Due Diligence – What’s it to Me?

Anytime you purchase a big ticket item such as a home, and investment property, a luxury car, etc, most people do their “homework” beforehand.  Homework and Due Diligence can almost be considered synonymous.  We always do our homework before spending just to make sure our decision is sensible and that we get a good value or return on our money.

Buying real estate as investment property can be likened to one of the most expensive, legally complicated, and financially risky buys of your life.  As such, there is a great deal of homework, or “due diligence” that any buyer, or seller for that matter, should be aware of in order to lower your risk and improve the outcome of your decision.  While, once in a blue moon, a great deal or lucky break stumbles across everyone’s lap, but aside from rare situations like that, most average homeowners are innocently unaware of the behind the scenes complexity and potential difficulty of every other home sale.  There is a lot of time and labor that goes into finding that perfect property.  There can also be a lot of waiting.  But you have to be prepared to strike while the iron is sizzling hot.  Entering the market brand new, you’re essentially looking at mostly leftovers.  Deals that don’t make sense.  But you run the numbers on them anyway, just checking to see if they’d make a good investment.  If they don’t, you set your system (or Realtor’s MLS Notification Emails) so that you get an immediate notice as soon as any property that fits your description is listed.  Run your numbers as fast as you can to see if it makes sense, and if it does, be the first to make an offer.  You can always change your mind, usually within at least 2 weeks, and walk away completely cost-free if things don’t suit your preference.

To give you a simple idea of the steps you need to take to be successful in Real Estate Investing, consider the following:

Always Do your Numbers – on Paper

If you’re ever to be a successful investor, this is probably the most important skill to possess.  Arguably second possibly only to physically finding the right homes for sale in the first place.  Every time you consider purchasing an investment, you need to do the numbers out in full.  Sure, we say here to do it on paper, but seriously, do it on whatever helps you get it done as complete and fast as possible.  Remember, you’re trying to be the first, if not one of the first, to make an offer on the property and the longer it takes you to run your numbers, the more time passes with the home sitting available on the market.  Sometimes it’s the first offer that takes it, even if it is a little low.  But in today’s real estate market, you really need to be on the money, no pun intended, all the time.  The generic term “numbers” refers to calculations that help you know if you should or will produce positive income on the investment property, and/or increased value in equity.  Terms like ROI (Return on Investment), Cap Rate (Capitalization Rate), and the ability to approximate income and expenses on a property are all things to learn about and develop experience working with.  If you’re able to buddy up to good lawyer and an accountant (stick to CPA’s), they might give you some free advice (which also amounts to free education), and help you make a better decision than you would in the first place.

Determine How You Plan on Buying

When buying an investment property, you probably should start here first.  Knowing a few things up-front can help move things in the right direction from square-one, instead of spinning wheels or having to “learn from your mistakes”.  The first question to ask is “are you a cash buyer, are you a loan buyer, or are you a creative financing buyer?” Once you know which one you are, it can be likened to having chosen the right golf club, or scoring the lucky free-throw from the mid-court line.  Cash buyers have the most negotiating power, obviously, because they’re working with cash.  Loans carry risks.  Owner financing carries risks.  Cash carries little to no risk.  But cash comes with a price… for the seller that is.  If you’re like me and don’t have a few hundred $k laying around doing nothing, you might need to finance your investment properties.  Financing involves getting prequalified up front, just like a traditional home buyer, except that you’ll probably pay a slightly higher interest rate, considering the loan is for an investment and not the borrower’s primary residence.  The additional cost has to be factored in.  Creative Finance buyers often look for owners who will “carry paper” on the property, which will get a buyer in the door with less cash out of pocket, and also gives the financier (owner) of the property foreclosure rights if the borrower defaults on the loan.  I like owner financed homes, but not every owner is in it for the long haul and they just want to cash out instead.

