What is Due Diligence in Real Estate?

What is due diligence in real estate? If you ask most new investors, they’ll have some sense of what due diligence is, but may be confused about what it really means. Is due diligence when you analyze your deal? Who should you be in contact with during due diligence? How long does a due diligence period usually last? And what happens if your deal turns out to be a dud in due diligence?

In reality, due diligence isn’t all that confusing. It’s simply the time that you, and your partners (if you have them), spend inspecting, double-checking, and re-analyzing the deal. The due diligence period is there for the protection of the investor, so you can use everything in your power to confirm that you truly are getting a great deal. But, before you start calling inspectors, make sure you follow some of these more granular steps that could save you a fortune in the future.

If you want Ashley and Tony to answer a real estate question, you can post in the Real Estate Rookie Facebook Group! Or, call us at the Rookie Request Line (1-888-5-ROOKIE).

Ashley:
This is Real Estate Rookie, episode 190. My name is Ashley Kehr, and I’m here with my co-host Tony Robinson.

Tony:
Welcome to the Real Estate Rookie podcast, where every week, twice a week, we give you the inspiration, information and amazing stories you need to hear to kickstart your real estate investing journey. My co-host, Ashley Kehr, what’s going on? What’s new in western New York these days?

Ashley:
Well, it’s per usual. My flight gets delayed and/or canceled, and so coming back from the Rookie Weekend in Denver, flight got delayed in our layover in Detroit, and I didn’t get home till about 2:00 a.m., and so, running on fumes today. The kids already missed three days of school to come to the event with me, so they had to get up at 6:30 this morning and get ready for school, and I’m sure they’ll crash tonight. But it was really nice getting to be able to have them come with me. But, yeah, we’re all pretty tired today.

Tony:
Yeah. But what’s unique about this delay, actually, is that it wasn’t weather. It wasn’t the bad weather in Michigan. It wasn’t the bad weather in New York. It was because they didn’t have a pilot.

Ashley:
Yeah.

Tony:
How do you book a whole airplane filled with people, but forget that you need a pilot?

Ashley:
Yeah. I don’t know if maybe the pilot canceled or what. I don’t even know the person that stands at the gate, the gate attendant, maybe, is called. I don’t know. But they kept making announcements updating us saying, “We’re just looking for a pilot. We’re very short staffed.” Then they were like, “We found a pilot who’s supposed to be having time off, but he is going to come, and he is about 10 minutes out.” And then he came, and everybody clapped.

Tony:
You just need to pack up and move to California with me. I never get my flights delayed. I’m never snowed in. My internet connection is pretty strong. It’s just like all signs points to Ashley coming to California.

Ashley:
Yeah. Well, we were trying to-

Tony:
And there’s dairy farms here.

Ashley:
Yeah. Well, we were talking about how many times we’ve been delayed, and Daryl was saying, my business partner, was saying how it’s always these two airports. I’m like, “Well, yeah, because there’s no other direct flights. There’s literally two or three airports you can fly direct to out of Buffalo.” So, yes, our layovers are always the same airport.

Tony:
Always here.

Ashley:
But, yeah. So, what’s new with you?

Tony:
What’s new? We’re still busy working on the resort out in Big Bear. As of right now, we’re supposed to be closing in about seven weeks.

Ashley:
Oh.

Tony:
We’re up against the gun. Things are moving fast. But fingers crossed that we kind of get everything done we need to. But I’m super, super excited for this project, and I still think there’s a lot of upside there, so me and the Alpha Geek Capital team are just hard at work trying to put that together.

Ashley:
Is your due diligence period over with?

Tony:
We have, I think, 10 days left in our due diligence. But we’ve gotten pretty much all of our inspections done. We did our phase one. We did the property inspection. We did the appraisal, termite inspection. So pretty much all the due diligence we wanted to do, we’ve we’ve pretty much completed. Luckily, no major red flags have come back yet.

Ashley:
Yeah. That’s what I wanted to kind of talk about on this Rookie Reply episode is due diligence in properties. Because you’re doing due diligence on your property in New York, too. Do you want to explain that one a little?

Tony:
Yeah. We actually pulled out of it because of our due diligence.

Ashley:
Oh, you did?

