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When you’re considering buying an investment property, you will most often receive an income and expense statement and rent roll from either the owner or a broker. These statements will give you a general understanding of the property but should not be relied upon as accurate, at least not as it relates to how you intend to operate the property. You will also get a cursory tour of the property and a quick look at the mechanical systems. This is intended for you to get a general feel for the condition of the property, but you’ll probably be shown only the best parts.
Due diligence is your opportunity to gather relevant and reliable information about your purchase to decide whether it truly meets your investment needs. It’s also the time to finish a detailed inspection of the physical condition of the property. Make sure you use your due diligence thoughtfully. The following three areas are where you should focus your energy.
Document Review
Understand that the broker’s or owner’s marketing material is intended to put the property in the best light possible. While typically no one intends to mislead or misrepresent, accept that you are most likely being shown the maximum possible return on an investment property. This may or may not apply to your business plan.
During due diligence, review the rent roll, income and expense statements for at least the past 12 months, deposit receipts for rent, service contracts that cannot be canceled with a sale, property tax bills, vacancy reports, bad debt reports, capital expenditures, leases and other documents related to the management of the property. Make sure the income and expense statements are certified by the owner as accurate. You should also have access to the tenant files of the property to audit the leases, applications and other documents in order to verify the reports you’ve been given.
Physical Inspection
The goal of a physical inspection is to determine whether the building has been maintained as you anticipated from your original tour. If you are planning a full renovation of the building, some of my suggestions may not be applicable. This advice is intended more for the investor purchasing a stabilized or moderate value-add property. If not, the result will be more expensive during your ownership than anticipated.
You should access every part of the property. Go into each unit to check for consistency of finishes, condition of kitchens and baths, and tell-tale signs of leaking (water spots on ceilings, buckled floors, etc.) You will also get a feeling for the tenants in the building. You should also inspect and examine all other parts of the building, including the roof, mechanical areas, common areas, basements, exteriors/facades, windows and doors. You can usually find a contractor who specializes in these areas who will accompany you on the inspection for a small fee, or gratis in hopes of being awarded any work you decide needs to be done.
Involve Your Lender, Lawyer And Broker
A common mistake buyers make is not understanding what their lender needs in terms of documentation or physical inspection. Many times the lender will want a copy of all the documentation or might want to tag along during inspections. If a due diligence period is waived or passes before the lender gets involved, the investor could be in a bad situation. If the lender is concerned with something you didn’t think about during due diligence, it might be too late for you to get out of the acquisition.
In this case, the only alternatives might be changing to a less-favorable lender or losing the earnest money by walking from the deal. If the lender isn’t concerned with due diligence items, sometimes they might see something that instead concerns you, but you wouldn’t have thought about without the lender’s involvement. Regardless, investors should involve their lender early on in a contract so they have the option of participating in the due diligence process.
Even if all the documentation checks out and the physical condition of the property meets your expectations, there are sometimes legal issues that create surprises leading to a less-favorable-than-expected acquisition for the buyer. These issues are usually related to survey, title and subsidies that run with the building, zoning code that prohibits uses as you intend for the property, code violations on record, and a myriad of other potential surprises. Too many times these issues are discovered after a due diligence period is over, and the buyer has less leverage to pressure the seller to address them.
Involving your attorney early in the process of the due diligence period will help you discover the unexpected while you still have control of the deal. Pulling a preliminary title report and submitting a Freedom Of Information Act request will usually shine a light on most legal issues. The rest will surface through written interaction between each party’s attorney.
If you are buying a property directly from a seller, there may not be a broker involved; however, if there is a broker (or brokers) in the transaction, make sure you include them in every step. A broker will facilitate and communicate between the parties regarding everything mentioned above. A broker will procure both access to the property and the collection of needed documentation. The age-old mantra of real estate transactions is “Problems don’t kill deals, but surprises do.” If a broker is involved in every step including inspecting the property, reviewing documents, understanding your lender’s needs and being copied on attorney correspondence, any issues can be effectively communicated to the seller as they are discovered. A good broker helps navigate issues, raising the probability of successful resolution.
In summary, remember the goal for due diligence: Confirm your assumptions made about the investment during your first tour, and look at the returns. Take the time to fully understand the physical property and the financial and operational documentation, and involve your lender, attorney and broker early and throughout the entire process.