Due Diligence in 500 words or less

Try to get a property under contract based on a cursory level of due diligence, then you can safely dive deeper into a more thorough analysis without the risk of losing the unit to another buyer.  Due diligence varies based on the classification of property you are purchasing.  A 200 unit apartment requires a different level of due diligence than a single family home.  Let’s focus on a single family unit for this discussion.

When you make an offer on a house, you are basing that value off of information provided by the seller or seller’s agent.  Do you think some of that information could be accidentally or intentionally inaccurate?  It’s your money and therefore up to you to confirm all aspects of the property that led to your estimate of value.  Areas I like to review are property taxes, insurance, utilities, recent maintenance/repair costs, current lease (if currently a rental), a survey and a property inspection.  Let’s expand on a few of these.

Property taxes vary greatly from county to county and state to state.  I invest in the great state of Texas where we boast the lack of a state income tax.  Guess what?  The money has to come from somewhere, if not an income tax, then the property tax bills, auto registrations, etc must compensate.  A house that cashflows in Arkansas, may not in Texas due to much higher property taxes.  When a home sells, the taxing authority often times adjusts the property price up significantly.  Keep this in mind when you forecast your monthly expenses after the purchase.  Protest the increase in taxes year #1, it’s your best chance in reducing an ongoing monthly expense.

Property inspections can be formal or informal.  Many experienced home buyers will complete this step on their own or with the help of a few subs they utilize on a regular basis.  A formal home inspection is nice, but remember they have 40+ pages to complete so you’ll get a lot of fluff.  However, you might be able to renegotiate the purchase price based on unexpected findings.  There may be significant findings uncovered on an inspection which might cause you to walk away from the deal as well.

Have your insurance agent give you a quote on the new property.  You can ask the seller’s insurance agent to provide a loss runs sheet to verify any claims that the seller may have made.  If they forget to disclose the little kitchen fire that required replacement of cabinets, you can often tease that out of a loss runs sheet.

The survey is helpful to ensure all improvements (house, fence, shed) are within the property boundaries.  Encroachment of improvements on the neighbors property can be costly to remediate, don’t let this be a surprise you learn after the closing.

I hope this short summary helps you to understand the rationale behind doing your own due diligence in a real estate purchase.  You can find nice checklists online to guide you step by step.  Take the time before closing to verify and you’ll be less likely to add a “money pit” to your real estate portfolio.

Making Offers on Rental Properties

After analyzing 20 property leads we received from our real estate agent, we finally have found a house that meets our selection criteria and passes the 1% rule. So now what? There are two ways to proceed. The first option is to make a sight unseen offer for a price that would make sense based on the information you currently have. Once you have the property tied up with a contract to purchase, you then begin the due diligence process (we’ll discuss this in detail with a future blog). The advantage of this approach is that you lock the property down quickly while you investigate further. This may be a good strategy in a competitive market where deals move very quickly. The use of a termination option, inspection period, third party financing addendum, etc will allow you some time to analyze the deal, renegotiate if needed and then walk away if the deal doesn’t make sense. Not a bad strategy, but not necessarily a favorite among sellers and their agents. You can develop a reputation of being a tire kicker and may not get serious consideration in the future if you never close these deals.

The second and more common option is to schedule a visit to view the property with your agent. I highly recommend finding someone to tag along that has knowledge of construction quality and cost of repairs. Perhaps you have a residential inspector friend or a home construction contractor buddy. Anyone who has knowledge you can borrow to determine what it will cost to repair any issues needed or to estimate the cost of upgrades you’d like to make. This information will be invaluable when making a fair offer for the property. As you become more experienced, you’ll be able to estimate the cost of repairs on your own.

Whether you choose option 1 or 2, there will come a time when you need to make an offer. I like to start with the market value of the property when it is rent ready and then work backwards. You may need to use your real estate agent to help you determine the ARV or After Repair Value. The ARV is the market price of your property if you were to elect to sell instead of keep as a rental after you make all of the upgrades and repairs. Start with the ARV and subtract the costs of repairs/upgrades and the percentage of profit/equity you’d like to have in the property. For example your property will be worth $150,000 (ARV) upon completion less $20,000 in remodel/repair and closing costs less $15,000 (10% profit/equity) = $115,000. You may not want to start with an offer of $115,000 as most sellers prefer to negotiate, but you have determined the highest price you are willing to pay.

