Due diligence may be boring, but it’s absolutely critical to get it right.
Here we’ll take a deep dive into what is perhaps the least fun but most indispensable part of real estate investing: the dreaded due diligence.
What Is the Meaning of Due Diligence?
While an entire book could be written on all the ins and outs of this subject, the definition of due diligence is rather simple. It’s the “investigation or audit of a potential investment or product to confirm all facts,” according to Investopedia.
Basically, the purpose of performing due diligence in real estate is to confirm what you believed to be true about a property when you got it under contract.
While it can be arduous, following the steps outlined below will help you avoid any unwanted surprises and greatly increase your confidence in the investment. And what do new investors need more than confidence?
Checklist: The Process
Performing due diligence can be broken down into several distinct stages.
- Pre-Offer Due Diligence
- Area Analysis
- Value and Financial Estimate
- Rehab Estimate
- Post-Acceptance Due Diligence
- Physical Due Diligence
- Financial Due Diligence
- Legal Due Diligence
- Retrading (if necessary)
- Final Decision and Walking Away (if necessary)
Use this as your due diligence checklist. Make sure you never to skip a step! Note that while there are differences in how to approach houses and apartments (as well as commercial), the fundamentals are the same.
Let’s take a closer look at each part.
Pre-Offer Due Diligence
Before any analysis of value should be done, you want to make sure the area you’re looking to invest in meets your criteria. Some of the most important things to consider are:
- Crime Rate
- Median Income
- Occupancy Rates
- Population Growth
- School Rankings
People generally want to avoid high crime areas, and families are extremely particular about which school district the home is in. If you intend to invest in low-income housing, that’s one thing. (In my opinion, newbies should shy away from this sort of investment.) Regardless, you should know what you are getting into before you buy.
Fortunately, there are some very good free sources you can look to for information (in addition to just talking to people in the neighborhood). City-Data.com and CLRSearch.com are good for demographics, and GreatSchools.org can help you evaluate the school district. There are also more advanced, albeit expensive, tools available.
Value and Financial Estimate
The next step is to determine a property’s after repair value (ARV). This is best done by looking at comparable sales. I won’t go into too much detail here, but a wealth of ARV guidance is available on BiggerPockets.
You will also want to make sure the property will cash flow by creating a pro forma. This is particularly true for multifamily properties but is helpful for houses, too.
Review the actual financials of those properties (particularly the T-12 operating statement) as seller-provided pro formas (future estimate) are almost always too optimistic. The best way to create your own pro forma is to base it off the property’s actual performance.
With regard to pro formas (at least for apartments), you will have three income categories and 10 expense categories:
- Gross Rental Income
- Other Income (i.e., laundry, utility chargebacks, late fees, etc.)
- Vacancy Loss (include both vacant units and economic vacancy)
- Property Taxes
- Management Fee
- Repairs and Maintenance
- Contract Services (i.e., lawn care, snow removal, etc.)
- General Administration (i.e., phone lines, eviction processing, etc.)
- Payroll (for larger properties with on-site staff)
- Recurring Capital Improvements (i.e., roof replacement, HVAC replacement, etc.)
After subtracting the gross expenses from the gross income, you will get the net operating income. From this, you subtract any debt service you expect to have in order to come up with the anticipated cash flow.
It should also be noted that, with apartments and commercial properties, you will use the cap rate to compare to other recent sales. Why? Because it is usually too difficult to find properties that are similar enough for a direct comparison.
More on cap rates and other financial calculations can be found here: A Guide to Internal Rate of Return & Other Must-Know Financial Metrics.
Overall, your pro forma will look something like this:
But I’ve found the best way to assess rent is to look at the map feature on Craigslist or Trulia for similar properties that are for rent in the area. Calling the numbers listed on lawn signs of nearby rentals or asking neighbors what they pay can also help.
There are simply not enough hours in the day, nor days in the year, to do a thorough inspection of every property you make an offer on. That being said, throwing out blind offers is usually a big waste of the seller’s time, as well as yours.
What you want is a “down and dirty” sort of due diligence pre-offer. The question to ask is, roughly speaking, what is the general condition and an approximation of the required repairs for this property?
