Due diligence is a crucial part of real estate investing. A seller may claim that all units in his building are rented, but your physical inspection could reveal an empty one. A look at the books could show that his reported income included the one-time sale of ten used washing machines. That $900 of extra income, if not subtracted out, would artificially inflate the value of the property by $11,250, based on a capitalization rate of .08.
Simply put, due diligence is your investigation of the details of a potential investment. The point is to avoid unpleasant surprises. You need to know what the real numbers are and what you are really getting into. This is especially important with income properties, because their are so many ways that they can "surprise" you.
When investing in real estate you'll often start the due diligence process before you even make an offer. You might do your own walk-through inspection of a property, for example. In addition, your offer will normally have provisions allowing for you to review (and approve) certain records, and have certain inspections done before you close on the property.
There is normally a deadline in the offer, by which time you need to complete your due diligence and approve of the results. If this deadline passes without your canceling the offer or notifying the seller of problems you have found, the legal presumption is that you are satisfied with what you found, and committed to close according to the terms of the offer.
Due Diligence - What You Are Looking For
Proper due diligence should start with a good due diligence checklist (more on that in a moment). It is just too easy to forget something without one.
What are you looking for? You can see the property when you walk through it, and the seller can tell you all the financial details. The problem is that sellers may exaggerate things, fail to mention things or just lie. Your goal is to verify everything the seller says about the property, and find any potential problems.
For example, you will want to look at the property closely, and have professional inspections done if you need them. Often sellers will put off necessary repairs prior to selling. This lowers expenses, which increases the net income - which makes the property appear to be worth more (income properties are valued primarily according to the net income they produce).
You will of course make a look at the "books" a part of the offer. You need to see how that net income was arrived at. You also are looking to see if the expenses recorded make sense. You may need the help of your accountant. On the other hand, you can certainly see that there is a problem if no expenditures are listed for snow-plowing of an apartment building parking lot, and you are in Minnesota.
Bottom line? Play it safe - do your homework. You want to look at the physical property, the service contracts (landscape companies, cable TV, etc.) that you may be obligated to, the rental agreements, the legal compliance issues, and the statements of income and expenses. Each of these areas has its own elements, so use a good checklist when doing your due diligence. |