Some folks say for every 100 leads they make 20 offers to get only 2 accepted of which only 1 ultimately closes. These metrics vary from location to location, but I think the point is to not get discouraged if your offer is not accepted. Don’t chase deals, do the numbers and let the numbers guide you.

Once you have a contract on the property, you’ll want to begin the due diligence process to confirm all of your assumptions are correct. Part 4 will go into more detail regarding a reasonable due diligence process that works for all properties.

Quickly Screen Rental Properties

During part 1 of this series on acquiring a rental property, we discussed the importance of developing a target property type.  It is possible to remain open to buying any “good deal”, but much more efficient to zone in on a single property class and then set selection criteria within that class.  For the purposes of this discussion we are going to assume you’ve decided to search for single family homes within 30 minutes of your current residence with a brick exterior, concrete foundation and preferably 3 bedrooms and 2 baths.

You call up your friendly real estate agent and ask them to search the MLS for properties that meet your selected criteria.  You get an email which contains 223 properties for you to review.  Wow, now what?  You could limit your search criteria further.  Perhaps you could limit this set of houses by using a price range, square footage limitations, school district, etc.  Once you get a list of properties that seems manageable, you’ll need a quick reference point in order to know if the house will make money or lose money as a rental.

The first metric I employ is the 1% rule.  In order for this tool to work, you’ll need a good grasp of the rental market in your chose area.  The monthly rent should be at least 1% of the sales price for the property to make a decent return.  So a house you buy for $100,000 must rent for at least $1,000/month or you can move on to the next deal.  This is a quick and easy way to screen properties.  Keep in mind it is only a screening tool, there are multiple other steps you’ll need to take once you get a list of properties that meet this initial criteria.

Let’s discuss a few issues with this rule.  The price you use for the house needs to be the “rent ready” price.  If you need to spend $20,000 before a tenant can occupy the property, that will need to be added to the purchase price.  So now the $100,000 house is a $120,000 house.  At a rent payment of $1,000/month, you will not make money.  Be sure you know the rent ready price of the property also called the “after repair value” (ARV).  Other issues to keep in mind would be any expenses that will be higher than typical, such as property taxes.  Some areas have higher property taxes than others.  Home Owner’s Association (HOA) dues would be another expense not all properties have.  Remember the 1% rule is simply a screening tool that helps you know whether to spend more time crunching the numbers on a potential purchase.  I hope this helps give you some ideas on financial screening of rental properties.  We’ll focus on the next step, due diligence, with Part 3 of this series.

Buying a Rent House

Many people are aware of the financial benefits of adding rental property to their investment portfolio.  The addition of real property provides a means of diversification you can’t achieve by simply owning stocks and bonds.  How do you know which property will make sense financially and which will lead to buyer’s remorse?

Over the next several months, I’ll be writing short blogs to address components of rental property selection.  One of the first decisions to make is to define your target property.  What type of property and in what location?  Perhaps you want to only buy brick exterior, 3 bedroom/2 bath properties in good school districts within a 45 drive of your current residence?  Maybe you would prefer to purchase a duplex or triplex near a college and focus on the student housing niche.

“Investing in real estate” is a very non specific statement.  Real estate can mean anything from a shopping center to 500 acres in W. Texas.  Each property type has it’s own set of pro’s and con’s.  Single family homes offer the advantage of multiple exit strategies when you get ready to sell, but at a cost of less monthly cashflow than a duplex or apartment complex.  By focusing in on one area of investment real estate, you are able to develop a level of expertise in your “niche” area quickly.  During our next installment, we’ll discuss tools and tips to quickly screen properties.

Welcome!

Thanks for checking out my blog.  If you read my bio, you know my interests are varied.  I love reading blogs but kind of get bogged down on the 5,000 word novella.  As a result, my writings will be a relatively short, quick reads on  topics ranging from cattle husbandry to bereavement.  If you like the topic you can find blogs or books that delve into more detail, that’s just not the focus of my writings.  Hope you enjoy!