As with most businesses, starting your real estate investment empire begins with developing a strategy and researching those investments that most closely align. While you might end up finding the deal first and basing your strategy around that transaction’s success (for instance, purchasing buy-and-hold rental properties in high rental demand markets that can be bought for the price of a car), in the best-case scenario, you’ll want to outline your strategy first, and then select properties based on that strategy (with refinements along the way, of course).
The research that you conduct, both on the strategy and property ends, is known as due diligence. Due diligence is the process of performing a systematic and detailed analysis of a given opportunity. Due diligence is particularly important when you’re buying a house for the price of a car, as the return on the investment during the early years rests entirely on your ability to renovate the house quickly and efficiently and make it move-in-ready. In addition to due diligence being an activity— that is, the process of analyzing, digging in, and discovering the pros and cons of a property— it is a period of time. The time is not absolute, it is subjective and defined by the investor and seller. For instance, the investor and seller may determine that the seller can take up to two weeks to complete a property inspection and submit a firm offer. That two-week period is called the due diligence period. During this time, the investor will also request all disclosures on the property. If the investor finds any issues with the house, either because it turned up in the property inspection or it was revealed in the disclosures, the investor can back out of the deal and be refunded their earnest money, with no further obligation.
THE PROCESS OF DUE DILIGENCE
Due diligence is beneficial for you as the buyer in minimizing the role of emotion in your decisions and reducing decisions down to numbers and facts. But should you find yourself as the seller, for instance, of a property that you are flipping, you will want to undertake these same steps in determining a sales price?
The due diligence checklist comprises the following components:
- Evaluate the neighborhood
- Assess the physical condition of the property
- Estimate the renovation costs
- Determine your potential returns on the investment
- Review the contract
The Neighborhood
Location, location, location is the guiding star for real estate agents, as they know the true value of a home lies in its neighborhood. All things being equal, real estate agents will tell you that you’ll get more bang for your buck buying the worst house on the best block than you will buying the best house on the worst block. This holds true with real estate investments as well, though with a bit more gray. In the case of a buy and hold, value accrues both from the appreciation of the property, usually realized over the long-term, and the rent from the property, realized as soon as the home is renovated and occupied. While there will be some indications of whether a neighborhood’s fortunes are on the way up (check the minutes of Planning Board meetings and the master plan for your city or town of interest), the steady-eddy indicators will be crime rates, school performance and employment opportunities.
The Physical Condition of the Property
Conducting due diligence on the physical condition of the property is best-accomplished through a property inspection. The purpose of a property inspection is to highlight the good, the bad and the ugly of a house. The Smart Cousin Definitive Checklist on Property Inspection offers a checklist of items specific to real estate investment properties. Key areas to evaluate include:
- House infrastructure: the foundation, roof and basement
- Major systems: HVAC, plumbing, well, septic and electrical system
- Exterior areas: drainage system, driveway, and sidewalk.
Renovation Expenses
One of the largest maintenance expenses that should be considered when evaluating a property investment is the cost of materials. Materials include everything from lumber and drywall to paint and flooring.
Another significant expense is the cost of labor. This can include both skilled and unskilled labor, such as electricians, plumbers, carpenters, and painters. Depending on the work that the electrician, plumber and/or HVAC technician will have to do, permits will need to be pulled, so factor permit costs into your renovation estimate as well.
The Financials
Once you have your arms around whether the location of the property can attract buyers (for the buy and flip crowd) or renters (buy and hold investors), and can be renovated quickly (aim for no more than two months) and cost-effectively, next it’s time to get out your calculator to begin determining what your return is on the property. Your return means how much money you earn on your investment.
Returns are usually framed as percentages. Thus, if you purchased an investment property and collect $10,000 a year in rental income, then your return is $10,000 / $100,000, or 10%. The saying, ‘it’s not what you earn, but what you keep’, holds doubly so when considering your return on real estate investments. So when calculating your return, base it on your net rental income, meaning the rental income that’s left over after financing expenses, property taxes, property insurance, property management expenses and property maintenance expenses are backed out. While there are additional expenses that your accountant or tax preparer will take into consideration (for instance, amortization and depreciation), the above expenses capture those items that stand between what you start with and what you finish with each month.
LEGAL DOCUMENTS
If you hire an attorney to draft or review documents related to the purchase or sale of an investment property, you may well feel that you don’t need to read these documents as this is what you pay your lawyer for. Nothing could be further from the truth. Yes, your lawyer is paid to make sure that the agreement is legally enforceable and won’t be thrown out in court if it ever comes to it, but your lawyer is not paid to ensure that your business interests are properly laid out in the agreement. A good lawyer will do so, but you can’t depend on this. Moreover, it is in your interest to read these documents so that you may use your hired expert— your attorney— to answer any questions you have about what it says.
Documents that your attorney will review include:
- The rules and fees of the Homeowner Association (HOA)
- Any pending litigations on the property
- Title search issues
- Any issues laid out as a condition to sale.
- Seller disclosures
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