing contractor come out and give us a full assessment of the roof condition for a very reasonable fee of $100. The report includes pictures and a brief written report. He also includes an estimate to repair any damage.
  • Structural inspection: Structural repairs can be expensive, but they can be remediated. If we see something that looks suspicious with the building foundation or the framing (typically in the basement), we bring in an engineer. For a small fee, he will do an inspection and write a report of his findings.
  • Boiler inspection: For multifamily buildings with one boiler heating multiple units, we will have a heating contractor inspect the heating system to determine its current health and life expectancy beyond closing.
  • Fire inspection: When there are hardwired smoke detectors or fire extinguishers in the common area of the building, we have a contractor inspect them to make sure they are working properly. Most municipalities will require this to get a clean certificate of occupancy actually.
  • Environmental inspection: This sometimes comes up for properties larger than a single family home and will just about always come up if you are getting financing from a local bank. It involves making sure there are no environmental hazards on the property. These hazards are a threat to the local environment and include things like an abandoned underground heating oil tank or asbestos insulation on heating lines or lead based paint.

The inspection needs to be done by a third party company hired by you (the buyer). It can be a very light inspection called an Environmental Analysis Survey or a full blown analysis called a Phase 1 Study. If any issues arise, the seller is obligated to remediate them, and the inspector is obligated to report them to the local environmental authority. Whether or not to perform an Environmental Inspection is really up to your lender, if you have one.

Once you complete your Physical Inspection, you want to go back to the owner and either get more clarity on some of these items or ask for them to remediate certain things (especially if an environmental issue comes up). You may even need to ask for an extension of the Due Diligence period to complete your investigations, as sometimes getting one question answered leads to another. If you find something that is going to cost you big time in the future, you can ask the owner for a potential discount before closing.

3. Financial Inspection

Before you put the deal under contract, you should have completed a financial analysis of the deal.

If it met your profit requirements, you made the offer and moved forward. There is a potential problem here: the fact that you had to use numbers you assumed were correct. This includes everything from the income numbers to the expenses — all these were probably given to you by the current owner or their realtor and need to be validated.

When I am evaluating a properties financials, here’s what I ask for:

  • Lease review: In the document inspection, we got copies of the leases. I look at the lease for three financial items: what they pay in rent, their security deposit and what they are responsible for. The last item is very important.

We are purchasing a mixed use building with a group of investors right now. I was reviewing the leases yesterday and saw that one of the storefront owners is responsible for 25% of the snow removal fees. That was on the 4th page of their lease — and could have been overlooked easily. Because I found that, I probably made us $500 a year in reimbursements from the tenant!

  • Utility bills: I always ask for 12 months of utility bills for anything that is in the landlord’s name. You definitely want to get at least 12 months because you want to see the utility cost fluctuates through all 4 seasons.

In my part of the world, here in New Jersey, gas bills are much higher in the winter. Another reason you want 12 months of utility bills is that water and sewer will fluctuate greatly with vacancies.

  • Real estate taxes: I once looked at a property where the realtor listed the taxes to be $6000 per year for a 3 family building (welcome to New Jersey, everybody!). Once I started our due diligence, I found that the taxes they had quoted were from 3 years ago.  The new tax rate was $7500 per year.

It actually was an honest mistake, but lazy on the realtor’s part. The taxes hadn’t been updated in the MLS in years, and they didn’t bother to contact the tax collector to confirm the taxes, which we did during due diligence. Imagine if we had taken the realtor’s word and gone to closing.

  • Maintenance: This is a tough one. You really need to take a close look at the building during the walk throughs. If you get an owner who is willing to be honest with you and show you their actual expenses, you can get a feel. Most owners I deal with “forget” the time they had to patch the roof for $1500 or leave out things like grass cutting or snow removal in their maintenance estimates.

You can also go with a rule of thumb on this one, which is risky, but it works. I usually estimate between $400 and $600 per unit per year in maintenance on a multifamily and am not too far off most of the time.

