Due Diligence – What Is Important When Buying Real Estate?

When you make a big purchase, or an investment, buy a car, sign up for healthcare, etc. you do you “homework” to hopefully make a sensible decision that gives you good value for the money you are spending.

When you buy real estate, which is likely to be the most expensive, most complex, and riskiest purchase you will ever make, there is an extraordinary amount of due diligence that you should do to reduce your risk and make a smart decision. It’s a time consuming, laborious, and expensive process of which most buyers fail to understand and complete. Most don’t even know many of the steps, or they don’t understand the time and cost required to perform the tasks, steps, procedures, analysis, review, etc. To give you a feel for it, here are the main steps in buying income producing property.

Pencil out your deal. In order to determine whether or not you are buying a fair deal, you must pencil out, or pro-forma, your particular deal. This involves investing rents, expenses, vacancy, financing costs, current leases, capital reserves and replacements and inputting those figures into your pro-forma. And you need to do your own research and use good numbers because if you take the seller’s figures, you’re going to find out quickly their numbers were probably overly optimistic. You might need a C.P.A. or financial advisor to help you.

Financing your property. You must also take the time to get qualified and procure several bids to secure the best financing for their property. Understanding the costs and terms involved in a financing agreement, and how those clauses could impact your investment returns and future financing options on the property is a must. Just accepting the loan documents, without your and/or your attorney’s review, is not prudent practice.

Title Issues, Site and Title Insurance. Title issues, at least expensive ones, are rare. But that doesn’t mean you don’t have to do all the needed review, maybe with an attorney, on every single purchase – because you do. You will have a title insurance policy to review, plus an abstract of title that could list easements, restrictions on use, and a schedule of exclusions related to the title insurance. Reviewing all of these, probably with an attorney, is an absolute necessity. And you probably have to have a survey done to see if there are any encumbrances on the property. You don’t want to discover an issue after you’ve closed escrow.

Property Inspection and Rehabilitation. You will also need to have a professional building inspector review the property and do a report of all the issues. Then have several different contractors to come bid on the work that is needed to get it into the condition that makes sense for your ownership and rental operation. These need to be done within the tight timeframe of your inspection period so you can terminate the contract if you find issues and the costs of renovation are prohibitive.

Dwelling and liability insurance policy. During your inspection period you should also get some bids for properly insurance your real estate. Sometimes there are insurance issues, and you may not be able to obtain a policy or the premiums may be unaffordable. For standard properties in decent areas, like apartments, it should be relatively straightforward and easy. But if you add in fire prone, flood prone, hurricane or high property crime areas, you might find a little more trouble obtaining a reasonably priced policy. Make sure to get some premium estimates early in the due diligence process.

Partnership, LLC, tax and ownership issues. If you are buying with other partners, or raising capital for the purchase, there are a myriad of legal partnership, LLC, and tax issues that need to be reviewed with a professional before your purchase. You need to set up the entity structure and tax items before you close escrow so all investors and partners are satisfied with the agreement.

Those are the main due diligence issues for an already built and operating income producing property. There are many other tasks and procedures depending on the circumstances of your purchase. So talk to your real estate broker, lawyer, C.P.A., escrow agent, title officer and others involved in your purchase for other items that need to be considered. And make sure educate yourself well before the process begins and give yourself enough time to do a good job of completing all these tasks.

Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.

Posted on 08. Aug, 2013 by in Real Estate

Rental Property – How to Project Cash Flows and Returns

If you are thinking about buying some rental properties as investments, you should probably understand how to project cash flows and evaluate the investment returns you hope to achieve on your hard earned invested cash equity.

There are really two types of returns that we can earn on investment property, first is appreciation in value which is the most common hoped for return. Secondly, and much more important but generally overlooked by investors, is the cash flow picture the property will generate.

The vast majority of investors buy real estate with the hope that it will go up in value. This is really a big mistake because many properties, particularly the prize “location, location, location” properties have corresponding negative cash flows on operations that may negate any true increase in wealth from one’s long term appreciation in value.

So a savvy investor needs to look at the cash flow picture and buy properties with positive cash flows, not negative cash flows. As an example of this in Monterey, one could buy a nice condominium for $500,000, which would rent for about $2,300 per month. That rent, minus all the maintenance expenses, HOA fees, insurance, property taxes, and mortgage payment would have a deficit on cash flows of about ($1,000) per month, or ($12,000) per year.

So while a buyer is hoping some appreciation in value will earn him or her a fair rate of return, that appreciation has to additionally compensate for all the money he has to take out of his savings to cover the negative cash flows. Those negative cash flows, on this example, could span several decades and hundreds of thousands of dollars before the property turns positive.

Alternatively, there are many properties that cash flow positive from day one as an investment. A moderately priced house or condominium unit, only a few miles away from downtown in the $150,000 price range, might generate $1,200 per month in rent and positive cash flows of $225 per month. That’s $2,700 per year of positive cash flow. As a side note – the appreciation in value, over the long term, will probably be similar on both properties anyhow. So why not go for cash flow plus appreciation in value!

To calculate a cash on cash return, we divide that $2,700 positive cash flow by the cash equity we invested, maybe $40,000 on the $150,000 property for a cash on cash investment return of 6.75% on our money. And that’s a really good deal! Especially compared to the fancy prize condominium that might generate a negative (8.5%) return on our invested equity.

As a long term investor, I can assure you that positive cash flow properties, so properties that pay all the bills and provide a rate of return on your money, are much better investments than negative cash flow fancy prize properties that just drain money from your bank account. Hopefully you’ll understand this concept before you buy that prize!

Posted on 29. Nov, 2012 by Leonard Baron in Real Estate