The In’s and Out’s of Due Diligence

The Importance of Due Diligence

When investing in real estate proper due diligence is one of the most important keys to success. There are many issues that can arrive after closing that could have been prevented with a little homework. Thankfully, many professional underwriters and lending companies will aide in this endeavor once a contract has been accepted.

The due diligence period generally refers to a set amount of time one has to investigate the aspects of the property after a contract is accepted and before closing. During this time the buyer may back out of the contract for any reason without repercussions. Generally, the length of time is pre-determined by either the state (usually 10-15+ days) or agreed upon in the contract and begins when escrow is opened.

Every lender and title company will have a set list of what they require to complete what they believe is proper due diligence on an investment. This not only protects them but you as the buyer. However, not everyone’s requirements and parameters are the same. A private individual lender may require very little due diligence to be done while the bank will have you jumping through hoops. Knowing what to look for and expect is crucial in this business regardless of if you are doing it all yourself or leveraging your team.

Buyer’s Due Diligence

  • Physical Inspection – plumbing, structural, roof, HVAC, pests, septic, well, etc.
  • Crime (including sex offender) statistics
  • Upcoming building plans in the neighboring area / Zoning
  • Talk with neighbors to get the inside scoop on the area
  • Median Household Income
  • Surrounding Rental Rates
  • School Rankings
  • Repair Quotes (if applicable)
  • Estimate your Debt to Service Coverage Ratio – DSCR (if applicable)
  • Review of Seller’s Disclosures
  • Property Rights
  • Submit all requested documents to lender
  • Review all legal documents for accuracy and understanding

Lender’s Due Diligence

  • Review of all documents for accuracy and suitability
  • Contract / Assignment – review terms and make sure the seller has the right to sell property etc.
  • Deed or Proof of Ownership – review chain of custody
  • Interior and Exterior Photos
  • Scope of Work / Lease Agreements
  • Bank Statements
  • Background Checks – this can include criminal, credit, tax liens, death index, bankruptcy, lawsuit history, etc.
  • Insurance Quotes – verify amount, terms, address, type (hazard, flood, windstorm, vacant, occupied, builder’s risk, commercial etc), and insured names
  • Flood Determination – what flood zone does the property lie in
  • Corporate Docs (if applicable)
    • Certificate of Formation
    • Certificate of Filing
    • Operating Agreements
    • Amendments
    • Resolutions
    • FEIN or W-9
  • Entity Search – verify the entity is active and managing members
  • Driver’s License (state ID’s) – citizenship
  • Social Security or W-9
  • Contact Information from borrower
  • Appraisal / Survey – Value of property and boundary lines
  • Permits
  • Homeowners Association (HOA) – restrictions and verify dues are up to date
  • Verify Taxes are Current and that there are no liens
  • Review of Title Commitment
    • Legal Descriptions
    • Policy Amount
    • Encroachments / Easements
    • Liens – Verify Clear Title / Judgements
  • Review of Loan Package and Closing Disclosure

Commercial

  • Phase 1 Environmental (if applicable) and Phase 2 if needed
  • Proposed Plat Changes
  • Drawings / Spec’s
  • Executive Summary
  • Rent Roll
  • Feasibility Study
  • Pro-Forma P&L

Ready to Invest?

This list is in no way meant to be used as a complete guide to due diligence, but it aims to serve as a starting point. There are many things to consider when investing in real estate and are often driven by one’s school of thought. Asset based lenders vs. credit-based lenders will have varying requirements, as well those investors who invest in fix-n-flip, rental, and commercial loans. The bottom line here is to do your homework throughout the entire process. Make sure you ask lots of questions and that you understand the legal documentation you are signing. Consult with your lawyer or financial advisor if you have questions or are still unsure. Don’t be afraid to walk away from a deal if you find an issue during the due diligence period that the seller refuses to fix or can’t. Better to lose a small sum of cash than to get in over your head. Be sure to partner up with a lender that you can trust. Now that you are armed with this knowledge, get out there and find some deals!

Calculating DSCR

If you are a part of the real estate investing world, then you probably have heard that properly calculating a property’s debt to service coverage ratio (DSCR) is crucial. If you are newer to investing, you may wonder why it is so important. Lenders use this equation to determine if a rental investment property’s cash flow is enough to cover their borrower’s loan payment in addition to all re-occurring expenses. As a borrower, the DSCR can help you gauge the profitability of your project saving you time and money.

