Achieving investment success boils down to one primary factor: risk management.
Investors that want long-term profitability from their investment portfolio need to consistently analyze the risk of their investments and make decisions that minimize risk. This requires due diligence and research to gather as much information as possible about the potential investment opportunity.
When it comes to investing in real estate, whether you’re considering residential homes or commercial real estate, conducting due diligence is the way to ensure the safety of your capital. If done properly, it’s a complex and comprehensive process, but it’s also critical to the safety and security of your investment.
You don’t want to be rushed into an impulsive purchase or investment decision. Take as much time as possible to review all the documentation with a critical eye. Make sure to identify any potential red flags along the way. The due diligence period is your opportunity as a real estate investor to smooth out any wrinkles in the deal before the transaction is completed, ensuring that you can go into passive real estate investing securely.
Many real estate investors skip this step, or do a poor job in their diligence, and end up signing deals with unexpected surprises or expensive fixes down the road. With due diligence being such an important part of investing in real estate, here are some ‘Must-Do’s’ when doing your homework on an investment property.
Become your own auditor
Think of this time as your financial due diligence as an investor. You want to take all the financial information provided and check that it’s accurate and all revenue and expenses are accounted for to ensure the maximum amount of passive income. Various third parties, such as real estate professionals or other real estate entrepreneurs, can be valuable as you verify the numbers. For example, reviewing bank account statements and rental agreements helps to verify the revenue actually exists.
Another trick is to look at the seller’s tax returns. Most rational people wouldn’t over-report their income to the IRS in order to pay more taxes. Income numbers you find there are likely accurate and indicate the actual historical performance of the property. Look for any differences in the tax return income and the income information provided by the seller to verify the income of that investment property.
During the financial due diligence process, you want to uncover and verify all future liabilities like loans, contractor debt, and deferred maintenance. These will all represent future expenses and there might be something hiding that the seller isn’t disclosing so you can account this into your decision, potentially saving you money in the long run.
Investigate the ownership history of the property
The ownership history can tell a compelling story about the property you’re about to buy. Pull a report of the property from a site like HomeDisclosure.com to find details about the property and neighborhood. Granular reports like these can help a buyer understand a seller’s motivation. Look for instances when the property was flipped, or if it’s ever been foreclosed on, or how long the seller has owned or occupied the property.
Make sure an insurance policy can be written for the property
During the due diligence period, discuss insurance with a provider and get an accurate quote for the cost of a policy on that specific property. Make sure you can even get a policy written. Some areas might be tough to get a policy if they are in a flood zone, or a fire-prone or hurricane-prone area. Finding your property in one of these situations can drastically increase the cost of the insurance policy, making it more difficult to maximize your passive real estate investments.
Study the marketplace
Don’t cheat on the real estate market research! Too often, amateur real estate entrepreneurs look at a few properties and don’t get a good understanding of the overall market in their target region. Take the time to investigate the market in this specific region. This will ensure you have a good expectation when it comes to purchase price and other financial details. So if one specific property doesn't fit with your investment strategy, a similar one in the area might.
Use American Land Title Association (ALTA) to access the land survey
Land surveys should be used to evaluate any problems identified by the exceptions. They allow buyers to visualize how any easements or licenses might hinder the property and is acceptable under the deal’s terms and property’s location. The survey will also reveal encroachments or physical uses not shown in the title commitment.
Have the building inspected
Hire a local inspector that’s qualified for the type of property you’re looking to purchase. The inspector will be attentive for any regulatory violations as well as issues depending on the location’s climate.
The inspection should focus on structural components of the property: integrity of the walls and roof, properly functioning HVAC units, a working fire suppression system, etc.
Hiring a third-party inspector will ensure an unbiased review on the property so that any repairs that would need to be made are mentioned up front - potentially saving you money in the long run.
Confirm your zoning designation
Don’t forget to check and verify the zoning and land use matters for the property. You want to make sure its current, intended, and potential uses aren’t in violation of the zoning regulations. This is an essential part of the due diligence process because you want to ensure the property won’t run into any unexpected zoning issues in relation to your intended use. Review all current agreements that affect the property: growth management agreements, public facilities agreements, covenants.
Note: Before checking off zoning from your list, make sure there isn’t a pending zoning change on the property.
Conduct an environmental inspection
This is another area where it’s beneficial to hire a third party to conduct an inspection and an environmental impact assessment. The extent of the investigation will depend on the property’s past, current, and future uses — i.e., an office building wouldn’t require the same depth of assessment as a gas station.
Select a title company
Look for a title company with plenty of experience and check with the Better Business Bureau to review any complaints against the company. Your title company will check and make sure the property’s title is legitimate so you can feel comfortable when the title switches into your name.
The title company will conduct a title search on your behalf to analyze the property’s records. They will verify the seller indeed owns the property, no one else has claim to the property title, there is no pending litigation to threaten the title, or if there is any mortgage or tax lien attached to the property. While a title company does this as their job, your job as a smart real estate investor is to double check their work as well.
Conduct an appraisal
Getting an appraisal on the property gives you an unbiased estimate on the property’s value. This is like getting the Kelley Blue Book value on your car to see what it’s worth given the type and condition. This can be a good reference point when negotiating terms of the transaction or purchase price.
Do NOT base your decision off the “pro forma” financial information.
When a seller or real estate agent provides you with a “pro forma” to review the financial information, the numbers are only estimates of how the property might perform in the future. Instead, you want to base your investing decision on how the property actually performed with historical data. In most cases, the actual performance is much lower than the numbers on the seller’s “pro forma.”
Create a checklist with the various “Must-Do’s’ and simply do your homework. You want to gather all the information possible so you can make a smart and informed investing decision. Due diligence will help remove some of the risk from your next real estate investment.