Tony:
I can share kind of what we-

Ashley:
Oh, I didn’t know that.

Tony:
Yeah.

Ashley:
Yeah.

Tony:
Yeah, we actually pulled out of it. We had a property under contract in western New York. Is that western New York or is that upstate New York, where we [inaudible 00:03:50] that property is at? What would you call that?

Ashley:
It depends where you live, because if you live in New York City, the whole state is called upstate New York. But I would say that was more central New York. Central New York is what I would say.

Tony:
Okay. All right. There you go. We had this beautiful property in central New York. It was a bed and breakfast, and it was built in 1922, so a very historic property in that town. We had it under contract. Our plan was to go in there, buy it, renovate it, turn it into an Airbnb. But, during our due diligence process, we flew out to New York, and we saw the property in person, talked to a lot of local people. We decided to pull out of it, and I’ll kind of explain why.
First was that we realized that we were already buying kind of at the max ARV, and our original goal was to purchase that property with either private money or hard money, do our renovations to kind of bring it up to 2022 standards, because it was very dated inside, and we just felt like it wouldn’t work super well as an Airbnb. Our goal was to buy it and renovate it and then refinance into some kind of long-term debt, but BRRRRs only work if you have enough spread between your purchase price and the after-repair value.
But this property was so unique, because it was a seven bedroom, eight bath property, and there just weren’t very many comps surrounding that property in that area. There were some that were kind of further away, but when we met with the realtors in person, they told us like, “Hey, honestly, where you’re at is probably the highest you’re going to be able to go.” So that was the first strike, was that we didn’t have any room to really push the ARV up.
The second thing we were saying, “Okay, even if we leave some money in the deal, it might still make sense.” But the other issue was finding good labor. Everywhere, everywhere, everywhere, right now, it’s really hard to find people to kind of take these projects on. We got a couple of recommendations. They all said, “Hey, come back to us in 12 to 24 months when all of our other projects have kind of cleared up.” And then they were saying like, “If you do find anybody that’s available right now, you should run away, because all the good contracting crews are pretty busy.”
So it was those two things, and then we found some other stuff in the inspection report. We tried to negotiate with the seller, and she wasn’t willing to negotiate. So there was just kind of all these things that got stacked on top of each other that we were kind of finding out during that due diligence process that made us realize that, “Okay, we like this area. We definitely want to move into that area with the property, but that specific house, we think it makes sense to pass on.”

Ashley:
Are you going to do any kind of direct mail or anything in that area to look for it, or just look at stuff that’s listed on the market, on MLS?

Tony:
We just started a direct mail campaign for here in California, where our Joshua Tree properties are, so we’re testing out there first. I think if we can really nail it in this local market, then we’re going to start using that same process to some outside markets, as well.
I was going to say, Ryan Dossey, who’s been on the podcast, right? I think he did a couple episodes before I came on. He’s got a company called Ballpoint Marketing, and he’s not paying me to say this, but it’s really, really a great product, because most postcards you send out, they’re typed, or you can tell that it came from a computer, but Ballpoint Marketing, he’s got some kind of robot that hand writes everything, so it looks like a handwritten letter. And our response rate on the first few postcards we sent out has been much higher than what we were doing with our other direct mail, so it’s worked out well for so far.

Ashley:
That’s what I use, too, and I was just thinking we should do an episode, maybe get him on again and walk through that process again. Yeah, we did ours right before Christmas. We did it for a lake house around two lakes that we want to get a short-term rental at for a lake house, and, of course, personal use. But we did it two days before Christmas, I think, and we were getting calls the day before Christmas Eve, when it hit everybody’s mailboxes.

Tony:
Crazy, right?

Ashley:
We were overwhelmed by it. But, yeah, it worked great. We ended up, actually, right now we’re negotiating on two properties from that campaign that was back in December of just us following up. And then that same round we did a round to campgrounds in the area, too. And that one we’re negotiating on a campground right now that came from that mail campaign. So yeah, we should definitely do a Rookie Reply or a full episode on direct mail.

Tony:
Direct mail works.

Ashley:
Yeah.

Tony:
Totally.

Ashley:
But, yeah, let’s do due diligence today, because I have a property, too, that also fell out of contract because it did not pass inspections, and we got out of the contract before our due diligence period was up.

