5 Tips for Performing Due Diligence on a Small Scale Investment Property
Perhaps you’ve recently read our blog article on Active Vs. Passive real estate investing and you decided that you wanted to be an active investor. Or perhaps, you came across a smoking good deal on a fixer-upper property in your hometown. Regardless of how you got started, congratulations on taking the giant leap into becoming a real estate investor! However, its critical not to get too excited yet as you are about to embark on the most important part of buying an investment property; performing the due diligence. Due diligence can be easily summed up as “doing your homework” on the property. During this process, you’ll want to investigate and inspect all the vital information that pertains to the property. Too many investors rush this step, or don’t think critically enough about the deal and wind up in trouble. Here are 5 things to make sure you’re doing during the due diligence process:
1. Perform a Physical Inspection of the Property
In most states, including Massachusetts, real estate properties are purchased under the guidelines of “caveat emptor”. This is just a fancy legal term meaning “buyer beware.” Essentially it does not legally require the seller to disclose much if any information and places all responsibility for validating and inspecting the property on the buyer. As a result, it is absolutely critical to perform a physical inspection of the property that you intend to purchase. If you are a seasoned investor or contractor, you can most likely perform this assessment on your own as you’ve grown accustomed to what to look for. However, if you are a new investor, or if you don’t have any construction experience, you should absolutely hire a third-party home inspector to inspect and undercover any potential issues with the property. For a couple hundred dollars, you can save yourself tens of thousands of dollars or more, and a whole lot of headaches. The last thing you want to do is buy a rental property that you plan on doing a cosmetic rehab on, only to find out that it has major structural or foundation issues. As you go through and inspect the property, take pictures of everything. After you leave the property you’ll likely forget half of what you’ve seen. Having pictures to refer back to makes it easier to create a construction budget and a scope of the work that needs to be completed.
2. Review All Legal Documents Related to the Property
“Caveat Emptor” doesn’t just apply to the physical condition of a property; it also refers to its legal existence and ownership history. During this step, you’ll want to hire a real estate attorney to review all the legal documents and information related to the property. Your attorney will perform a title search, which will reveal a lot of important information. First, it will show the “chain of title” which is a history of the property and most importantly a history of the owners of the property and who the current legal owner is. Additionally, it will show whether or not the title is “clouded” or in other words a non-marketable or transferable title. A “clouded” title can be a result of existing liens filed against the property, a prior foreclosure, probate, or legal disputes over the correct ownership. Your attorney is a valuable piece of the process but don’t rely on him or her solely to catch every potential issue with the property. You'll also want to check with the city or town to see if there are any existing code or occupancy violations that need to be resolved with the property. Often this information can be found on online databases or at the building department. If the previous owner did work that was unpermitted you may be forced to remedy any issues; something you’ll certainly you want to know ahead of time.
3. Determine Your Rehab Costs or Holding Costs
Once you have completed the physical and legal inspection of the property, the next step is to determine your rehab costs and/or your holding costs. If the property is a fix and flip or condo conversion, then you will want to get an accurate accounting of how much it is going to cost you to repair the property before it can be resold. If you are a seasoned investor or contractor, you probably already have a spreadsheet for this exact purpose. However, if you are a new investor and don’t know where to start, then your best is to find a contractor (or two) who can walk the property and give you a rehab cost estimate. Before you have the contractor visit the property, you’ll want to have a clearly defined scope of the work of what you want to do in order to ensure an accurate bid. If the property is a buy and hold, then you want to figure out what your monthly and yearly holding costs are. These holding costs can be things like taxes, insurance, utilities, vacancy, property management and financing costs.
4. Run and Re-Run Your Numbers Backwards and Forwards
The first and last step you should be doing when considering purchasing an investment property is running and re-running your numbers. The creed that real estate investors should live by goes a little something like this... “Fall in love with the numbers, not with the property.” When you made your first offer on the property you probably ran your numbers based on some assumptions. Now that you have completed the due diligence steps above, you have most likely learned some new information or clarified some aspects of the property. Therefore, it is imperative that you look at your numbers again and modify anything that is not accurate. You’ll want to make sure that your projections still look good. At this point if the numbers no longer work, you should consider passing on the project or re-negotiating with the seller (if there is critical new information discovered during the due diligence process.)
5. Consider Different Exit Strategies
This is one of the most important things you should do when buying an investment property. Although you may be buying the property as a fix and flip, it is crucial to look at the property from a few different scenarios. What if the market totally crashes and what you once thought would be a $75,000 profit suddenly starts looking like a -$25,000 loss? Aside from being conservative on your projections and numbers, you can further prepare yourself for a scenario like this by considering a different exit strategy. In the event the market turns and demand subsides, perhaps you can rent the property instead and still enjoy monthly cash flow from the property and wait to sell until the market recovers. If you consider different exit strategies from the onset, you will be much more prepared to pivot and change course in the event the market requires it. If the property has only one path to making a profit, realize you’re taking a substantially higher risk purchasing that property.
There are many other factors to consider within the due-diligence process, particularly as you encounter larger more complex projects with zoning components. These 5 tips are a good start to taking the necessary precautions to protect yourself against making a bad investment. Do not be afraid to walk away from a deal after going through proper due diligence. The purpose of the process it to be critical of the project and poke holes in your assumptions. It is never a good idea to skip or rush the process as doing so could result in more than just a bad deal. “Caveat emptor” or “buyer beware” must be taken seriously.
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