About Due Diligence in Real Estate (+Free Checklist)

Investing in rental property carries a potential risk wherein you acquire the seller's existing issues along with the property. Engaging in due diligence in the realm of real estate serves as a crucial step to prevent significant financial setbacks by thoroughly understanding the income property you intend to purchase before finalizing the transaction.

The Definition of Due Diligence in Real Estate

In essence, due diligence in real estate involves thoroughly investigating and examining the physical and financial aspects of a property, as well as evaluating the surrounding area. It can be likened to "doing your homework" both before submitting an offer and after your offer is accepted.

Regardless of whether you are purchasing a single-family home or a larger multifamily property for generating income, due diligence should be approached as a comprehensive and time-intensive process.

For rental property investors, conducting due diligence plays a crucial role in confirming that the property and its expected cash flow align with what you are paying for.

How the Due Diligence Process Operates

In most residential real estate purchase contracts, the due diligence period is typically included as a standard clause or predetermined timeframe. The specific duration can vary depending on the state, with some allowing 10 days, while others allow 15 days or more. The commencement of the due diligence period can be triggered either upon the execution of the real estate contract between the buyer and seller or when the escrow is initiated.

It's worth noting that the buyer and seller have the option to negotiate and mutually agree upon a different due diligence period than the one initially specified in the contract. However, agreeing to a short due diligence period when purchasing real estate may limit the time available for thorough property research. If an extension of the due diligence period is required but the seller refuses, there is a risk of forfeiting the earnest money deposit should the buyer decide not to proceed with the purchase.

It's important to remember that the physical condition of the property is just one aspect to consider when looking at a new investment property. If you’re buying or selling rental real estate you will also want to run market analysis and do proper financial due diligence to ensure the deal doesn't turn sour, either now or later. Employing a financial due diligence service at this point will help you safeguarding your investment against unforeseen financial pitfalls.

Pre-Offer Due Diligence

Before making an offer on a property, there are several aspects of due diligence that can be conducted. Gathering as much information as possible in advance allows for a well-informed offer that aligns with sound business principles. A few areas to focus include:

1. Area and Neighborhood Analysis:

   - Evaluate population and job growth in the area.

   - Assess median household income levels.

   - Determine the percentage of renter-occupied households.

   - Research vacancy rates and median rents.

   - Track property value trends.

   - Consider neighborhood and school rankings.

   - Examine the crime rate.

2. Pro Forma Financial Statement:

   - Calculate the gross rental income.

   - Account for additional income sources like application or late fees.

   - Estimate vacancy and credit loss.

   - Factor in various expenses, such as leasing and property management fees, repairs and maintenance, property taxes, and insurance.

   - Determine contributions to a capital reserve account for future significant improvements like HVAC upgrades or value-added room additions.

3. Review Financing Options:

   - Utilize the insights gained from the neighborhood analysis and pro forma statement to explore financing options.

   - Engage with lenders to secure a loan if financing the purchase.

   - Lenders specialize in risk reduction and may identify issues during the pre-offer due diligence that you may have overlooked.

   - Their input can provide alternative perspectives on how to structure the potential deal.

By conducting thorough pre-offer due diligence, you can acquire valuable information that empowers you to make an informed offer and increase the likelihood of a successful and profitable investment.

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Post-offer due diligence

Once your offer is accepted you're under a tie pressure to complete your due diligence process. As such, you need to know how to complete the process efficiently.

1. Physical inspections

• Do a general inspection of the property. This inspection should cover important structural items including the roof and foundation.
• Inspect the utilities and mechanical systems such as plumbing and HVAC and ensure they're in working order
• Condition of each room
• Outside grounds including driveway, sidewalks, and drainage
• Inspect for wood-destroying organisms such as termites, and water damage
• On properties built prior to 1978 you'll want to run a lead-based paint test
• Radon gas and defective drywall inspection (normally done in Florida for property built during the last decade)
• Flood zone verification may require additional flood insurance coverage.
• The property may necessitate additional assessments such as surveys, septic inspections, well water inspections, and Phase I environmental reports, particularly if the property is situated in close proximity to commercial or industrial zones.