The formula is quite simple, but first you must learn another acronym, PITIA. PITIA stands for property, interest, taxes, insurance, and association (HOA). These are the most common re-occurring expenses taken into consideration by a lender.

To calculate the DSCR take your annual rental income (numerator) and divide it by the property’s annual PITIA (denominator). The result is your DSCR. Anything below a 1 means you have negative cash flow and would be an unlikely candidate for approval.

Be sure to check with your lender regarding their DSCR requirements. As a rule of thumb, shoot for a DSCR above a 1.25. Remember, the higher the number the better chance for profitability. You can also find a DSCR calculator online at https://ils.cash/resources/.

How to Add Value to Investment Properties

Everyone wants to get the most BANG for their buck when it comes to real estate investing, but where to start can be overwhelming. Luckily, there are a few simple things you can do to accomplish just that and increase the value of your fix and flip property.

Add a fresh coat of paint.

The older your property is the more likely it will need a new paint job inside and out. Stick to neutral colors, as the majority of people may not share the previous owners love of red walls. A dove, oatmeal, or cream color are great choices for inside as they go well with most décor. A lighter color will also make your interior rooms appear larger.

If your interior is covered in dark wood paneling, consider removing it. This trend went out in the 70’s and we can say, “good riddance!” Another option would be to paint over it. Many beautiful renovations choose a soft neutral white to brighten the space. Pair it with a light beige or gray on the walls and it will look beautiful, while staying within budget.

For the exterior, power washing can do wonders and remove years of dirt and grime. If a new paint job is in order, then do not hesitate. You can also consider replacing exterior doors and doing some simple landscaping – at the very least mow the yard. This will help your curb appeal and entice buyers.

Trash the carpet?

Flooring decisions should be based on the condition of the flooring, the price range of the home, and your budget. First, check under the carpet to make sure you do not already have wood floors. You may luck out. If you do, a quick refinish can save you a ton of money.

Consider keeping existing floors if they are in good condition and are consistent with what buyers expect and demand in that particular market and price range. If you do trash the carpet, be sure to select a flooring option that is within your budget and will add value to the property. For example, you don’t want to blow your budget and install premium hardwood floors in a home that you plan to sell for $100,000. Manufactured wood, tile and/or carpet may be the better option.

Upgrade light fixtures.

Outdated light fixtures can easily date your home.  Conduct a quick web search to find more appealing options that will modernize the space. This quick fix can change the entire tone of a room and is well worth it.

Also, consider changing out your light switch and outlet coverings. If your electrical allows for it see if you can install a dimmer.

Upgrade the appliances.

Stainless steel, matching, and energy efficient appliances can help increase the value of your property. If you find dents on the doors to your appliances consider replacing just the door. 

Consider bathroom upgrades.

If you can add another bathroom, do it. Even a half-bath can increase your home value by 10% +/- in some areas. If that is not in the cards, focus on updating the ones you have. Regrouting the tile, removing the tacky wallpaper and replacing old shower fixtures can do wonders for your space. Opt for a new vanity, frame the mirror, build a vanity – the options are endless and all will help the home show better.

Add a bedroom.

Another way to add value to the home is adding bedrooms. This may not always be an option, but there are ways to add bedrooms without adding square footage to the home. One idea is to turn an existing study into a bedroom by adding a closet. This can be an easy alternative that adds significant value to your investment without breaking the bank.

Don’t forget to deep clean.

This should be common sense and part of everyone’s rehab process. A little elbow grease never hurt anyone and if you simply just do not have the time, consider hiring professional cleaning service. Otherwise, a dirty home may be a red flag for prospective buyers who may assume that the home was not well taken care of. Be sure to remove stains from the carpet (if you decided to keep them), make sure your bathrooms are mold and mildew free, clean the baseboards, etc.

Upgrade the kitchen cabinets.

Depending on your budget and condition of your existing cabinets, you may not need to completely replace them. Consider splashing a new coat of paint on them and replacing the door pulls. This simple step will help to update your kitchen in a major way.

Replace windows.

Replacing older windows will give you the chance to update the look of your home. Be sure to opt for energy efficient options, as this will significantly add value to your investment project.

