Buying a home is a significant financial commitment, so you want to make sure you've made the right choice. While the seller is required to disclose a lot of information, it is your responsibility as the buyer to make sure you uncover as much about the home as you can.
If you are investing in a rental property, you could find that you are buying a home that isn’t as you expect, which will hurt your return on investment.
We look at what you need to do during due diligence to ensure you don't make a significant financial mistake.
What is Due Diligence in Real Estate?
Doing your due diligence in real estate means investigating the property and the area it is situated. Proper research means examining the physical condition, along with the financial situation of the home.
The due diligence buying a home process involves more work from you to ensure the property is as expected. While it can be time-consuming, you are doing it to avoid problems later on. This due diligence needs to be done both before making an offer on the home and after the purchase contract has been accepted.
Researching the property's history will be a crucial part of your due diligence to ensure no issues you should be aware of.
How to do Due Diligence in Real Estate
When dealing with a typical real estate home purchase, there will be a standard due diligence period in the contract. This could be 7 to 14 days in most states, but it could be longer.
There can also be differences about when this process period begins in different states. It can start when the contract is agreed upon between the buyer and the seller or when the escrow account is opened.
While there is a standard due diligence period, the contingency can be negotiated to increase the length of time available. When you are buying, you want enough time to complete the research into the property so that a longer time may be better.
If you find that you need more time to be sure that you have done enough research on the property and the buyer refuses, you might risk losing your earnest money. You could take the risk and continue with your purchase, but it is better to give yourself enough time.
When you are buying a home, whether it is an investment or not, you need to think about more than simply the house's condition.
Due Diligence Before Making an Offer
The more things you know about the home, the better you can decide on your offer amount. Learning more about the property will allow you to create a more financially sound offer.
One thing you need to check before you make an offer is the subdivision or neighborhood and the direction it is heading. This includes:
* Property values
* Household incomes
* Increases in jobs
* The ratio of rented properties
* Vacancies in rented property and rents
* Crime rates
* School rankings
Pro Forma Statements
The pro forma financial statement for the property will show its projected cash flow and will give you a better understanding of whether it will make an excellent rental investment or not. The statement will include:
* Rental income
* Extra income like an application or late fees
* Property management fees
* Maintenance costs
* Property taxes
* Property insurance
* Capital reserve account contributions for future upgrades
Your Financing Options
With your neighborhood research and pro forma statement, you can check your lending options. Lenders don't like to risk their money and want any home loan repaid fully. They might discover gaps in your research and offer you advice on how to create a better deal.
Using Your Due Diligence Period
When the seller has accepted your offer, your due diligence period will begin. This only gives you a limited amount of time to get all your research completed, and the things you need to check can be divided into three categories; physical, financial, and legal.
* A home inspection to check the main structural elements
* Plumbing and electrical
* An inspection of the exterior of the home. including driveways and drainage
* Pests like termites or rot caused by water
* Flood zone check
* Lead paint
* Radon gas
* Properties located in rural areas might need a survey or well water and septic inspections
Financial due diligence
* Current rent
* Profit and loss for the current and last couple of years
* Rental agreement including deposit amount, any discounts provided, and expiration date
* Rules regarding pets and additional fees or deposits
* List of repairs and invoices
* Current service and property management contracts
* Property taxes
* Proof of payment for tax on rental income
* HOA contract to show that rental is allowed
* HOA balance sheet to confirm they are financially stable
* Homeowners or landlord insurance costs
* Title insurance costs
* Pending litigation or liens on the property found in public records
Seller Disclosure Statement
Sellers are required to disclose any problems they know about the property. Known defects are required to be given in writing to the buyer. Discovering issues will be particularly important if you are investing in property at a distance.
The seller will have to reveal problems that could include a previous pest infestation or a neighbor boundary dispute. If there have been too many insurance claims, it will affect the new buyer’s ability to insure, which is also required in the disclosure statement.
What Can the Buyer do if They Uncover Problems During Due Diligence?
If an issue is uncovered in the due diligence buying a home process, the seller can make a request to fix the issue. The buyer can cancel the contract with their earnest money returned during this period if the problem remains.
While some things will be straightforward, like missing information, other items can be more of a problem. Even a leaking roof can be fixed, though the seller might want to avoid the expense. Other things, like the actions of neighbors that are outside of the seller's control, wouldn't be able to be solved.
Due diligence is required to make sure you get what you pay for. If during your due diligence, you find things you don't like, you have the option to cancel the deal and walk away with your earnest money returned to you.
Hopefully, you now have a much better understanding of the importance of the due diligence process in real estate.