Due diligence is the investigation and evaluation of a property from a number of different angles and ways to evaluate the numbers behind a property, and is extremely important when you’re thinking of purchasing an investment property.
The due diligence process starts when you first lay eyes on the potential income property and ends when you either decide against the transaction or sign the contract. You want to make sure that the seller from whom you’re buying is trustworthy and hasn’t left you a rental property that could be deficient in any way.
Another reason you want to do this is that some owners may live out of town and will not have thorough knowledge of the investment property they want to sell. If they slack off with this kind of important information, then how can you honestly make a sound and confident decision, and more to the point, earn money?
To put it into perspective, pretend you’ve decided to attend a university without ever visiting beforehand or deciding what your major and pursuant career will be before starting school. In both scenarios, you’re blindly entering a contract without knowing the risks involved or the future that could unfold or how things change.
This is an important step, so let’s get on with what you need to do. Let’s say you’re purchasing an apartment complex. Once you receive the rent roll from the seller, you’ll need to analyze the market rent rates for surrounding properties. Then, you’ll need to bring in your team [see Putting a Group Together] and actually walk through each rental unit, including closets, porches, and crawlspaces. It’s also a good idea to get the lease agreements from the owner as well, so you can see the contracts and the length of each tenant’s lease.
While conducting your walkthroughs and evaluations, some of the issues you need to address are:
- Take a look at the profiles of your tenants. Have they been paying on time? Are they tenants that should not have been allowed to move in? Are they too much of a risk? If so, then this significantly decreases the value of the property.
- Service agreements are also important. Is the property locked in to a specific landscaping company or cable company that your tenants are not satisfied with? Does the property have a security gate that repeatedly malfunctions and breaks down?
- Is the property individually metered? You don’t want to pay each tenant’s expenses, unless of course, they signed an all-utility-paid lease with the owner.
- Water and sewage costs on average over the year
- Is there enough parking space for the property? Is there a one or two car garage? If you're in a bigger city, most likely you'll need good parking near the property. If you're in a smaller town, outside the city, then you'll need a two car garage. Weather is also a factor, you can't leave a car out on the street in a city where it's very cold and snowy in the winter months.
- Laundry – Are these services provided, and if so, what is the condition of the facilities?
- Type of tenants – Do they have a history of paying on time?
- Criminal background checks
- Property Management Company - Check them like your tenant if you are keeping them when you buy the building
- History of building with the city – Have there been any violations, past and present?
- Price for each unit - Are some units worth more than others? For example, do some have a view or amenities that warrant a higher rate?
- Lease agreements - Verify length, rate, and stipulations
- Service contracts - Cable, landscaping, carpet cleaning, maid service, etc.
After you’ve conducted a thorough evaluation of the investment property and its tenants, and find that it requires new carpeting, a paint job, or other related renovations, then you have to factor those expenses into your price and use them as a point in your negotiations. But maybe you own a painting company, or know a friend who does, and can offer these services to the seller to reduce overall costs for everyone—a tradeoff, where everyone benefits. Look for ways that your knowledge or skills can save you money.
Deals are Discovered in Doing Due Diligence
While conducting your evaluation, you might find that a number of units (or the entire property itself) have rents below market rate. If so, you've just discovered a golden goose, which means that future earnings are built right into the property. But this potential hinges on a few factors that will determine how much you can earn: sustained population growth, property cache, employment, condition of the building, socioeconomic status of the tenants and surrounding neighborhood, and several more dynamics, all of which can be found here: The Real Estate Cycle.
The more information you have, the better. This enables you to figure out how you can increase your cash flow with the property, perhaps by reducing expenses or creating more value. For example, maybe the units don’t have enough washers and dryers, and tenants are forced to go to a laundry mat. Or, you could offer more parking space or storage units on the premises. Be creative and be kind. Pretend as if you were a tenant and then consider what you would want in order to make your residence more attractive and comfortable.
REMINDER: The more data you have about the building, condo, apartment complex, single family home, the in general area, and the plans for the neighborhood/city, the more creative you can get in your offer. Plus, your mind will automatically work to find ways to increase revenue, as a force of habit.