The Importance of Due Diligence When Investing in a Rental Property
Due Diligence is More Important for Rental Property than For a Homeowner
Buying an investment property to rent to tenants is nothing like buying a home. With your home, you make an offer, get a property inspection, go through financing, then close. With your investment property you are far more things to consider.
Before you even make an offer you should have their pro-forma rent and expense information. This is essentially what their costs and income should be under normal circumstances. If it is a 1-4 unit building it may be rather informal and may even just be verbal. Sometimes there may be no information at all and you need to assume the information
As part of the offer you should make it mandatory to see:
Proof of actual rents received. This can be deposit slips, receipts, bank statements, or even tax returns. It is very important to have this because you'll know who pays and when. Also, you'll if the property has truly been earning that income or if it was just a recent rent increase.
History of Expenses
It's good to get a copy of the tax returns with the expenses related specifically to this property. You need this for two reasons: first, it will give you a feel for how much maintenance the property truly needs. Second, owners generally over-state their expenses on their taxes. You can use this information to negotiate down the price.
Related: Is Real Estate a Good Investment?
prior to spending any money on an inspection, do the following:
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 sales person 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
Finally, once You have done all the leg-work, Get ready to spend some money on:
This is a tough one because I've seen it from both points of view. You don't want someone who will miss things but you also don't want someone who will blow things out of proportion. The problem is, the most recommended inspectors are actually the worst ones. The one that blows small problems into huge ones gets the referrals because everyone things they were saved from disaster, even though the inspector really just killed a deal.
Instead, look for a good inspector who will put things into perspective, find all the problems, and recommend solutions.
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.
Always Get Certificate of Municipal Liens
You don't want to find out six months later that there is 2 years of back taxes. Every state is different, but most require that all liens are paid at closing.
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.
Some people will make poor assumptions. It was quite common a decade or two ago, but some would just assume the last person did a thorough inspection, so they just search back to the last sale. In reality, the last person also made the last assumption. The problem is, if a problem was missed, it will never be found.
By going back 50 years or more, 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.
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