Due diligence plays a crucial role in real estate investing. Whether you're evaluating a real estate investment trust (REIT) to purchase, a crowdfunding opportunity to back, or preparing to purchase your own investment property, having a real estate due diligence checklist can be an invaluable tool to help you understand the opportunity fully.
While the variants of due diligence can change from a commercial real estate transaction to a residential real estate transaction, generally speaking there are certain due diligence requirements that should be completed on any transaction before buying. This due diligence checklist can help guide you through the process of analyzing an investment property and identifying any major issues or risks that may be involved.
What is due diligence?
Due diligence is a form of research focused on discovering or uncovering any issues that may affect the viability of the investment. In real estate, this could include things such as a title encumbrance, environmental concern, zoning issue, structural problem, or other defects.
While many issues uncovered during real estate due diligence can be rectified, it is still a critical period that allows the prospective buyer to identify these issues by utilizing certain inspections, title searches, or title reports, among other research, and determine if and how they decide to move forward with the transaction.
Is real estate due diligence necessary?
Some investors choose to waive certain types of due diligence, especially experienced investors who may have the knowledge and confidence to conduct certain inspections on their own. But generally speaking, due diligence should never be skipped and in many transactions, will be required by a lender if financing is being obtained for the purchase.
Most general real estate contracts outline a specified period of time for due diligence. In residential real estate, that period is 14 days or more if needed. In commercial real estate, that period can be 20 to 30 days or more, depending on the size or type of commercial property.
Your due diligence checklist
Unlike a real estate closing checklist, which walks you through the closing process, or a real estate evaluation checklist, which helps you evaluate the potential return of the property or its likely costs and values, this real estate due diligence checklist is focused on the research that must be done after a purchase contract has been executed and a security deposit has been placed with a title company or escrow account.
If you need financing for the property, it's a good idea to have an established relationship with a lender to help walk you through the due diligence process according to their requirements. It's fairly common for a lender to require you to use approved partners for things like inspections, especially with commercial property, and may have additional due diligence requirements for the real property or for you as the borrower, depending on the loan program.
Most times, the lender needs to be the one to initiate the request for the report, inspection, or other due diligence method for it to qualify for underwriting.
Here are the steps to follow.
1. Confirm balance sheet, including all income and expenses
If the property is being acquired for cash flow as a rental property, it's imperative you confirm the property's income and expenses. This can include:
- Getting an estoppel certificate to receive copies of tenant leases. Check for:
- Lease rate
- Security deposit amount
- Lease expiration
- Late fee policies and pet fees or any other additional fees.
- Review bank statements, tax returns, profit and loss statements, and balance sheets from the property owner for at least the past year; however, two to three years is ideal.
- Confirm expenses paid, including utilities, property taxes, insurance, and other service contracts, such as property management, lawn care, or more.
- Request a detailed list of capital improvements on the property, including the company that completed the repairs or improvements, cost, and year completed.
It's a good idea to go to the tax collector's website and determine the estimated real estate tax bill based on the contract price. While not always the case, most annual property tax bills will increase after closing and affect your return on investment (ROI) as the buyer.
If the property is vacant or underperforming, you will need to determine the market rents with data to support the potential rental income based on the property's location, amenities, and condition. If the property will be improved in order to achieve these numbers, you should have a detailed outline of construction costs with quotes to back it.
2. Complete property inspections
If you're buying a residential rental property, the property inspection will be done as a home inspection by a certified home inspector. If you're buying commercial property, you can choose to have the property inspected through a building inspection, but the lender will also require an environmental inspection commonly referred to as a Phase I environmental site assessment. If the property is on septic, you will likely need to conduct a separate septic inspection to determine the condition of the tank and expected time span remaining before it needs to be pumped or replaced.
3. Have the title company request a title search
A title search is required by a lender in order to obtain title insurance but is one part of the due diligence process that should never be skipped. Title searches help uncover any defects that could impact the property, including liens, encumbrances, easements, zoning issues, and ownership defects that could delay or altogether prohibit the transfer of title and allow the possibility to obtain title insurance.
4. Request a survey
A property survey isn't required by all lenders, especially for residential real estate, but it could be and generally is a good idea to have done if a survey hasn't been conducted recently. Always ask the seller for a copy of their most recent survey, and prepare for the lender to order one if buying land or a commercial property.
5. Confirm property value
Most lenders will require a home appraisal to be completed, no matter the type of real property, and the appraisal will be requested by the lender directly. If you plan to use alternative financing or are buying the investment in cash, an appraisal is not required but can be very helpful in confirming the property's value at the time of purchase.
6. Request insurance
Before closing, you will need to have coordinated an insurance policy, which could provide coverage for things like property damage, fire, environmental hazards, or flood. Depending on the property type, you may need to get special policies designed for landlords or flood insurance if the property is located in a flood zone. Shopping around for quotes before closing ensures you get the best price for your coverage.
The Millionacres bottom line
As long as the due diligence is completed in the allotted time period as outlined in the contract, the prospective buyer has the ability to walk away from the contract because of any negative findings while still having the right to a full refund of the earnest money deposit. As you can see, there is a lot that goes into real estate due diligence and ensuring any issues are uncovered before closing. While due diligence costs money upfront, if done properly, it can save thousands of dollars down the road by revealing potential problems.