Real estate undoubtedly has its risks with unforeseen factors that may stop you from closing a deal or earning as much as you’d hoped on an investment. However, while some factors are out of your control, there are many that can be managed through due diligence.
Why is due diligence important?
The ultimate objective of due diligence is to make it so that the buyer can understand as much as possible about a property before entering a contract and making a purchase. For instance, a seller may be concealing or misrepresenting information about a property, or may not even know everything that the buyer should know before purchasing.
Early in negotiations, a buyer should have and present a comprehensive due diligence checklist to the seller. This process can be daunting, especially to beginners, and can be costly, too. But committing thorough due diligence is a crucial step. It ensures that you are making a successful real estate investment and will not be stuck with unforeseen problems and expenses that might turn an otherwise rewarding transaction into an expensive mistake.
Every investor will develop a specific way of going about due diligence that works for them, but a general due diligence checklist can be split into three broad-ranging sections: financial, physical, and legal due diligence.
Financial due diligence: When looking into financial due diligence, you want to understand how much the property currently produces or “Net Operating Income” (NOI), and how much you will be able to produce when you have purchased it and are running it. You want to have a thorough understanding of both the income and expenses of running the property.
You also want to secure all of the paperwork that will help you understand not only what the property currently makes, but what it was making over previous years. This may include a pro forma statement, financial data going back at least three years, the rent roll, utility bills, and other operating expense-related bills, leases, and property taxes.
By learning as much as you can about how the seller has operated the property, you can have a clearer sense of how the way you operate the property will be different and what the resulting expenses might be.
Physical due diligence: This is concerned with the physical features and structure of the building and its surroundings. This part of due diligence usually requires third parties to commit standard reports as a representative of the buyer. Some of these reports include zoning compliance, appraisal, environmental investigation, and engineering reports. Hiring these third parties can be expensive so buyers usually hold off on these reports until after preliminary due diligence.
Legal due diligence: The most important part of legal due diligence is examining the existing title policy, which is supplied by the seller and title insurance company. Utilizing an attorney, you can review the existing policy and order an update. Once your conditions are met, then the title company can issue the updated title policy.
Remember: There is a process for a reason! If you stick to your process, then you will be able to stay away from excessive risks or problems that inevitably come up. For instance, if you fail to vet your partners or investors appropriately to make sure that they are trustworthy, you may need to fall back on your process to see whether it is safe to proceed on the investment. If so, you may need to do more research or take a step back.
If you commit the basic due diligence and you still feel the need to change your mind about the investment during negotiation, or if you are unsure about the people that are part of the deal, then you should remember that there will be financial repercussions. Some repercussions may look like losing money (on attorney’s fees, an upfront payment to a property owner, a lender application, etc.). Even if you have already invested money into a project, you may still find that the best option is to back out or change your strategy, even if that money will not likely be recouped. However, it is better to lose hundreds or even thousands as opposed to tens of thousands or more, and if you’ve been sticking to your due diligence process, you can weigh the potential rewards and judiciously calculate the most economical choice.
Practice thorough due diligence as much as possible, engage an attorney to assist you with what you cannot do yourself, and adjust as you go. If something comes up, don’t get discouraged, but learn from it and tweak your approach for due diligence on future projects. Remember that not everything can be accounted for. However, as you learn through various situations and mistakes, you can fine tune your processes for tried-and-true due diligence that holds up deal after deal.
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