Related: How Due Diligence Can Save You Hundreds of Thousands of Dollars

  • Management: Most realtors use crazy numbers for management, like 4% to 5% per year. I have yet to meet a management company that will take a contract to manage anything less than 100 units for less than 8%. In our case, we manage the property with our own management company and charge 10% for the service.

Although it makes brokers unhappy that I blow away their projections for profit by increasing the management fee, it is way more realistic. And as a side note, even if you are planning to manage the property yourself, put in a management fee anyway just to be safe. If the numbers work with it, you can always hire someone later.

  • Insurance: This one is pretty straight forward. In the document inspection, you should have gotten a copy of their policy. Take that and send it to your preferred carrier and ask them to price it out. Just have them adjust it to meet your desired deductible, replacement cost, etc.
  • Capital expenses: This is the forgotten expense — but one that will come back and bite you years later. Capital Expenses are things like boiler replacements, roof replacements, major apartment turnover and common area upgrades.

You need to set money aside for these things year over year, even if you don’t do them, so that you have a reserve for when that roof does need repair or the electrical in your building needs to get upgraded.

Once you’ve crunched all the numbers above, you either validate the profit projections you had when you made your offer, or you show them to be false. If the numbers are far off and you put that clause in your offer (see the beginning of this article) you can go back to the owner and ask for a price adjustment to meet your original expectations.

You may not get everything you want, but if you did your homework, you can show that the property does not perform as they said it would.

Conclusion

I view the purpose of Due Diligence to be validation and long term planning. The validation is of the financial performance of the building and the expectations I have for the physical condition of the property. The long term planning comes in when I see that roof report or find out that the boiler has 5 years’ worth of useful life. The Due Diligence period is a time to really get to know my new asset so I can keep it performing over the years.

Some people use the Due Diligence period to look for places to get a discount. I have done that, too — but don’t get caught up in it. You should make an offer you are willing to stand by up front, not use the Due Diligence phase to get to your price.

Have you done some other things for Due Diligence that I missed?

Thanks for reading and please leave me a comment!

About Author

Matt Faircloth

In 2005, Matt founded The DeRosa Group along with his wife, Elizabeth. At the time, the two person company owned and managed two assets – a single family home and a duplex. Over the last nine years, they have grown the company to a 12 person team owning and managing over five million dollars in residential and commercial assets throughout the central NJ and Philadelphia area. One of DeRosa’s mantras is “to make money while making a difference.”

42 Comments

  1. Great checklist and great article. Another to-do on a buyer’s due diligence checklist should be review of the property’s current title report (which sellers are generally expected to order from a title company and provide to buyers). In addition to confirming that the seller is the owner of record, the title report can also highlight issues a buyer is unaware of or has forgotten about, including restrictions on what can be done with a property. This might include limitations on rent increases or restrictions on structural changes to the facade of the property, for example. Hopefully, your attorney is looking closely at title but it’s a task you want to make sure gets completed.

    • Hey Kris,
      Thanks for the feedback. I agree – doing research on title is important and should be a part of the “document review” phase! In New Jersey we typically use attorneys to support a closing so they do most of that side (we are spoiled, LOL). It’s not customary in all states to use attorneys so it pays to be aware of what to look for on a title report.
      Take care,
      Matt

  2. Brooks Rembert on

    Thank you for writing this. My wife and I are under contract on our first rental home and will start the inspection process soon.

    The capital expenses could be very easy to overlook, so thanks for the reminder.

    • Hi Brooks,
      First, CONGRATS on your first rental home under contract! More to come soon I hope.
      Yes, Capital Expenses can come back and bite you in the future. Rental property ownership is a long term game to wealth; knowing what needs to be addressed in the future and setting money aside for it will help you out long term!
      Matt

  3. Hello Matt,
    Awesome points. Thanks for sharing. Also, Just like Kris has mentioned, do a title check and if in fact buying the property, ensure to get a title insurance and also include that during the number crunching phase.

