Due Diligence in Real Estate Investing Simply Defined:
The steps a responsible investor takes in order to expose the risks associated with the purchase of a particular piece of real estate.
The Allure of Checklists
I get it. Checklists make jobs seem to go faster, easier, smoother, and give the user a sense of accomplishment. BUT, Asking another real estate investor for their checklist for performing due diligence is like asking a mechanic: “can you give me a checklist for repairing a car?” The request seems simple enough but if you think about it, what would a checklist for repairing a car look like?
Well without knowing: What’s wrong with the car? What exactly are we repairing? What is the make, model and year of the car? We couldn’t possibly begin to create a repair checklist because there would be too many variables.
The same goes for Real Estate Investing Due Diligence. Looking for a Due Diligence checklist is way too generic. No two properties are alike and therefore, the act of performing Due Diligence for real estate is NOT a one size fits all process. There is absolutely no possible way one checklist can serve your needs without knowing critical details.
The Problem with Due Diligence Checklists
The problem is that most of the people looking for these checklists are new (“newbie”) real estate investors and newbies stand to lose the most. How so you ask? Well, studies show that if a newbie real estate investor experiences financial loss on their first investment, they are 80% more likely to give up on their dreams of creating wealth through real estate.
Something as simple as an incomplete checklist could be the difference between a good investment and a bad and to demonstrate how a one-size fits all checklist could fall short depending on just one tiny difference let’s take a look at a typical single family house with the only difference being: Where is this property listed for sale?
Due Diligence MLS vs. Foreclosure Auction
Real estate investors often buy property from their area MLS (multiple listing service) and we also buy properties from foreclosure auctions. So let’s pretend we’re performing due diligence for a single family house – one is for sale in the MLS and the other for sale at a foreclosure auction.
And let’s see how we do when we use this handy checklist (one of many) I found on a real estate website which offered this up as: the Ultimate Due Diligence Checklist. Here is the Checklist
- Study the Marketplace
- Visit the Property
- Hire a Building Inspector
- Check Zoning Laws
- Research the Title
- Access the Most Recent Land Survey
- Get an Appraisal
- Schedule an Environmental Assessment
- Figure Out Financing
- Consider Title Insurance
Let’s take this ultimate checklist through both the MLS property purchase and the foreclosure property purchase. We’ll start with the MLS property.
Due Diligence for MLS Properties
MLS –Multiple Listing Service
When you purchase a property off the MLS, each party signs a prewritten, standard contract. In my area, Buffalo, NY, this standard contract is about 13 pages long. It also contains specific instructions and timelines for all parties, including attorneys, agents, buyers, sellers, appraisers, inspectors, banks etc.,
As a real estate investor, buying a property that is listed in the MLS will provide quite a safety net when it comes to performing due diligence. Each party having an attorney and a real estate agent working on their behalf, helps to ensure that the buyer and seller are protected throughout the sales process.
Even though you’re largely protected when you buy on the MLS, still, as the buyer, you will be responsible for following the instructions and hiring qualified individuals as part of your due diligence.
Due diligence for traditional MLS properties consists of things like:
- Hiring a good Real Estate Agent – consider an agent who LIVES in the area you’re looking to buy.
- Hiring a qualified attorney (one who specializes in Real Estate)
- Reading and understanding the entire terms of sale/purchase agreement
- Knowing your power positons AND the seller’s power positions. Meaning, where can you get out of the contract and where can the seller.
- Conducting a thorough property inspection by hiring a qualified home inspector
- Conducting a radon inspection – many buyers forego this $99 inspection but it costs thousands of dollars to remediate.
- Understanding the implications of any additional terms that are written into the contract. Such as “buyer agrees to xxxxx”
- Verify rents, leases, tenant quality (if you’re inheriting a tenant)
Using this very short sample list of things you should be doing to perform Due Diligence with a MLS property; you can see that we already have 6 items that are NOT included on “The Ultimate Due Diligence Checklist”… Not so helpful.
Now let’s take a look at how well this ultimate checklist serves us at a foreclosure auction.
Due Diligence at Foreclosure Auctions
Foreclosure Auction – Sales via a bidding process.
Bank foreclosures occur every day and many municipalities hold annual or bi-annual tax foreclosure auctions. Properties sold at these auctions are up for bid because the owner did not pay their property taxes and/or fell behind on their mortgage payments.
Bidding at foreclosure auctions is completely different than buying property in the MLS because the buyer has no safety net, no realtor and no attorney looking out for their interests. All of the work an attorney or realtor does during a traditional sale becomes the burden of the buyer BEFORE bidding.
To make matters worse, the terms of sale at a foreclosure auction are entirely one-sided and are designed to protect the selling entity only. You’ll often see terms like AS-IS, Seller is Not Responsible, Buyer Assumes all Risks, Buyer Forfeits., Seller makes no guarantee…and so on.
Due diligence for foreclosure auctions consists of things like:
- Locate and Read the Terms of Sale – they are not always provided up front.
- Visually inspect each property – most property cannot be viewed on the inside
- Preform market analysis to support your max bid price
- Estimate repair costs based on exterior indicators
- Research chain of title
- Research liens that stay with the property
- Investigate easements or encumbrances
- Identify if there will be Super liens
- Are there deed resale restrictions
- Verify outstanding code violations
- Call Utility companies to verify last time in service dates
- Find out if there are any owner or government rights of redemption
- What repairs can you be reimbursed for if the property is redeemed
- Is this property insurable
- Verify occupancy and prepare for eviction process
Again, in just this short example, you can see that if you were using “The Ultimate Due Diligence Checklist”, you would have missed some pretty critical steps for protecting yourself from financial loss when bidding at foreclosure auctions.
Do you see how vastly different the two types of sales are and how each requires completely different steps of Due Diligence?
How to Really Approach Due Diligence
Stop relying on someone else’s checklist! There are far too many variables with each piece of real estate to have confidence in a one size fits all checklist. In this post we only used the difference of “where it’s being sold” and look at how “The Ultimate Due Diligence Checklist” left me exposed to financial loss.
The path to performing proper due diligence begins with you, the buyer, educating yourself on the area where you are investing, inspecting a property top to bottom, inside out, and fully understanding the terms of sale for the property you are considering for purchase.
Whether the terms of sale are 13 pages or 1 page, read them repeatedly. Let the terms of sale serve as a general outline of your risks and address each risk separately. Become the investor who dissects terms of sale, be the one who knows it like the back of your hand. Fully investigate every single term and find out if those terms have negative results that could result in financial loss.
Terms of Sale Due Diligence Example
Proper Due Diligence Example:
You see terms that say: Sold subject to any rights of redemption of the USA.
Your Job: Perform Due Diligence for this term: In other words: Find out if the USA has any rights to or liens against the property.
- If your Due Diligence reveals that the USA has no rights or liens against the property, then you have cleared your due diligence for this term.
- If your Due Diligence reveals that the USA has a $25,000 tax lien against the property, then you have NOT cleared this term. You’ll need to perform even more Due Diligence to find out how this impacts your plans for this property.
Continue your Due Diligence all the way down the rabbit hole with every single term. The object of Due Diligence for real estate is to clear each point OR know where you are exposed so you can make educated buying decisions.
In closing, knowing the area in which you are investing, thoroughly inspecting every inch, and investigating the implications of every single term you are agreeing to will serve you far better than any random checklist when it comes to performing Due Diligence for Real Estate Investing.
To your success!
Investors Edge of Buffalo