Ultimate Due Diligence Guide for Rental Property - Ideal REI

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Ultimate Due Diligence Guide for Rental Property

Buying a rental property is nothing like buying a home.

It isn't as easy as getting a simple home inspection!

Believe it or not, there are far more things to consider when buying a rental property than when buying a home.

This is true regardless if it's a single family rental house, 4 unit residential property, or a 20 unit apartment building. There is a ton of stuff you need to investigate to protect your investment!

In this article we are going to cover the fundamentals of due diligence both before you make an offer as well as before you close the deal, including:

  • Administrative
  • Legal
  • Environmental
  • check
    Financial
  • check
    Physical

Diligence Before Making an Offer

You probably don't want to blindly make offers. It's a huge waste of time for you and for the seller and it also negatively affects your reputation in the area.

But, you also won't have every piece of information you need up front. So, you have to find a balance and make offers based on the best information you have available at the time.

There are 3 things you'll need before making an offer.

Rent Rolls

If the building is occupied, you absolutely need to know what the terms of the lease are. This includes length of the lease as well as the amount and any other fees the tenant is responsible for paying. 

It's also helpful to know how long the tenant has been there. A 10 year resident is more likely to be below market rents than a recent move-in.

This is important regardless if it's a 1-4 residential or a 5+ commercial multifamily property.

Think about it - you're buying this property for it's ability to pay rent. So, it's important to know what that rent looks like before even making an offer!

Sure, you might plan for rent bumps or renovations. But it's important to have a baseline when you walk into it.

History of Expenses

This is amazingly difficult, so don't get frustrated!

Most owners are jacking up their expenses in order to have bigger losses and pay less taxes, or they are not accounting for things that should be expenses (like not paying themselves when they work on the property).

So, in one situation expenses are really high and in another situation they are too low! You just can't win.

Regardless, you need to get the information and then compare it to other properties in the market, rules of thumb like the 50% rule, or your own experience.

If you can, get a copy of their tax returns (usually on a schedule E and/or a Schedule C, but sometimes on a K1)

Additionally, you can have their property manager print out a copy of their expenses, or even have the owner just write them down and sign that they are accurate. 

Building a Pro Forma

The reason you need their rents and expenses is so you can accurately calculate your cash flow.

Additionally, you'll want to create a pro forma rent/expense.

Basically, you want to put what you assume the rents and expenses will be. These will definitely be different from the current owner, but you use that as a baseline and make adjustments from there.

It will look something like this.

pro forma rents and expenses

Example Pro Forma Rents and Expenses

Once you build a pro forma and know your net operating income, you can determine what you future returns look like as well as knowing what you're walking into.

Knowing the Market

In general, you want to have a fair understanding of the market, the street, and the specific property. Often, this requires you to physically go there, but sometimes you can make offers as long as someone you trust has seen it or knows the area.

First, you should know the local market and sub-market. Not only do you need to know the city/town it's in, but you should also know if that particular part of town is good.

After all, most cities have their good areas and bad areas. The last thing you want to is buy property in an area that isn't great, but pay a price as if it were in a good area!

Also, you want to know the street it's on. Not only do you want to make sure this specific street is good, but that the building conforms with other properties in the area.

And, you want to make sure you aren't buying the best property on the street! Actually, you don't even want your property being one of the top 50% - you want to leave room to add value and improve the property.

If you see anything quirky with the property, it's good to talk to the town/city to make sure everything is good to go.

Common examples are if there is a second building on the lot, a multifamily in a neighborhood of single families, or a commercial building in the middle of residential ones, etc.

Diligence After Getting An Accepted Offer

Generally, the diligence items you want to do first are the ones that are free or cost the least.

So, start with all the admin and financial stuff first!

You're going to hire an attorney to do some items and you'll hire an inspector (or inspection team) to do the physical diligence.

But, verifying a lot of the information is free. So, let's start there!

Lease Audit

It's important to get a copy of all of the leases and verify the information on the leases is current and accurate. 

Also, you want to make sure the information matches the rent roll they provided!

Recently I made an offer on a property. When I got copies of the leases, I found that they all offered a $50 discount if the rent was paid on time.

So, all of the leases were effectively $50 less than what was advertised.

You'll also want to have this information on hand when you do your physical walk through so you can ask any tenants that are there to verify their information.

