“Chance favors only the prepared mind.” Louis Pasteur
Due diligence is a phrase given considerable weight in the investing community and for good reason. It is probably one of the better ways of mitigating risk when it comes to investing activity. Today I want to focus on why due diligence is an important process when considering real estate as an investment.
For the past six weeks I have been actively searching for property to add to my investing portfolio. Here is the “screen” I have been using: foreclosures, preferably multifamily properties under 60k. This screen is similar to what a person would use when they are searching for stocks. You decide what it is you’re looking for and run a screen to find stocks that meet your selected criteria. The initial screen is just a way of narrowing possibilities.
I use a handful of search engines and a real estate agent to find my list of potentials. On a side note let me say this, it is worth the effort and frustration to find a realtor that you trust. The right agent truly is an advisor in the best sense of the word.
Now that you have narrowed your potentials down to a few likely candidates the real work begins. Researching stocks is nice because you can do in your pajamas any time of the day. Hell, with tablets and smart phones you can do it anywhere. Technology has provided an enormous amount of pertinent information just a few key strokes away. Looking at real estate is a different animal. True, you can use mapping programs to find out what area of town the property is in and you can use photos to get an idea of what shape the property is in. However, nothing replaces actually going to a property and viewing it. There have been some properties that looked great when viewed online, but when I arrived to actually inspect the property I didn’t even bother getting out because the location was horrible. You will log many miles during this phase of the due diligence process.
Now you are to the point that (hopefully) you have found a few properties that have potential. When I find these I have already been to the property and completed an initial inspection. This includes determining if the location is acceptable. I also like to get an idea of the structural components of the house itself. What does the roof line look like? Are there any issues with the foundation? I’ve crawled under many a crawl spaces over the past few weeks looking at these things. If I see a property that has boards over the doors or windows this is not troubling to me. Doors/windows are easily replaced, a new roof on the other hand is not. Once I have done this initial inspection and I’m satisfied I call my realtor to schedule a showing. I would say that for about every 5-6 properties I initially find and go look at myself, I end up having my realtor show me only one. I’ve ruled the others out.
Now we are getting to the point of really digging into the guts of a property. In a foreclosed home you have to be prepared to find the inside in all kinds of disarray. If you cannot see past what is merely cosmetic versus what could be a prohibitively expensive repair then you may either brush off a potential gem or become too enthusiastic in something that could be a money pit. Most of the properties I have been in need drywall repair, new carpeting, paint, and appliances. These things are doable and not that expensive. If you come into a home that has extensive water damage, roofing issues, sagging floors and foundation problems you really, really, really need to research this further and get quotes as to what it would cost to repair these defects if you are unable/unwilling to do it yourself.
If you have made it this far, congrats. You really have found a property that you are seriously thinking of making an offer on. However, your due diligence is not over. If you are investing in a property with the intent to collect rent you have to know what your expenses will be. Rent is to a rental property owner as dividends are to a stock holder. Unlike the stock holder, the rental property owner has several expenses that must be deducted from the rents. If these are not carefully accounted for most of the profit will be devoured by unplanned or uncontrolled expenses. Knowing what these expenses are before going into any real estate venture is an absolute must.
With the current property I’m looking at I was unable to verify what the rent had been when it was occupied. I’ve had to call around and see what one and two bedroom units are renting for in the area. If I were looking at a property that was currently leased then I would want to see the rent-roll . I also called and found out what the utilities were in these units. Water is the only utility paid for by the landlord, but I also wanted to know what the electric would be for each unit. Get a quote on insurance and find out what the taxes for the property have been. Inevitably I will fail to account for some kind of expense that I have just outright not planned for or under budgeted. However, being as well prepared as one can goes along way towards avoiding surprises.
This has been my due diligence process thus far. Keep in mind this is a new venture for me and one that I have yet to complete. I have a very steep learning curve ahead of me and I’m sure I will make some mistakes along the way. Any of you readers who have experience in real estate investing please share with me what you have learned.
The Stoic Investor 
Good luck with your investment. I’d like to become a landlord too in a few years. Hard to beat the steady income that grows at/above inflation. Hopefully you can do most simple repairs yourself. I don’t personally own rental property, but my dad does. He has tried to manage it himself but it became too much for him (he’s not very handy) and ended up hiring a manager. It’s sort of expensive to go that route, but he now sleeps well at night and still gets great monthly rent checks.
Thanks BGH. I think managing a property yourself or hiring a management company is one of the early decision that have to be made. My plan is to manage it myself in the beginning. This could always change though…
I was about to pull the trigger on a duplex townhome, 3br one side, two bedroom the other side, with the intent to live in one side and rent out the other…but finally backed out when the out of pocket expenses for closing on two homes at once and all the paperwork involved became a bit too much…I have now settled on a small 3br 2ba home for me, at a very good price, with the prospect of buying a separate rental property in the next year or two after I get settled into my own home…since I am single, I also plan on renting out one room in my new home…being a landlord, is one of my primary goals going forward, but as you indicated, it isnt nearly as easy as just buying a dividend stock and sitting back and collecting the quarterly ‘rent’:}
HYS, Thanks for stopping by! There is certainly a lot to be considered when thinking of going into the rental business. It’ been helpful for me to think of it more as a business than an investment. I think it is actually both, but any potential rental property owner has to ask themselves if they really want to handle the business side of the investment. I think this might be one of the things that scares people about rental property.
Great post! These are some very useful tips, and ones I could have definitely used before I made my purchase (I learned the hard way, which was learn as you go).
I’ll probably start looking for a second property sometime next year, and like you, I’ll probably have to cash out on some stocks to help fund the downpayment.
I agree, you have to do your DD, and factor in every little cost. When the market is down, it’s not as critical since you have some margin for error. A lot of markets are on fire right now though, so locating positive cash flow properties is difficult. It’s better to overestimate the insurance, property taxes, etc. rather than risk being burned later. I just got my property tax bill, and it came out 1k lower than I had factored in.
Thanks FI Fighter. I can’t take all the credit. I have had some people in my corner helping me along the way. I’m still on the fence as to what to do with this property. I know what it will take to purchase and do the rehab. The thing is it will eat up most of my free cash. I’m having doubts as to whether I’m ready for that or not…