For this, I designed a one-page estimation sheet based on J. Scott’s The Book on Estimating Rehab Costs. Typical rehab expenses are broken into 25 categories; however, I added a 26th by splitting the foundation from the basement. Here is what my sheet looks like:
As you can see, when I initially go through a house, I make a quick estimate of all the repairs required for each major category. (For apartments, depending on the size, I will either use several sheets, or for something over four units, take broader notes about the general condition.)
Then, I add a little bit for the knickknacks, estimate the holding costs (which are often forgotten), and throw in a 20 percent contingency for unforeseen expenses. (If the electrical looks questionable or the property is older, I may throw in an additional contingency for the electric and/or sewer line.)
I should stress that this is not the only way to do this. There aren’t any real estate dictionaries that define due diligence by laying out the perfect method to go about it.
For example, J. Scott doesn’t add a broad contingency. Instead, for each line item, he rounds his “estimate up to either the next $100 or next $500 (depending on how big the expense is).”
The important part is to get the basic idea of due diligence and create a system that works for you. Then, use that system every time to the T.
Key Things to Look for When Estimating Rehab Costs
There are a lot of things to look for when doing your initial (as well as post-contract) walkthrough.
The first thing is to simply get a good feel for the property. Would you grade it as being close to rent ready or bulldozer bait? Maybe somewhere in between? You should always note a property’s general condition.
More specifically, the following items should be on your radar:
- Furnace and A/C: Are they old or rusty?
- Fuse Box: These really need to be replaced with an electric panel.
- Ungrounded Electrical Outlets: You can use a plug tester from Home Depot or Lowe’s to test for this.
- Plumbing Leaks: Run the water, check each of the faucets, and look in the basement (if accessible).
- Galvanized Plumbing: Lookout for steel pipes, which have a tendency to rust.
- Foundation Cracks: These could be signs of bad grading or roots pushing on the wall and should be epoxied and likely shored up with braces.
- Foundation Movement: Anything over four inches should probably be braced or have dead men added. Much more than that and the wall might need to be pushed back, which is very expensive. (Pro tip: If you can’t tell how much the wall has moved, go outside and run you finger along the bottom of the siding. It should go about to your knuckle. But just running it along the foundation wall should give you an idea of where and how much the wall has moved.)
- Mold: This usually occurs in the basement. Also look for the bottom half of the drywall missing (like in the second picture below). This virtually always means mold was torn out. Mold isn’t hard to remove, but the key is to find out where water is getting in so new mold doesn’t grow back. This could be easy or very difficult, depending on the house.
- Roof Leaks or Damage: It will be hard to tell if the roof leaks unless it’s raining, but you can see damage by getting on the roof. How many layers are there? More than one is a problem. Check from a side view, too. If the edges of shingles are lipping up, that means the roof’s old and on borrowed time. If you see what look like small, discolored impact craters on it and granules are missing, that’s probably hail damage.
Help With Estimating Rehab Costs
Unfortunately, learning how to estimate rehab costs isn’t an easy thing to do. And doubly unfortunate, the best way to learn is through experience.
I’ve found that comparing the costs of previous projects that were of equivalent size is the best way to get a feel for the costs of upcoming projects. This goes for individual expenses, too, like gutting a bathroom. Newbies don’t have this luxury, though.
In the meantime, one of the best alternatives to experience is to use contractor bids to get an idea of various costs. For instance, a standard toilet is around $150 and a standard medicine cabinet will cost around $100. You’ll start to learn this as you look at more and more bids.
You can ask a contractor to give a you bid up front, and many will do so. But don’t abuse this privilege—they’ll quickly stop returning your calls if they don’t get any actual work from you.
You can also ask seasoned investors to share their thoughts. (Maybe offer them a free lunch for it.) Plus, J. Scott has some good tips in his previously mentioned book. There are also websites like HomeAdvisor.com that can help—although their estimates should be taken with a grain of salt.
Post-Acceptance Due Diligence
When people think of due diligence’s meaning, this is what they really think of. Post-acceptance due diligence is when the rubber hits the (very tedious) road.
First and foremost, it’s critical to understand the timetable you’re under, which depends on what’s in the purchase and sales agreement.
Every contract is negotiable, but most residential contracts have a 30-day period to close and will allow 15 days for inspections before your earnest money “goes hard” (is no longer refundable).