Tony:
You have to tell us about it.

Ashley:
The property for me was 700 acres, two beautiful ponds, two lodges for wedding venues, a Barton restaurant, 80 RV hookups, 18 cabins. I mean, just amazing, one-of-a-kind property.

Tony:
So it was a really small property.

Ashley:
Yeah. We ended up getting it under contract for $3 million. With that under contract, it was basically “as is”. They weren’t going to make any repairs, but we still put in a due diligence period. I had used a broker on this deal. They had brought me the deal. But I have to say that-

Tony:
Ashley, can I stop you really quick?

Ashley:
Yeah.

Tony:
Because I want to highlight something, right? When you say “as is”, let’s break down what that means for the listeners. So when you agree to “as is”, what does that mean? What are the limitations you have as the buyer?

Ashley:
Basically, if I find anything in the inspection, they’re not going to fix it. I ran into this with the campground, right now, I’m trying to negotiate. When he countered me for a higher offer, I accepted that counteroffer, but I put that I now want a longer due diligence period.
He was like, “Well, this property is ‘as is’. If an outlet’s not working, I’m not going to fix it.” Blah, blah, blah. I had to explain, “I completely understand, but I can’t go into this property blind, and then all of a sudden I get a bill for $100,000 of repairs that needed to be done. I just need to make sure that there aren’t a ton of issues that aren’t coming up.” And I said, “At the lower price, I was willing to take that risk.” Because then I had a lot more capital to play with and could add in a large capital improvement in there.
So, yeah, just remember that if someone says “as is”, that doesn’t mean you have to buy it “as is”. You can go and do your due diligence on it and see what kind of costs are going to be associated with purchasing that property.

Tony:
Honestly, even “as is”, even though they won’t repair it, you can still ask for a credit. Because, I’ve had it done both ways, right? Some people they say, “‘As is’. I’m not going to fix anything. Don’t ask me for any more money.” But I’ve had other offers where even though it’s “as is”, I’ve still been able to negotiate credits to say, “Hey, this is a much bigger expense than what we were anticipating, so we need some kind of reduction in the purchase price. I don’t need you to fix it, but I just need a little bit of break there.” I just wanted to pause on that, because I know that term gets thrown around a lot, so we could break it down for the rookies.

Ashley:
Yeah, it definitely doesn’t hurt to ask to get that negotiated, even if they are saying “as is”, I would still … maybe they’re not even aware of the issue, and if you pull out of that contract and they go to another buyer, another buyer is probably going to find the same issue, and then it’s just going to happen again. That’s great advice to definitely try and ask for them to give you a discount on the price.
Okay, so this property, some of the things that we found out first going into it, first, it was a foreclosure property and there was back taxes owed on it. The county ended up taking possession of the property first, before the bank foreclosed on it, and it went up for tax auction. So the county sold it at tax auction, and the bank was the one that ended up buying the property. Because what someone else was bidding at, it wouldn’t even cover their whole loan that was owed to them, plus the back taxes, so the bank ended up buying the property.
Now they’re selling it through a broker, and they don’t know anything about the property. There’s no financials on the property, so already stepping into this, this was a very, very blind deal to go into. There was really no guidance. We actually hired a consultant who actually helped us build the financial pitch deck and the proforma for the property based off comps in the area as to what we could do with it, because there was no really financial history. So that was kind of a big red flag for us.
So, with that, kind of ties in the financing piece. When you purchase a property and there is no financial history or background on the property, it’s going to be very hard to have a bank finance it for you. A bank is going to want to see that this property has been generating revenue. Well, this property hadn’t been generating revenue for two years. It sat vacant. So, no bank wanted to touch it. We were going to have a private money lender and then raise the rest of the capital needed.
The second issue that came up was that we could not get title insurance on the property. This was something that our attorney found out for us during the due diligence period, that because it went up for auction and there was no title insurance purchased at that point in time, there was a three-year redemption period. We ended up having to go to a title attorney, an attorney who specializes in title issues, and he was the one that kind of discovered that for us, that it wouldn’t be until three years after the auction date that you could actually get title insurance on it. That means there’s still two more years before a bank would finance the property if we wanted to go and refinance.
But also, looking at it, what investor wants to invest in a property as the private lender or as a limited partner in a syndication deal where there’s no title insurance on the property? Especially when it was a very messy of a deal where the county took it over, the bank then bought it, and the bank was in the process of foreclosing. So, those were kind of the big issues.

