We are frequently called upon by clients to assist them with reviewing their real estate purchase transactions to ensure that their interests are adequately protected.
While every real estate purchase transaction is different, there are due diligence items that are common to most real estate purchases which we believe are important for investors to review in order to, as best as possible, identify the investment risks arising from the transaction.
Of course, there is never a guarantee that any particular investment in real estate will be profitable, but having a checklist of due diligence items will help you identify potential issues as early on as possible before it becomes “your” problem. Common due diligence items may include:
- Title Investigation – A current Preliminary Title Report (“Prelim”) should be obtained and reviewed as soon as you express interest in a property since the Prelim will show the liens, encumbrances, or claims that exist on the public record against the property. Getting a prelim early on in the process can help the investor make an initial determinations whether there are issues that will require further investigation (e.g. tax or judgment liens, mortgages, easements, etc.), or instead, whether there are clouds on title that are so insurmountable that there would be no point in wasting additional time or money on the property. Keep in mind that in most cases, a Prelim is only an opinion, not a guarantee of the condition of title, and we have seen instances where Prelims even from reputable title companies turned out to be inaccurate. However, as the name suggests, a Prelim merely provides initial information about the property and is a tool for determining what additional investigation or action may be needed.
- Inspections and Contingencies – We all know we should be doing inspections on the property, but should we just do a physical inspection or are there areas that need to be explored? The purpose of inspections is to identify defects that affect the value of the property, and there are many potential defects that cannot be discovered by mere physical inspection alone. In most states sellers are required to provide a written statement disclosing known defects relating to the Property and many states have specific forms for this purposes. Having a disclosure form signed by the seller may be helpful down the line if a defect is discovered that the seller was aware of, but failed to disclose. In addition, most buyers know that they should reserve a contingency that allows the buyer to cancel the contract if the buyer does not approve the physical inspection report. However, depending on the circumstances of the property, additional inspections and contingencies may be necessary to protect the buyer’s interests. For example, does the property have any environmental, natural, geologic hazard, pest, or man-made hazards? Are there any increased risks due to crime or other demographics? If improvements were made to the property, were they all permitted and built to code? Is a survey necessary to address questions regarding the property boundaries or whether certain features on the property is your responsibility or the neighbors? Are there zoning or other restrictions on your intended use of the property (for example, local restrictions on short term rentals?). If the seller is an entity or a trust, have you confirmed that the seller you are dealing with is in good legal standing and has the actual authority to effectuate the sale? Has the seller ever been, or currently in litigation? These types of issues go far beyond the customary physical inspection, and the type and extent of investigation in any particular case will depend on the unique circumstances of the property. Having a comprehensive checklist of due diligence items that you can selectively apply to each deal depending on the peculiarities of that particular deal can go a long way in mitigating investment risk.
- Property Value – Everyone wants a property that will appreciate and so performing due diligence on the value of the property by evaluating comps or obtaining appraisals is a MUST in virtually every transaction. Most investors in real estate will have a financial calculator or some form of matrix or method of analyzing the property’s return on investment. For example, if the property is being acquired as a rental, appropriate due diligence may be needed on the fair rental value, vacancy rates, rental demand, economic conditions, demographics, and the strength of the rental market in that area? If the property is currently used as a rental, you may need to obtain rent rolls, financial statements, or tenant estoppel certificates? There are many resources available that can provide much of this information and don’t just take the seller at his/her word that the property is a good value, but verify.
- Solid contracts – Of course no discussion of protecting your interests in a transaction would be complete without emphasizing the importance of having detailed written contracts. If a dispute ever arises during or even after the transaction, in most cases the focus will be on what terms and conditions were agreed upon in the contract. While a detailed discussion of contracts is beyond the scope of this article, the contract should be detailed enough to address foreseeable issues that could arise during the transaction, and the expectations of the parties in the event the “what ifs” of the particular transaction occur.
One of the many virtues of investing in real estate, as compared to other asset classes, is that there is a lot of very specific due diligence and information that you can obtain to mitigate the risks for any particular real estate investment.
Of course there is always the possibility of a deal that go bad even after doing all appropriate due diligence, but getting into the habit of executing a designated due diligence plan will go a long ways in identifying those issues that could cause the deal to go bad before it ever becomes part of your investment portfolio.