What Is Due Diligence in Real Estate? (Best Practices, Tips)
Nearly every article on real estate cautions investors to do their due diligence. But what does that mean exactly?
In the broad sense, due diligence is the process of collecting and analyzing data on all factors that affect ROI. The due diligence process is necessary to ensure that the initial and subsequent investments into the opportunity make sense.
You’ve probably heard the adage “measure twice and cut once.” This is especially true when it comes to real estate: you should thoroughly evaluate any opportunity before investing.
Due diligence is necessary to prevent costly mistakes such as:
1) investing in a project that won’t meet strategic goals, and
2) failing to mitigate and manage anticipated risks for a better and more predictable outcome when you invest.
The depth and breadth of the due diligence you perform will vary by the asset class of the real estate: It will be different for commercial properties, rental property REITs, and real estate crowdfunding opportunities. The kind of due diligence will also depend on the specific investment itself (location, financials, property condition, etc.).
For example, you use different financial metrics to evaluate commercial and residential rental properties. And some real estate crowdfunding opportunities have specific differences that call for in-depth analysis that won’t apply to other crowdfunding options. When you invest in rental properties, due diligence is essential before and during the purchase process.
The Short Version
- For any real estate investment, you must do thorough due diligence to ensure that you'll get a high enough return to make your investment worthwhile.
- The due diligence process differs for rental homes vs. REITs and real estate crowdfunding sites.
- Any real estate investment carries risk, but you can minimize that risk by carefully investigating all investment opportunities, even pre-vetted ones.
Due Diligence for Rental Homes
Rental property real estate investors typically look for three things:
- Short-term cash flow
- Long-term property appreciation
- Ongoing tax benefits.
Your pre-purchase due diligence will focus on the two most important factors: cash flow and appreciation. This includes extensive research in several key areas:
- Property condition
- Property Location/Market
- Financial Analysis and projections
Here are some of the significant issues to check out – keep in mind that every property and opportunity is unique, and your due diligence may lead you to dig deeper into specific areas. Let's get into each of these three areas in more detail below.
Evaluate the Property Condition
It's important to spend a lot of time and effort evaluating the property’s current condition and determining what you need to do to improve the home before you buy it. Generally, it would help if you looked at these things:
- Structural integrity (interior and exterior) – Are there foundation cracks, signs of termite damage, issues with water not draining away from the house, an aging roof, blown-off siding, tree roots growing into the sewer line connecting to the house, sloping floors, an inadequately sized electrical panel for the size of the home, inadequately sized HVAC, or improperly installed ductwork?
- Mechanical systems – You’ll want to look at the current condition and remaining life of major systems, including the HVAC, water heater, major appliances, electrical and plumbing.
- Safety – You'll need to fix any hazards. Do you need to take care of any mold? Do the steps need a railing? What do you need to do to get an approved inspection required for a rental license? You can likely download a copy of the rental inspection form online. It is crucial to understand which improvements must be made (and how much it will cost to make them) to get a rental license.
- Initial maintenance needed – Is there deferred maintenance, and what’s the cost to get the property “rent-ready,” meaning it is clean, safe and attractive?
Pick the Right Location & Market
The one thing you cannot change is a property’s location. You need to understand and analyze both the broad area (city/town) and street level (neighborhood/street) location of your rental property.
- Job market for potential renters — tenants need to have a job to pay rent. Are there ample employment opportunities within commuting distance of your rental? Is a large-scale employer moving into the area?
- Rental pool demographics – Talking broadly here, you want to know that pool of potential renters will likely pay rent in full and on-time.
- Analysis of comps – You never want to overpay for a rental property; to avoid that, you need to gather information on and study the comps in the area.
- Analysis of rental market – Is there a demand for affordable housing in your rental area? If there’s no shortage of rental properties, you’ll need to entice tenants and likely charge less than the market rate to get the best tenants.
- Neighborhood – Do current neighborhood residents care for their properties? Is there trash lying around? Are homes in need of maintenance? Just like you, your tenants want to live in a clean, safe environment – it will be challenging to attract good tenants to a neighborhood in obvious decline.
Research rental markets >>> 7 Best Places to Invest in Real Estate in 2022
Crunch the Numbers
Here’s where the rubber meets the road. The numbers have to work!
- Property acquisition cost (purchase price plus closing costs) — You’ll need to find comps (recently sold similar properties nearby the property you’re considering). Look at the comps compared to the property you’re considering and adjust your offer price based on the features and condition. A lot goes into this process as no property two properties are identical, so it's not an apples-to-apples comparison. Closing costs are based on the home’s price and other factors – a lender can help you estimate those.