Tony:
Yeah. Just to break down, the risk of that property not being able to get title insurance means that, say that someone else was on title or has some kind of stake in that property, after you purchase it, they could go back and say, “Hey, I actually owned 50% of this, and I need my money, or I need ownership, or X, Y, Z.” Now it becomes a very dicey situation. But if you have title insurance and someone says, “Hey, I was actually on title,” it’ll be the title, insurance policy that would pay that person out, as opposed to you, as the new owner.

Ashley:
Yeah. Yeah. Thank you for explaining that.

Tony:
Yeah, so a lot of risk if you don’t-

Ashley:
You’re doing a way better job of breaking things down for me.

Tony:
Well, I’m just saying, it’s a lot of risk there, right, if you were to buy that and you didn’t have that in place?

Ashley:
Yeah. That was kind of like the first thing for us. The second thing came up during the due diligence period. I want to highlight first is, when you’re doing the due diligence period, make sure that you’re looking at your financing options. What will work for the property and can you get financing on them? And not even for how you’re going to acquire the deal, how you’re going to purchase it, but if you plan on refinancing down the road, make sure that you can refinance. Go and start talking to banks and say, “What will you need from me to put a mortgage on this property in two years or so?” They may say, “Two years of tax returns on the property.” That means, actually, it’ll be over two years that you could actually go and refinance by the time your tax returns are done. So, go and ask all those questions. Also, what’s the loan to value? Different things like that. Just kind of get an idea of what it would be like to finance, so you can kind of work that into your deal.
The second thing besides the financing is talking to people that issue the permits that regulate the property, especially commercial property. You want to talk to the code enforcement officer. With this property, it had its own sewer treatment facility on it, and that was regulated by the DEC, the Department of Environmental Conservation, and they’re the ones that oversaw that.
Before we even contacted the code enforcement officer, he actually called my attorney and said, “I’ve heard a rumor this was selling, and I tracked it down. If it’s okay, I would like to have the purchaser call me.” He said, “I’m just curious what you’re doing with this property.” I said, “I’m going to turn it back into a campground and operate it.” He said, “Okay, well, I need to tell you some things about it.” I think this was very nice that he took the initiative before we even reached out to him.
But he just said that 50 of the RV sites that have full water, sewer hook-up to them, and electric, were never permitted. That means for the town, the county, to come back and issue me a building permit, if something doesn’t look right, they have to dig up all that infrastructure. There’s no site plans, no engineering plans were even handed in to the town or the county to put in all of this new infrastructure for these new RV site hookups. So that right there, I’m like, at 50 RV sites that are not permitted out of 80, that would be a huge expense for us if we did have to go back and redo it if there was something wrong and it wasn’t along with code or something like that. So, that was kind of like our second flag.
When you are talking with the DEC or with a code enforcement officer or whatever permit issuing agency is, we found out that in New York State, you can actually request a foil, F-O-I-L. And what it is, is you can get all of their information, all of their records on that property. I mean, this one for this campground site was, I mean, this huge thick folder. He actually said, “Why don’t you come into my office, because that would actually be faster than me just scanning all this in and emailing it, or copying every page and mailing it to you.” So check out what kind of options you have and what kind of information you can get, too, from the government agencies that have regulated and permitted these properties.

Tony:
Yeah, Ashley, I think going into the local town hall or wherever and get information on the property is super critical. We did that for our Big Bear property. We were just up there last week, and part of our stop was going into city hall and just saying, “Hey, we’re looking at buying this property. What can you tell us about it?”
When we were in New York, same thing. We went into the town hall there and said, “Hey, we’re looking at buying this property. Tell us what we need to do, what the steps are, et cetera.”
You get to go straight to the source and understand kind of what the potential risks are, what you need to do as a new buyer to make sure that you’re operating in a legal way, et cetera, et cetera. Yeah, there’s so much value that comes from just in person, talking to people, and getting information straight from the source.

