Pre-Purchase Due Diligence for Landlords and Tenants – Part 1
Pre-Purchase Due Diligence – Part 1
It is extremely important that adequate due diligence be performed when considering the purchase of real property. Real estate tends to be the most costly purchase that most people make in their lifetimes. Buying a “bad” property can result in serious problems and many problems can be extremely costly. Most of the issues that will be discussed in this series will apply to purchasing a property for investment or for personal use.
There are a number of important categories of concern regarding adequate due diligence. The more important ones include (1) property location, (2) legal issues, (3) physical condition, (4) design issues, (5) natural hazards, (6) environmental issues, and (7) financial issues.
Property Location
We’ve all heard many times that the most important thing governing value is “location, location, location.” We’re sure that almost everyone who would have any interest in buying real estate has a good understanding of this issue and won’t discuss it further in this first article of the series.
Legal Issues
There are a variety of potential legal issues that should be investigated. Included are zoning laws, building permits, possible code violations, and liens or other matters that might affect title. For a property currently occupied by tenants, the terms of the existing lease agreements are also of concern. Investors who are considering a property that has been extensively rehabbed or remodeled must be particularly concerned about whether all work was properly done in accordance with zoning laws and building codes and that work requiring permits was done with the proper permits. Zoning laws and building codes are of particular concern to an investor who plans to rehab or remodel a property in order to ensure that the planned work can be legally done.
A buyer should not rely upon assertions that meeting building code requirements is proof that no deficiencies exist in the property. Building code inspections and property inspections are entirely different types of inspections. Courts have routinely held that the building department inspectors are not liable for construction defects even for items that have been specifically “signed off” as passing inspection.
Physical Condition
Physical condition often includes (1) mechanical issues such as structural, electrical, plumbing, roof, and other components; (2) primarily cosmetic issues of various components such as paint and landscaping; (3) environmental issues related to the property including asbestos, carbon monoxide, groundwater/soil contamination, lead-based paint, mold, and radon; and (4) physical characteristics related to legal issues such as zoning and building codes. The physical condition of a property, from a buyer’s perspective, is determined by observation, research, and testing.
While we will provide in future parts of this series brief general discussions regarding some inspection issues concerning certain specific property components, this series is intended to provide a general overview of various issues related to the purchase of properties rather than a “how-to-do-an-inspection” course.
Seldom is there only one single inspection regarding the physical condition of a candidate property. There are usually multiple inspections, including (1) an initial drive-by and walk-around view of a candidate property; (2) a visit and walk-thru accompanied by the owner or agent; (3) whatever due diligence can be performed before writing an offer, particularly regarding those issues that most impact value; (4) formal inspections during the escrow period, usually including those by one or more professionals; and (5) a final walk-through a day or so before closing escrow.
Although floor plan, window and floor coverings, appliances, and various amenities (e.g., pool) are also important in the buying decision, the focus of physical inspections must be on the conditions of structural, mechanical, and other components of the property.
The physical condition of a candidate property is important in making a prudent buying decision. The condition of the property directly affects both its current value and its potential future value. Current value determines the cost-effectiveness of repairs and upgrades necessary to maximize both near-term and long-term future value. Accordingly, investors should always conduct careful inspections regarding the physical condition of a candidate property to the greatest degree practical and as early as possible before committing additional time and resources to pursuing a deal.
While real estate investors will often need or want to involve professionals in inspecting the physical condition of a property, it is important that investors be able to adequately perform basic inspections themselves. This is particularly true for pre-offer consideration of properties, for which it is usually not cost-effective to hire professionals because of the number of properties that must usually be considered in the process of finding a candidate property worthy of a purchase offer.
The necessity of property inspections holds true not just for older properties obviously suffering from a bad case of deferred maintenance. Even new construction must be of concern. In fact, it can actually be more important to be concerned about some issues for new construction, partly because a property that hasn’t been used hasn’t been tested.
Design Issues
Design issues such as number of levels, the floor plan itself (including number of bedrooms and baths) and whether there is a carport or a garage can significantly affect value, although buyers of a personal residence may accept certain design defects because they do not bother them enough to overcome their desire for certain features or amenities. For a rental, such items affect the rent obtainable and ease of filling vacancies. Although some design deficiencies can be corrected, most cannot. Accordingly, investors should consider the wants and needs of their likely target pool of tenants.
Natural Hazards
Natural hazards such as wildfires, soil stability, and extreme weather affect the value of the property, the availability/cost of financing the property and the availability/cost of insurance. For a property that is to be rented, natural hazards can also affect the level of rents and the vacancy factor.
Environmental Issues
Environmental issues related to the property can relate to either the location – e.g., radon, groundwater/ soil contamination – or to the structure and its components – e.g., asbestos, carbon monoxide sources, lead-based paint, mold, or, due to construction methods, susceptibility to radon.
Financial Issues
Money is a primary concern whether purchasing for a personal residence or a rental property. Whether considering the purchase price, obtaining a loan, necessary fix-up costs, potential market rents, operating expenses, or future sale price, as well as income tax benefits at end and during the period of ownership, financing is critical. Accordingly, buyers must understand and adequately utilize the various analysis procedures.
Interaction Among Categories
Items in the various categories often interact with one another. As examples, (1) natural hazards and a variety of potential environmental issues (e.g., radon and soil/groundwater contamination) are physical issues that are usually related to location; (2) legal issues of zoning, building codes, permits, and existing leases are related to physical issues because they affect the current value of the property improvements and what can and cannot be done to increase the value; and (3) the condition of the property and costs of correcting problems directly affects the financial viability of the property as an investment and to the availability and costs of a loan.
Initial Look
The first viewing is usually a drive-by for a “look-see” to evaluate the neighborhood and the candidate property. A lot of information can be gained in a short time during the first viewing of the property. First impressions do count and an investor will quickly learn to spot both favorable and unfavorable conditions.
Even though buyers don’t usually have access to the property, especially the interiors of the structures during the initial look, a visual inspection of the exterior of the structure and its grounds from outside the property line can often yield valuable information and clues as to rehab costs and maintenance expenses. Walking around the property exterior can help spot problems with the foundation, the main structure, porches and decks, roofs, detached garage or other out-buildings, drive-ways and walks, drainage, and fences or walls.
Pre-Offer Inspections
Many investors don’t think about inspections until they already have a fully executed contract. Unfortunately, this can result in a lot of wasted time for all parties concerned when it becomes obvious that there are problems with the property that are not obvious without significant investigation and cannot be resolved. Those problems may have been obvious if more effort had been put into evaluating the property prior to writing the offer. In such a case, a lot of time would have been wasted in analysis that was based on incomplete or erroneous information.
It is important to obtain as much information as possible about the physical condition before submitting a purchase offer because the value of any property is dependent the various issues previously listed. This means that you should go beyond the “initial look” inspection to the greatest degree possible.
Buyers should push as hard as is reasonable to obtain access prior to writing the offer. Even a short inspection of interiors can be valuable in deciding whether to make an offer and, if so, how much to offer and what contingencies are important. Access is often not easily available for tenant occupied properties, but even compromising by accessing only a few or just one unit of a multi-unit property is worth insisting on.