Verify Town & City Data

Most municipal governments require permits for major work that is done on a property. If you go to the building department in that city, you should be able to get a list of permits that have been pulled.

Cross reference this against work that is advertised on the listing. If they advertise a "New Roof" and there is no permit, how could there possibly be a new roof? Same goes with that new heating system, HVAC, or new half bath on the second floor.

Additionally, the assessor's office should have information about the property, commonly called a property card.

Major work with permits may feed into the assessor's office where they will record changes to the property and re-evaluate taxes.

  • If it was a 3 bed 1 bath house and the owner did a renovation to make it a 2 bathroom house, the property card should clearly show it has two bathrooms.
  • If it has only one bathroom on the card and no permit, the city could eventually have the work ripped up and inspected.
  • It is extremely common that work is done without permits in order to cut corners and/or avoid additional taxes.

This can be a very strong negotiation point. Once it is revealed to the real estate salesperson that work was done without a permit, they legally are not allowed to advertise that work as "new" and they are also bound to disclose the un-permitted work on the property.

This may put you in a very strong negotiating position under the right circumstances.

Talk to Municipal Agencies - health department, police department etc.

You are looking for evidence of "problem tenants." If there are several outstanding health code violations, you will inherit these problems. The police department or online records can provide information about when they were dispatched to that property.

Unless you are an expert landlord with a strong background in evictions, avoid problem tenants. If you are an expert, then use this to seriously negotiate down the price.

Chat with Tenants

Sales agents and current owners absolutely hate this, but it is a must.

Tenant's are nervous about their owner selling. They are afraid they will lose their home or that the rent will jump suddenly.

Because of these fears, they will do anything to get into the good graces of the new owner, including telling you about every single drip, spot, crack, or speck of mold.

Ignore the owner and agent and make sure you have very long conversations with all current tenants.

Check to See if it's in a Flood Zone

This seems obvious but most people don't check. Flood insurance is extremely expensive and will blow your numbers out of the water.

Check before you spend any money on inspections! It's outlined a bit more in this article on land investing.

Physical & Legal Diligence

Now that you've got all the free stuff out of the way, it's time to get on to the part of diligence that costs money!

Property Inspection

Who you hire will depend on what kind of property you are buying.

If you are buying a 1-4 family residential property, a regular inspector will do just fine. When you are getting something larger you'll want someone that specializes in commercial property.

If it's even larger, say 40+ units, you'll want to hire a company that specializes in multifamily diligence. They'll have a whole team of people, provide reports, and even provide estimates for work that is required.

Some of the things that hang people up all the time is electrical and plumbing. Most inspectors are not qualified to say much about these except they will tell you to hire a professional.

These systems can be costly to upgrade, so make sure to get opinions from a plumber or electrician!

Another thing to consider is doing a roof inspection and checking the foundation for settling or shifting.

Pest Inspections

Every region has different pest issues, but at the minimum, you should check for termite, ant, and beetle infestations as these cause serious structural problems that are expensive to fix.

Not all inspections come with a pest inspection, so make sure it's part of the package.

Always Get Certificate of Municipal Liens

You don't want to find out six months later that there are 2 years of back taxes. Every state is different, but most require that all liens are paid at closing.

This is something your attorney should be on top of, but you should verify they are doing it.

Title Search

Your title company or real estate attorney will ensure this gets done. You should verify what type of search they did and how far they went back.

The goal is to go back a minimum of 50 years or to the last instance of government ownership.

It's important to hire a great title company because it wasn't always done right. In the past, many title companies would start their search after the last search was completed.

They just assumed the last guy did a good job!

But, that guy did the same thing and assumed the previous one did a good job. And so on...

And often, major things were missed!

By going back 50+ years, your title search will uncover problems. It is actually quite common to have title problems, so make sure your search is done properly.

Do Your Own Research Too

This list is by no means all-inclusive. Every deal has its own nuances that may require you to do different things.

The point is, you have a lot of work to do before purchasing your investment, and you need to do it all in order to protect yourself and your money.

About the Author Eric Bowlin

Eric is an investor that achieved financial independence at the age of 30. He started in 2009 with the purchase of his first triplex and now owns over 470 units. He spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate. Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, and other financial publications.

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