Remember that you do not have to do it all. Chances are you have some major big-ticket items that must be taken care of first.  When considering rehab, especially the cosmetic stuff, always consider your target buyer, location, and budget. If your rehab is in a lower income area you may want to skip the fancy modern light fixtures no matter how good of a deal you get on them. Prioritize and spend money on what matters.

Talk with industry professionals about the right updates for your project. Discussing these options with a hard money lender you can trust will help ensure you make choices that will increase the value of your real estate investment, without blowing the budget. Be sure to include a contingency in your scope of work to help cover unexpected expenses and stick to your budget. Many new flippers get wrapped up in the fun of cosmetic upgrades opting for unnecessary improvements and imposing their personal style preferences. Always remember that your fix and flip property is an investment, not your forever home. Focus on what matters and choose the best renovations for resale.   

Commercial Real Estate Terms Investors Should Know

Commercial real estate is in a league of its own when it comes to the real estate world. Evaluations, terminology, due diligence, and requirements all change when one ventures into this type of investment. Here are a few popular terms to help you feel more confident in this arena:

Real Estate Broker A licensed real estate agent/firm that has completed additional training and who negotiates deals between buyers and sellers serving as intermediaries.

Letter of Intent (LOI) – a pre-agreement between two parties to hold terms while due diligence is being conducted and finalized terms are being set.

Executive Summary – Summarization of the proposed business plan. Gives an outline of strategy, management, financial projections, exit plan, descriptions, property details, improvement, etc. This is usually the first document potential lenders/investors see and will determine whether they decide to move forward on a deal and learn more.

Building Classifications – Industry standard divides commercial buildings into three letter classifications to help investors better understand a potential investment.

(Classifications can be upgraded through renovations)

  • Class A: These are the best quality buildings in said market area. Rents are typically above average; buildings are newer with better amenities and fewer maintenance issues. Class A investments generally hold the least amount of risk.
  • Class B: These would be considered your “average” properties that command average market rents, have mid-grade cosmetics, show slight wear and tear and are usually a bit older than your Class A’s.
  • Class C: These properties tend to have the most maintenance issues but are the most affordable of all classes, so they are often in demand.

Net Operating Income (NOI) – A standard real estate formula, used by lenders and borrowers alike, to determine the potential profitability of a commercial property in relation to operating costs.  This is calculated by subtracting the operating expenses from the total income of the property.

Balance Sheet– a report which includes a list of a company’s assets, liabilities, equity capital and debt at a point in time.

Profit and Loss Statement (P&L) – is a record of revenue, cost, and expenses incurred by a business in a given period of time.

Pro Forma – A report that outlines a properties future projected potential cash flow. This can be found by subtracting the projected future expenses from the gross rental income minus vacancy rate.

Capitalization (CAP) Rate – A formula used to determine what a potential investor’s return will be on a property. Net Operating Income/Property Value = Cap Rate

Rent Roll – a document that shows rental income (present and historical) from a real estate asset. This information is then used in many formulas to determine profitability.

Debt Service Coverage Ratio (DSCR AKA DCR) – The annual net operating income from a property divided by the annual cost of debt service (Insurance, Taxes, HOA fees, etc). A DSCR below 1 means the property is generating insufficient clash flow to cover debt payments.

Scope of Work – a document that outlines work to be completed and estimated cost for materials and labor on a specific property. This document will be used to determine loan amounts and the After Repair Value (ARV)

Environmental Site Assessment (ESA) –  a report often required by  your state and or lender for commercial acquisitions that identifies  the existence or potential for environmental contamination liabilities.  This is one of the first steps in commercial due diligence. If contamination is found a Phase II assessment may be performed.

Easement – a legal right to use another person’s property for a specific public or private purpose written into public records.  Easements can be created for a variety of reasons. Common easements include driveways, fences, utility, etc. These should be listed in your title commitment.

Encroachment – The intrusion of a structure that extends, without permission, over a property line, easement boundary or set back line. This can be found out by conducting a survey.

Whether you’re looking to buy, sell or lease commercial real estate, knowing these commercial real estate terms will benefit your business. This knowledge will help you make informed decisions, like determining if a property is a good commercial real estate investment. It will also help you prepare for conversations you will have with potential lenders when looking at commercial real estate loans. Armed with the right knowledge and vocabulary, you will be ready to dive into the world of commercial real estate investing and have the important conversations needed to grow your investment portfolio.