Ashley:
Yeah. I think the only other thing that I would add to that is just talking to an attorney, too, about the property, especially if it is a commercial property, and seeing, what deals have you done like this? That was when I picked my attorney for this deal was an attorney I’d used before, but before I decided I was going with him on this deal, I said, “What’s your experience with properties like these?” He was able to tell me similar deals he had done, and able to guide me and help me in the due diligence period as the things I should look for, and things he had noticed with other properties that came up that he had helped close on, too, which was very helpful. And then, just kind of like Tony said, he had contractors come out, inspectors, and I think lining those all up and really knowing what you’re getting into and putting a dollar amount to it is very important.
And check the utilities. If you have well, you have septic, is it public utilities? One property I just purchased has propane tanks. Actually, there’s two buildings on it. One building has a propane tank and the other one doesn’t. It’s all wired, all hooked up, it has all the plumbing and everything for the gas, but there’s not actually a propane tank in the ground. Which isn’t a big deal for us. That’s something we easily can take care of. But imagine if you went into there not knowing that, and you’re like, “Oh, here we go. This is almost ready. I just have to finish this little cabin off a little bit, but oh, there’s no propane. I need a propane tank.” So, checking your utilities and making sure they’re all operational, or what you have to do to fix them.

Tony:
And just asking, “Hey, is this on septic or is it on city sewer? Is it on city water, or is it on well?” My mind is still blown by the well water concept, like the property in New York. They were like, “Yeah, there’s a well under here.” I was like, “So there’s just water underground, and that’s just coming into the property?” And he was like, “Yeah.” I was like, “So is it ever going to run out?” He was like, “Probably not.” Just knowing those things, I think, are super important, as well.

Ashley:
I can’t wait for you to come visit me sometime and have your first taste of well water at my house.

Tony:
Well water. Blow my mind.

Ashley:
Okay. Well, anything else you wanted to add to that?

Tony:
I think those are all the big things, Ash. I think that’s everything. I guess the last thing is just understand that the purpose of due diligence is to uncover as much about the property as you potentially can, so that way you can make an informed decision. You’re going to have to get up in the seller’s business sometimes. Right? You might need to ask for information that they’re not super keen on sharing. But at the end of the day, you have an obligation to yourself and to your business to turn over as many stones as you possibly can. And if you need to walk away, be prepared to walk away. Because the last thing you want to do is discover something during your due diligence that is a major red flag, but you’ve become so emotionally involved in the deal that you make the bad decision of moving forward anyway. Work with your data, work with the hard facts, and not so much your emotions, and that’s how you get the most out of your due diligence.

Ashley:
Tony, that hits home to me so much. The screen saver on my phone was the view from this property. My passcode on my phone, I should probably change it now, after this episode airs, was the address, the house number to this property. And that was just, I wanted this property so bad.
But, you know what? The opportunity cost of all that time wasted, even money wasted, I still have to pay my attorney. I still have to pay for, I had a drone footage done of it. I paid the maintenance guy to come. Just a lot of time and money wasted, but it’s an opportunity cost, because, or else I could have ended up with … we had already, I think had $300,000 of cap ex that needed to go into this property, and it could have been up to half a million as we started to find out more things. So, think of that as an opportunity cost instead of money wasted, but that emotional detachment is very important on a property, too.

Tony:
Cool. Well, glad you had the courage to walk away from it, Ash. Yeah.

Ashley:
You know what? The silver lining to it is this other property, this other campground we’re going after now, honestly, seems so easy after going through the due diligence of this other property. Just taking it over. It’s already operational. So I think it was a very good just-

Tony:
A stepping stone?

Ashley:
… learning curve for us, too. Yeah. And stepping stone. It’s making us take over this other campground, hopefully, if we can get a signed contract this week, a lot easier. But, okay.
Well, thank you guys so much for joining us. We will be back on Wednesday with a guest, and if you guys are loving the show and you have taken value, please leave us a review on your favorite podcast platform, and let us know how this podcast has impacted your life. I’m Ashley, @WealthFromRentals. He’s Tony, @TonyJRobinson. We’ll see you guys next time.

 

 

2022-06-11 06:02:06

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