2. Financial due diligence and review: 

• Profit and loss statement for the current year and the last two years
• Examine the portion of the previous owner's income tax return that discloses income and expenses reported to the IRS.
• Current rent roll
• If there's an existing tenant, assess the lease agreement to analyze its terms, expiration date, deposit amount, as well as any distinctive provisions, such as discounted rent in exchange for the tenant taking care of landscaping responsibilities. Additionally, check for clauses regarding the allowance of pets and any associated pet rent, deposits, or additional fees.
• Receivables report
• Prepare a comprehensive inventory of repairs and capital improvements, ensuring to include invoices and verifiable proof of payment.
• Collect copies of the current service contracts in place, such as those for landscaping and property management.
• Verify the status of property taxes, including any potential increases resulting from the property changing ownership. Also, confirm the payment of transfer fees and provide evidence of full compliance with sales tax obligations related to rental income.
• Conduct a thorough analysis by comparing the proforma obtained during pre-offer due diligence with the current information at hand.

3. Legal and loan issues

• Examine the covenants and restrictions of the homeowners association (HOA) to ensure that renting the property is allowed.
• Assess the financial stability of the HOA by reviewing the profit and loss statement as well as the balance sheet.
• Review public records and obtain proof of payment receipts for recent work to identify any pending litigation or unrecorded worker's liens.
• Obtain quotes for homeowners and landlord insurance.
• Review the history of title search provided by your escrow company.
• Verify the cost of the owner’s title insurance.
• Ensure the property appraisal comes in for at least the purchase price on the contract.

Seller Disclosures

Sellers are legally obligated to provide written disclosure of material facts and known defects about the property. This is typically done through a seller disclosure statement. In cases where sellers are long-distance real estate investors, they may rely on their property manager to gather and provide relevant information, as the owner might have limited knowledge about the property.

Sellers are obligated to disclose the following material facts and defects:

• Presence of noise pollution from nearby highways or other sources.
• Information regarding recent termite treatments, if applicable.
• Situations where the neighbor's fence encroaches onto the seller's backyard.
• Disclosure of any insurance claims filed on the property within recent years. Multiple claims can potentially affect the property's insurability, making it more difficult and costly to obtain insurance.

By disclosing these details, sellers ensure transparency and allow potential buyers to make informed decisions about the property. It is important for sellers to fulfill their disclosure obligations to maintain ethical and legal standards in real estate transactions.

Homebuyer Rights

As a homebuyer, you possess certain rights when it comes to discovering issues about the property during the due diligence period. You have the option to request that the seller addresses and resolves the problem, or you can choose to cancel the contract and receive a full refund of your earnest money.

Different types of issues can arise during a property transaction, and their solvability can vary:

• Certain issues can be addressed and resolved by the seller, such as fixing a roof leak or providing missing information in a tenant's file.
• However, there might be physical defects or issues that are not easily rectifiable, like a nearby vacant lot that is used for off-roading.

If the seller agrees to your requests resulting from due diligence, it is important to ensure that the purchase contract is amended to incorporate those agreements as a condition of closing escrow. Additionally, consider another inspection if necessary. It is crucial not to solely rely on the seller's word that a problem will be addressed.

By understanding your rights as a homebuyer, you can effectively navigate any issues discovered during the due diligence period and make informed decisions about proceeding with the purchase or seeking alternative options.

The Real Estate Due Diligence Checklist

Performing real estate due diligence serves the purpose of ensuring that you receive the expected value in a real estate transaction. If the findings are unsatisfactory, you have the option to renegotiate the terms and conditions of the purchase agreement or terminate the deal and receive a full refund of your earnest money.

Download the free due diligence checklist below. The list is comprehensive, however, depending on the specific property being purchased, it may not be necessary to review every item on the list (in such cases, a real estate agent or broker can provide valuable assistance).