Step Four: Do your due diligence
Due diligence is making sure all your ducks are in a row so you can acquire the asset. Its like doing your homework in preparation for an exam: you want to become intimately familiar with all aspects of the property, because this is the only chance you have to back out of the purchase if you uncover anything that concerns you. Much like an exam—once you take it—the grade (read “cost”) will stick with you forever.
Here’s three aspects of doing your due diligence.
1. Verify the income.
Verify the income through Estoppel Letters (aka Estoppel Certificates) to ensure income lines up with what the seller is telling you. Expenses can be estimated fairly accurately, and income needs to be traceable down to the penny. The estoppel is a semi-formal document that asks each tenant to verify that they pay the stated amount of rent every pay period. You can snail mail them, but the odds of getting this back is next to nil. Although this can be time-consuming, I suggest you can personally go to the property to get the information you want. While you’re there, you will also want to get bank statements and copies of tax returns, if possible. When you’re doing this and you hear the word “cash”, that’s a red flag. If you hear this, you could assume the owner is probably lying to you :) You want a paper trail to verify income. Remember that if you can’t verify income, you’ll have a hard time getting loans for the acquisition, reselling it, and failing with the IRS.
2. Inspect the site.
You can really get lost in the minutia here, so let me give you a macro-level analysis of what to look for as you inspect a piece of property. You want to check the following.
- The ingress and egress of the property (how traffic moves in and out)
- Potential environmental and easement concerns
Usually, you’ll want to get a boundary and a phase 1 survey, because the lender will likely ask for it anyway. The boundary survey will help determine the ingress and egress of the property, and the phase 1 will show you what previous uses the property may have had, which may provides clues to potential contamination concerns. It will also address encroachments or anything that would affect the title to the property. (For example, you might have a well that’s owned by the neighbor, but it’s on your property.) You have to figure this out, because it can cause disruptions with the title and the transference of ownership. That’s why you want to get title insurance, as well, because lenders *always require this*.
3. Assess the surrounding area.
Look at the surrounding area to assess the sustainability of employment in the area. This is directly correlated to income predictions. If employment is strong in the area, you know that people are moving there or that they will remain there. If the rate of employment seems to be going down because people are moving elsewhere, think twice about closing on the asset. The surrounding demographics and the employment predictions are an important point of concern and of your due diligence. All this research can be used to negotiate a price change or concessions before you close on the asset.
Keep in mind the parameters and goal: due diligence is a defined period of time in which you do your homework to make sure everything lines up with your goals. Now onto financing.