With most contracts for apartments and other commercial properties, there is a 30-day inspection period and the close is in 60 days. However, it’s possible to add a clause that extends the contract an additional 30 days with another earnest money payment, just in case. I would recommend adding something like that, particularly for larger transactions.
You can always ask for extensions if something comes up during your due diligence (although you may not receive them without a clause like the one mentioned above). The critical thing is to know exactly what the contract says so you can plan your due diligence accordingly.
Physical Due Diligence
“Many sellers and even some real estate agents will tell you it’s OK to walk every second or third unit. Ignore this “advice” with extreme prejudice. If you only view every other unit, do you think the seller will show you the best or the worst units? How many hidden problems are you leaving behind closed doors, only to find out later once the property is in your name? It is critical to know the condition of each unit, even if there are 100 of them.”
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In order to do this properly, you will need to turn the utilities on if they are currently off. This is not always possible (say, if the copper was stolen out of the basement). In those cases, make sure to add an extra contingency in your rehab budget to protect yourself from unknowns.
When going through a house, I use the following sheet to put together a detailed scope of work that includes every line item I believe will need to be done. The document is six pages in its entirety, but here’s the gist:
I then transcribe these items and budget them individually using a spreadsheet program designed for project management. It ends up looking like this:
I break out the categories into four major subheadings:
- Pre-Construction Work: Work that must be done before the main work can start (i.e., removing trash or repairing electrical issues).
- Construction: Everything you plan on having done by the main contractor.
- Vendors: Anything that will be done by a vendor other than the main contractor (i.e., painting, flooring, plumbing, etc.).
- Punchout: Last items to be done to button up the property (i.e., install appliances, put up blinds, install outlet covers, etc.).
I recommend taking pictures of each issue. The project management software I use (called Smartsheet) even allows you to attach the photos to that item’s cell within the spreadsheet.
This way, I don’t have to be there when each contractor goes through to create a bid. I can show them photos of the issue instead. Here’s an example of a picture I attached to a line item called “Replace supply vent – white.”
Once you have a detailed scope of the work that’s needed, it’s a good time to re-assess your rehab estimate.
Budgeting for each line item provides a much fuller picture of the costs. Then, you can compare the new budget to the previous “quick and dirty” estimate to double-check whether it was right. And with the property under contract and a line-item scope, you can ask a contractor to get a full bid for you to verify your estimate.
I must once again emphasize that there is no perfect way to do this. For example, if the contractor will do all the work, you won’t need a vendor list.
But the method I’ve described fits within a general outline of an effective system. Amend it to fit your own needs and follow it dutifully.
Now, returning to the walkthrough, you should also evaluate anything you questioned during your original pre-offer walkthrough and make sure it is up to snuff. This likely requires paying for professional inspections (discussed below).
Finally, evaluate the tenants, if there are any.
If you encounter a lot of meeth (what I call meth teeth), that’s something to be concerned about. If the house or several units of a property have been treated horribly by the tenant, you can surmise the quality of that tenant quite easily. For apartments, I also recommend driving by at night to see if it looks safe and tranquil or more akin to a war zone.
Here’s a “tenant watching” example of proper due diligence that comes to mind.
Once, a friend of mine was walking a fourplex just before the close. He got into a conversation with a neighbor about the property, and it turned out she had a lot to complain about! Most notable amongst her complaints was that she’d gathered many of the tenants were drug dealers and prostitutes.
Needless to say, my friend walked away from that deal.
The key takeaway? Yes, talking to tenants and neighbors is a good idea.
The seller will usually not want you to mention you are buying the property, but you can ask broad questions like, “How do you like it here?” Or say, “Have you had any maintenance problems?”
Financial Due Diligence
Just as important as the physical due diligence is the financial due diligence. This is especially true of apartments and commercial properties, but it is also something you should look for with occupied houses.
Sometimes, a seller won’t provide some or all of the financials on a property until after it’s under contract.
The seller is all but begging for you to re-trade in these cases (discussed below), but you should absolutely demand the financials once the property is under contract. When you receive them, go through them with a fine-tooth comb.
The key documents you will want are:
- T-12 Operating Statement: Minimally for the past 12 months—particularly for apartments—but preferably for the last three years.
- Current Rent Roll
- Aged Receivables Report: A list of who’s behind on their rent and by how much.