Check the Title

Yes, this is a biggie and one that not just any novice can do without at least a little help.  You never want to buy your investment and then in two weeks, here comes along Uncle Eddie who says he loaned the previous owner $20,000 on the home and now has a title claim to the property.  Oh what a mess.  This is where, what I refer to as, your “wealth team” comes into play.  If you’re ever to become a successful real estate investor, you’re going to need someone “on the inside” who can run a quick title search and make sure there aren’t any undisclosed liens or encumbrances on any property you may be about to buy.  Fortunately, this service is free, and they can usually do it in a matter of minutes, or you can even do them yourself online.  All you need to do is make contact with a sales rep from any of your preferred local title companies.  A title company is always involved in the escrow closing, so having your foot in the door with a good title agent can be a win/win for both of you.

Inspecting and Rehabbing

Whether buying a home to live in yourself, or an investment property, I always recommend a professional home inspection.  But that’s for a property you’re already buying.  If you’re investing, you’ll need to develop some skill in this area, or partner with someone who has.  Back to the point of the article, being quick, you’ve got to learn how to quickly assess the condition of a property and estimate any repairs or improvements accurately, before you’ve bought the home, and factor all of that together to make sure you earn a return on your investment (ROI).  One way to gain experience is to enroll and attend a local chapter of home inspector’s trade group and participate in any educational training or certification they offer.  Now this might not be a good idea for everyone, but the other way just takes trial and error experience.  Some homes, you’ll make money on, some you’ll break even, and hopefully, as few as possible will lose.  Understanding these costs up front can help you make a good choice in a time-limited situation.

Check with your Insurance Agent

Run the property by your local insurance agent.  Make sure there aren’t any limitations to having the property insured.  If you use the same person over and over to buy insurance for your investments, they will certainly have no problem assisting you in uncovering insurance problems before they occur.  Some properties may extremely high to insure, while even others may be un-insurable completely.  It just depends on the location, the proximity to fire or other environmental hazards, and other commonly known factors about homes in the area.  Ask about insurance costs up-front, because even though insurance isn’t needed to cover the property contents, it sometimes costs more because the home has higher potential to sit unoccupied when they’re a rental.  Don’t ask me, I didn’t make that silly rule, but it is what it is.

Consider Incorporating

Depending on your local and state laws, incorporating can be a valuable way to protect yourself from personal liability if anything goes wrong at one of your investment properties.  I am not an lawyer or a CPA, so I do not give direct financial or legal advice, but I can give you some things to think about and some questions to ask.  Different kinds of corporations (generically covering other legally recognized entities, such as LLCs and LLP’s) give different kinds of protections, and they also have different kinds of tax issues.  Consider which laws or tax benefits will fit your plan best and exercise your choice.  Otherwise, understand the liabilities of a “sole proprietorship” and the pros and cons of each.  Again, this is where a good wealth team may be able to advise or help out.

Building your Wealth Team

One of the best places to start, if you’re new in business, is to join your local Chamber of Commerce and start going to functions.  There, you’ll meet anybody and (nearly) everybody who conducts business in town.  Make friends with a few select ones.  Try to get a CPA and an Attorney on your list, in addition to the aforementioned Title Rep.  Take them out to lunch one day and tell them your plan.  Listen to any advice they give and keep notes.  Stay in touch with your wealth team, especially after closing by sending them a thank you letter or small gift (in accordance with RESPA requirements), and let the people you meet grow your portfolio through your own taking of their advice, knowledge, and recommendations.  It was once said, “you don’t have to know everything, but you do need to know the right person to ask.” You might also try to get in good with a local Property Manager, a Realtor, a Handyman, a legitimate Building Contractor, and a Mold Inspector and a Home Inspector.  Build it right, take care of your Wealth Team and they’ll take care of you.

So if you do all these things, build your portfolio wisely, and exercise due diligence in all your investments, keeping yourself disciplined and always looking at that bottom dollar, you’ll do well in the investment game.  Learn how to leverage your capital and control the largest number of properties you can, with as little money as possible.  Stay on your toes and always look for ways to improve your efficiency and/or profits.  Consider using a the same realtor to represent you as the buyer, agreed upon in advance, to only work for the commission of the seller.  That way, you could get the professional help for free!  Otherwise, become really be good friends with numbers and your calculator… you’re gonna be using ‘em a lot.  Happy Investing!