    Thanks.

    • Hi Naveen,
      Yes, I really appreciate Kris C’s comment. Research of the Title report should be included in the document review section of due diligence – no doubt. I always buy title insurance, it isn’t worth the risk to save the money.
      Matt

  4. Hi Matt,
    Great post, especially for a newbie trying to wrap my head around all the moving parts of a real estate deal. I might make a mind map of this information, if that is okay with you.
    Thanks for your advice.

  5. Richard Guzman on

    Class Act!
    A great article and again thank you to BP for coming just in time –
    I am in the process of placing bids on a couple of multi-family homes this week and this article came just in time as I did not think about a couple of the bullets! This article was thorough and precise, easy to understand which made it a pleasure to read.

    Thank you!

    • Hi Richard,
      Thanks for the comment. I’m glad the article was “timely”, LOL. Let us know how you make out on those bids! I hope you get ALL the deals you made offers on, good luck. If you want more feedback on Due Diligence during the purchase process let me know.
      Matt

  6. Brent Mattison on

    Great article. I’ve been looking for a checklist and this one looks great. Thanks for sharing on BP. Do you have this in a spreadsheet to make sure you don’t miss something? I would sure like to get a copy if you would be willing to share. Thanks again for the great article.

  7. Hello Matt

    Thank you very much for providing this info…especially the tips on utility bills! I’ve been reading your posts (and I unfortunately was not able to meet you in person at the most recent SJREIA meeting). I’m new to investing and looking to volunteer / assist other experienced investors in the area.

    C.L. Cherilus
    B.S. Rutgers, MBA Wharton

  8. Hi,
    You mentioned having a roofing contractor look at your roof. I’m not sure I agree with that. They might tell you you need a new roof to get the business even if the roof has some life left in it.

    • Matt Faircloth

      Hi Brian,
      Thanks for reading. You are correct, there are contractors out there that will always tell you that you need to replace it! Never ask a car salesman if you need a new car, right?

      Although I have had my share of contractors tell me to replace a perfectly good heater or roof, I also have honest contractors that know that if they take care of me they will get repeat business. That’s the case for my roofer. I use him regularly because he’s never let me down and has been willing to tell me that we don’t need to hire him when that’s the case. he also gives me pictures of the roof during his inspections so I can see proof of the damage he says is there.

      Thanks again!
      Matt

    • Matt Faircloth

      Hey Frankie,
      Due Diligence is key for making sure that what appears to be a good deal is actually a good deal. Lots of things are hidden at first sight, those things need to be uncovered before closing or they become your problems down the road!
      Matt

  9. Bernard A.

    Thanks for sharing your knowledge Matt. I started looking into real estate last December and I made my first offer today. I was looking for a checklist for due diligence and came across this article. Very well put together and precise. One thing I would like know is if I can still request for these documents if my offer gets accepted. They were not requested as part of the offer.

    • Matt Faircloth

      Hey Bernard,
      Congrats on your first offer! If your offer is accepted you need to make sure that the contract allows for some sort of Due Diligence period or inspection period. During that time you can ask for these things. The seller may not be willing to give them until you are under contract if they are sensitive like financial docs.
      Take care,
      Matt

  10. Gerald Demers

    Hello Matt. Thanks for the list. One thing i would add in checking the leases is also getting an estoppel letter from each tenant asking them when their lease ends, how much they pay for rent, are they current, what else do they pay for, etc. Then compare it to what the owner told you. They should be the same but many times, they are not.

    Gerald Demers
    Brooks Young Financial Group

  11. Matt Faircloth

    Hey Gerald,
    Good idea. We typically dont use estoppel letters unless the owner doesn’t have a lease for the tenant. Getting a letter when the lease is already in hand is a good way to double check, and to get the tenants confirmation of the lease data. Something I see all the time is an owner that claims that the tenant had no security deposit. I have made an exception in that circumstance and gotten anot estoppel letter, just to be safe. Thanks for the comment!
    Matt

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