- List of Recent Capital Improvements
There are two major things to watch out for when reviewing financials, specifically with larger properties:
- Bad Debts
- Misallocated Capital Expenses
If a property uses accrual accounting, then it is deemed that all the rents are received until the bad debts (rent not collected) are charged off. Make sure that all the debts have been charged off when reviewing financials and you aren’t looking at phantom income.
The bigger problem I’ve found, however, is misallocated capital expenses. Many owners will put operating expenses (i.e., maintenance, turnovers, etc.) under capital expenses so they don’t show up on the operating statement. This makes the property’s performance look a lot better than it actually is.
For this reason, I plead with new investors to consider recurring capital expenses (usually called “replacement reserves” by banks) as a line item on their pro formas. Yes, you only need to replace the roof once every 30 years or so, but you should understand such costs are an ongoing part of owning the property.
Make sure to demand a list of all the owner’s capital improvements in the last year (or, even better, the last three years) and their costs. Unless they were genuinely upgrading the property (i.e., installed central air when it previously had window units) or were rehabbing an underperforming property, these expenses should be considered recurring capital expenses and included as part of the profit and loss statement.
Many a time I have had to reconstruct a seller’s operating statement from the various pieces they’ve provided (which are often poorly kept in the first place). It’s no fun, but it is essential!
When performing due diligence, you’ll also want to get a copy of each lease that’s currently in place. Make sure to demand this immediately upon getting the property under contract—sellers notoriously drag their feet.
You’ll want to carefully look at the following:
- Rent: Make sure it’s the same amount listed on the rent roll.
- Type: Month-to-month or a year-long lease? When does that lease end?
- Deposit: Again, make sure it’s the same as what the rent roll says.
- Utilities: Who is responsible for paying what?
- Pets: Do tenants have them? Is there pet rent?
- Late Fee: When is it applied, and how much?
- Special or Odd Arrangement: Do any tenants get a discount for doing maintenance or something similar?
If you’re under contract on a commercial property (office, retail, or industrial), you should also get an estoppel certificate. An estoppel certificate goes to the tenants of the building and asks them to confirm the rent, deposit, and other terms of the lease.
With commercial properties, you usually only have a couple of big tenants who often have long leases, so it’s very important to know exactly what the terms of the agreement are.
One final note is that, oftentimes—particularly with houses—there won’t be much (if any) financial due diligence to do. If it’s a vacant, bank-owned house for example, there won’t be any documentation to review. In those cases, just double-check your area, rent, and ARV analysis, and move on.
Legal Due Diligence
Let’s start by discussing homeowner associations (HOAs). Many houses and all condos have HOAs, and you will want to review their bylaws to make sure they’re in accord with your plans.
In the case of condos, you will also want to make sure the HOA has sufficient money in reserve for capital improvements. If they don’t, the association can impose a special assessment and charge owners a portion of the cost to cover repairs.
Key things to look for in the HOA bylaws include verifying that the HOA fee is what the seller says; checking that there aren’t restrictions on pets or other such things; and, most importantly, ensuring that you are actually allowed to rent out the property.
I once bought a condo in an HOA that didn’t allow renters. I had requested the bylaws but never received them and foolishly forgot to follow up. We had to flip that one and made a “healthy” profit of $1,700. (HOA fees can eat up profits like you wouldn’t believe.)
Another consideration: is the property odd in some way? For example, is it a house that was converted into a duplex?
If the property is odd, you will want to verify that it is legally permitted. Ask if conversions were done legally. If not, it may be “grandfathered in” and considered “legal nonconforming.”
This classification shouldn’t necessarily be a deal breaker, but it can come with added restrictions and/or decrease resale value. Laws vary by region.
In Independence, Mo., for example, any legal non-conforming unit can continue to be rented unless it sits vacant for six months, at which point it can no longer be rented.
If you intend to add more units or convert the property (say, from residential to commercial), check to make sure the property is zoned correctly or whether it can likely be rezoned. This may require a trip to the zoning department.
In addition, verify property taxes with the county. Usually you can do this on the county’s website.
Finally, it is critical to always close with a lawyer or title company. They will run a title report to make sure you are getting a clear title—not picking up some random mortgage or mechanic’s lien from way back when.
If a lien is overlooked, title insurance will pick up the tab so you don’t have to. Again, there is no gray area here. ALWAYS close with an attorney or title company, no matter what.
