Monday, 14 May 2012

Investing in Real Estate - Doing the Due Diligence

This is my ninth post in my Investing in Real Estate series and covers things you should check when buying a property.  This is one of the most important steps in the process however is the one which is also the hardest to carry out. 

You have found the perfect investment property, have your finance in place and have gone through the  stress of negotiation with the other party saying yes.  If you have gotten to this stage well done!  However the most important part of the process is the due diligence.  It allows you to carry out the terms you and the vendor agreed to in your contract before there is formal settlement of the property.  It is the hardest stage because by this stage you cannot help but be emotionally involved.  However you need to try and detach yourself because if there are real problems with the property (e.g. structural problems) then you need to back out pretty quickly or you will have some serious problems in the future.

The due diligence that you do is totally dependant on what you put in the contract.  At the very minimum you should include a building and pest inspection clause.  Do not use the pro forma wording that the real estate agents suggest.  Use wording that is as unambiguous as possible for this.  I suggest googling around for appropriate wording - I am not a lawyer and do not want you using a broad suggestion that I put on this website in a contract. 

The building and pest inspection
For your building and pest inspection use a reputable building inspector.  You want a person to tell you the truth, not what you want to hear (i.e. that it is perfect).  In Australia a lot of investors and home buyers use Archicentre.  I have never used them though I have heard from friends who have that they are not as detailed as they could be.  They do not tend to get right into the property to find any potential flaws.  I used a person recommended to me by a real estate agent friend.  He said that this person was hated by real estate agents because he found every single little problem and caused people to back out of contracts.  Make sure you tell the inspector that you want to hear about everything.

At the same time do not run away at the first sign of a problem.  All houses develop their own little problems over time and some are not very serious.  When I got my report back from the building inspector I almost had a heart attack with the amount of problems there appeared to be.  I then asked the following questions which I think are essential
  1. I asked him if he could take me through the whole report slowly and explain it to me in simple terms as I do not have any building experience
  2. I asked him what was necessary to fix right away, what could wait and for how long
  3. Finally I asked in his estimation how much all of it would cost me.  This was important because I discovered that actually many of the 'problems' were super cheap to fix and not really an issue at all
A lot of inspectors are reluctant to give you that information because they fear you will sue them if they get their estimates wrong etc.  If you make clear that you are just trying to put things in perspective I have found that they are normally very good.

Property and title searches
This is a bit of legal due diligence that you should never skip over.  Ensuring that the vendor has the right to sell you the property before you hand over the cash is essential.  This is often done by a lawyer or a paralegal.  People often argue about whether it is better to use a lawyer who tend to be more expensive however have a better understanding of the law if anything goes wrong or a paralegal who do this as their bread and butter work every day, are cheaper though will not be able to help you as well in a bind.

My personal strategy was to use a paralegal (Moira Ryan - I highly recommend her if you are buying a property in Victoria, Australia) who came very highly recommended but to have a lawyer in the back of my mind (I didnt retain them) just in case things went a bit pear shaped.  I found this worked perfectly for me as most times there are no real issues.

Check any and all representations that the real estate agent has made before signing the contract
Contractually representations made before signing the contract but that are not in the contract do not count for anything.  For example if the real estate agent has told you that this land is prime development land, you do not check and it turns out the council refuses to develop any land, if it is not in your contract then you cannot get out of the contract for this reason.

There are some things which you can put in a contract though.   One of the easiest things to check in diligence (and which they should have no objection to) is seeing the rental agreement with any existing tenants.  You should always check this just to make sure that the real estate agent has not inflated the amount that the property is being rented for.  Specifically check the term of the agreement to make sure that the agent has not rented the property at an inflated rate for a few weeks / a month to get a good sale (I actually did see this once and never dealt with that agent again)

There are an unlimited number of things which you can put in your contract for the diligence phase which can give you an out for things you are worried about.  However keep in mind that more conditions are likely to make a vendor nervous about the certainty of the sale.  The conditions above should never be left out so consider them an absolute minimum for your contract.

Most importantly after they are in your contract make sure that you follow up on them in the appropriate amount of time and exit the agreement if necessary.  Not exiting when you know something is wrong or too costly to fix is the biggest mistake you make.  You wont catch everything but if you ignore information that you have been told then it is your own fault. 

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