- Mortgage, insurance and taxes – The most significant cost of owning a rental property is the monthly mortgage which typically includes PITI (principal, interest, taxes and insurance). Make sure your monthly rental income projections exceed the cost of PITI to cover regular maintenance, a vacancy allowance, property management and other expenses associated with keeping your property actively rented. And while with a fixed-rate mortgage, the interest and principal will stay the same each month, you should budget for a gradual increase in taxes and homeowner insurance over time.
- Cost to get it rent-ready – What improvements do you need to make? Maybe you just need to paint and shampoo the carpet. Or perhaps there are more substantial repairs. The major mistake I see novice investors make is unnecessary improvements to the property. Look at rental comps in the area. You may not need central air, granite counters or an exterior deck to fetch tenants willing and able to pay market rent.
- Appreciation possibility – Not only do you need to know that the property is appropriately priced and worth what you’re paying for it, but you also need to look at trends to project whether or not you’ll see appreciation over time. It’s OK to purchase rentals where property appreciation isn’t expected, but you should make sure your monthly cash flow is solid and high enough to make investing worthwhile.
- Rent projections – You need to know what your gross annual rent will likely be. Has the property been rented before, and if so, what was the tenant paying monthly? What is the current market rental rate for this type of property in this particular location?
- HOA Restrictions and Financial Stability – Does the HOA allow the property to be rented? If rentals are permitted, what are the rules governing that provision? For example, some HOAs require you to submit your lease, while others need to approve your lease. Is the HOA in good financial shape? You’ve probably noticed that not all HOA communities allow Federal Housing Administration (FHA) financing for homebuyers – that’s because they don’t pass muster when FHA lenders review them for financial security or adequate management. This will affect you negatively when you go to resell as it rules out many potential buyers.
Information gathering and due diligence on all these factors are necessary to determine whether you should acquire a property or not. I’ve heard that “you make your money when you buy,” and I’ve found that rings true. You'll be behind before you even start if you choose the wrong property.
The Due Diligence Process for REITs and Real Estate Crowdfunding
Investing in rental properties might seem overwhelming. Fortunately, there are plenty of ways to invest in real estate without buying and managing properties, but you still need to do some due diligence.
Most real estate crowdfunding sites pre-vet opportunities and partners before posting them on their platforms. What’s nice about that is you don’t have to gather all the information or visit the property to do due diligence.
For example, RealtyMogul does a lot of hands-on due diligence before they host an opportunity on their platform. They have a due diligence team of underwriters that review the property personally (not just on paper). There's also an asset management team that thoroughly investigates the operating partners (sponsors) and an internal committee that reviews all the data and opinions. If it isn't a unanimous thumbs up, RealtyMogul will not put the project on its platform. Once the deal is in place, their asset management team actively manages the project and sponsor to meet on-time and quality goals.
How To Assess Pre-Vetted Crowdfunding Opportunities
- Understand what “pre-vetting” means – What does the pre-vetting process include, and is it sufficient?
- Investigate the success of the platform provider – Did most of their past deals meet expectations?
- Investigate the sponsor — Most crowdfunding sites only host opportunities with experienced sponsors. Ensure that the persons behind the deal have sufficient real estate experience and have previously been successful as a sponsor.
- Review all due diligence documents — Ask questions if you don’t understand what you’re looking at or don’t see documents that should be included.
- Do your due diligence to verify that the information you’ve been provided is accurate — Search for comps to review. Investigate the job market and trends in the property area.
Like crowdfunding, Real Estate Investment Trusts (REITs) are designed for investors who choose to be less involved. As actively managed investment securities, there’s less due diligence involved in buying REITs. The managers are responsible for delivering a competitive return on investment for shareholders. They do their fair share of due diligence on the real estate investment trust funds.
Still, just as you would do personal pre-purchase due diligence on any stock, mutual fund or bond, you should do the same with crowdfunding opportunities and REITs.
The Bottom Line
Experts recommend you balance your overall investment portfolio. One way to diversify your portfolio is by holding some of your assets in real estate. How you include real estate and how much of your portfolio you devote to it is a personal decision.
While all investments involve risk, real estate investing carries unique risks that require due diligence. Owning and managing rental properties involves more extensive due diligence than investing in a REIT or real estate crowdfunding opportunity.
Proper due diligence in real estate investing, particularly rental properties, cannot be overstated. The goal is to bank some monthly cash flow and own a property that will likely appreciate. One poorly chosen or poorly-managed rental property can cost you a lot of money instead of adding to your wealth. Doing thorough due diligence upfront puts you in a much better position to achieve your goals.
More on real estate:
- Passive Real Estate Investing: What It Is & How To Get Started
- Is Real Estate a Good Investment Right Now?
- How to Invest in Underserved Communities Through Real Estate