If you’re just starting out, in my opinion, always get a property inspection. Even seasoned investors would be wise to get them.
Property inspections can be a bore to read, but go through each point anyway. An inspection will look something like this:
Some issues, like the above, are rather small. Others, like the one below, definitely need to be addressed.
You shouldn’t rely entirely on an inspector either. As mentioned earlier, thoroughly walk through the property yourself, as well. But inspectors can certainly catch things you missed and will generally know a lot more about building and safety requirements than you.
Furthermore, inspections can be used to verify your rehab expectations, realize you need to look deeper into something, or be used for retrading. Many buyers demand a seller fix all or some of the problems an inspection brings to light before they are willing to close.
Additional inspections you may want to consider, depending on the property, include:
- Lead, Asbestos and Radon Inspections: Lead inspections are only necessary if the property was built prior to 1978.
- Termite Inspection: Particularly if you see signs of termite damage, like damaged joists or mud tunnels.
- Roof Inspection: If the roof is older, appears damaged, or you aren’t sure about it.
- Phase One: Environmental survey required for apartments and commercial properties.
- ALTA Survey: Usually for larger properties with unclear easements, boundaries, etc.
Unsure of something? Ask a specialist. For example, you could ask an HVAC technician to look at the furnace in a property if you’re unsure of its condition.
Lastly, get the sewer line scoped on any property over 30 years old. Replacing a sewer line can be an expensive proposition (usually over $4,000), so you want to find out whether the line has collapsed or is ridden with roots.
You should be able to get a plumber to scope it for around $200. Make sure to view it with them. Some will try to convince you to replace a line just because there are a few roots in it. However, these lines can be snaked out.
Either way, you want to know what you’re dealing with ahead of time. You’re not going to win the adoration of any tenants if they have raw sewage back up into their home.
When Is Re-trading Necessary?
There are two major reasons for due diligence. The first is to make sure the property is what you thought it was. The second is to give you the chance to renegotiate if it’s not.
With due diligence, real estate is not only safer but also more profitable.
For larger deals, I like to list my assumptions up front. Examples of assumptions might be that approximately 90% of tenants are paying, the HVAC is in pretty good working order, the roof needs to be replaced, and so on.
By documenting this, if assumptions are proven inaccurate when performing due diligence, they can be referenced when asking for a price reduction.
But even without such a list, you can always ask for a price reduction or amend other terms if you find something amiss. Remember, everything is negotiable.
Aside from a price discount, problems discovered during due diligence might be resolved by asking for certain issues to be fixed, asking for financing, asking to extend the closing or inspection period, or some other way.
That being said, you shouldn’t plan on retrading from the get-go or retrade over something trivial. If you do, you’ll quickly get a reputation and sellers will be less likely to want to do business with you.
Final Decision and When to Walk Away
When all the hay is in the barn (as my old football coach would say), I like to play devil’s advocate. I do this right before the inspection period expires, and I only do it for larger acquisitions. But I’d recommend that newbies definitely consider it—even for a house!
The problem we’re often fighting is our own confirmation bias. The tendency is to want to be consistent or to simply be right. If you have thought the deal makes sense from the beginning, you may ignore contrary evidence to maintain your initial belief.
To fight this tendency, I make the best case I can to not go through with the deal. Remember, the person who usually wins a negotiation is the one who’s willing to walk away.
Always be willing to walk away, and never become emotionally attached to a property. At the end of the day, it’s just an investment. No one becomes emotionally attached to their GE stock. (I hope.)
And despite being under contract, until the ink is dry on the settlement statement and the deal is funded, you’re still in negotiations.
Summary of the Process
Some parts of real estate investing are a lot of fun. Some aren’t.
Due diligence requires time, effort, and attention to detail—but it’s absolutely worth it. Not only will it save you from costly mistakes, but it will also provide you with opportunities to get even better deals.
Furthermore, many new investors struggle with confidence and are scared to death going into their first deal. Knowing how to perform thorough due diligence can alleviate much of that fear.
Nothing is entirely certain in real estate investing (or life!), but due diligence can provide a much higher level of assurance.
Do you have anything to add about due diligence? Or would you like copies of any of the documents I’ve referenced?
I’d be happy to share! Comment below.