Is Your Investment Property Ugly? Due Diligence Will Tell You.
Updated: Aug 17
The Real Estate Investment Due Diligence Steps to Take Before Making an Offer and Applying for funding
Have you found the real deal or just fool’s gold?
How do you know if you are really onto a profitable real estate deal? Is it worth your time and money?
These questions and more are answered when the savvy investor completes thorough Real Estate Investment Due Diligence. But this raises the question…what due diligence should property investors engage in before making an offer and presenting it to potential lenders?
Everyone Thinks Their Baby is Beautiful
Beauty is definitely in the eye of the beholder. But when it comes to investing in real estate, investors need to look beyond beauty, and test their optimism with real, fact-based due diligence. Investors not only need to make sure the opportunity will be profitable, but it also needs to be attractive to lenders.
How to Screen for the Right Money Makers.
Six quick steps for making smart real estate acquisitions
Match your basic investment and acquisition criteria to your property choices
Ensure you are following smart principles and rules of thumb
Optimize your screening, offer, and loan application process
Verify the numbers before making an offer
Present the deal to the right financiers
Dig in and further verify your estimates
Investors simply can’t waste their time looking at every available property. No matter what your level of experience, you should have some basic criteria for what you are looking for so you can spend your time on the most viable opportunities.
Location and Marketability
Square feet of living area
Potential profit spread or rental income
Number of bedrooms
Complexity of repairing and re-marketing the property
If properties don’t match your criteria, your marketing and due diligence should reflect that. Your referral sources and property locators should have a good idea of your buying criteria. If you’re marketing through your website, your messaging should target the kinds of houses you’re looking for so you get good quality prospects.
Serious volume investors often have acquisition assistants to for deals that meet their requirements. Keeping your eye on the ball prevents you from chasing deals that aren’t the right kinds of deals – and helps you avoid “shiny object syndrome” where every new opportunity becomes a distraction and a waste of time.
Rules of Thumb for Real Estate Investment Due Diligence
Following are some general rules of thumb used by many real estate investors. Each may not work for you, or in every location every time. But having your own rules of thumb is important to quickly analyze property deals and maximize your results.
The Rule of Financial Intelligence Robert Kiyosaki, real estate educator and author of “Rich Dad, Poor Dad,” reminds us to invest intelligently by remembering these definitions:
Asset – puts money in your pocket
Liability – takes money out of your pocket
Good Debt – finances your assets, on which someone else makes the payments
Bad Debt – finances your liabilities, which you make the payments on
The Rule of 72.
This rule calculates how many years it will take you to double your money in an investment. Divide your annual rate of return by 72 to get the answer.
The 50% Rule.
The 50% rule assumes that non-mortgage expenses will eat up half of the income from a rental property each month. So if your rental is bringing in $1,000 per month, expect maintenance, taxes, etc. to cost you $500 per month. This is a quick and dirty calculation. A better option when really digging in to the numbers is Net Operating Income (NOI).
The 1% Rule.
The 1% rule calls for investors to only look at income properties which can rent for at least 1% of the purchase price per month. So if you are buying a $100,000 property, it should be able to rent for at least $1,000 per month. Some investors set the benchmark even higher at 2%.
This, like the 50% rule, is a QAD (quick and dirty) calculation. When it comes to rental real estate, before you make any buying decision, use NOI (net operating income) calculations for single family properties and CAP rate (capitalization) rate for commercial properties.
Debt Service Ratio.
Debt Service Ratio (DSR or DSCR) is normally used by commercial property lenders. This compares annual mortgage payments to expected net operating income. Most lenders demand at least a ratio of 1.2, meaning your NOI is 20% more than your mortgage payments.
Cash on Cash Return.
As your business grows, you may be faced with deciding between two or more investment opportunities. You may not be able to close on them all, so that case you want to do a Cash on Cash Return analysis. This helps you compare one investment opportunity to another based on the amount of cash invested.
Confirming Property Values.
Before you invest, or even figure out if a property is a good deal at a given price, you’ve got to know how much it is really worth. This is where comparable properties come into play. Just as with other due diligence, comps need to be thoroughly investigated.
Zillow & Other Online Valuations.
Even though notoriously and often wildly inaccurate, Zillow’s ‘Zestimates’ continue to often be used to guess the potential market value of properties by novice investors and sellers. This has resulted in losses by sellers – the false belief that their property was worth much more than reality leads them to refuse viable offers. Buyers – especially investors can make tragic mistakes by paying too much using online valuations. Online valuation tools too often rely on old data, and simply can’t accurately reflect the realities of your market.
Property Tax Assessments.
Property tax assessments can be a useful tool. But you need to understand how “inaccurate” they are in your market. For example; tax assessed value might typically be 25% lower than what properties are currently trading for in a given county. Tax values may not reflect a newly gentrified area, or any area experiencing environmental or other issues that negatively impact value. Time and experience in your market makes it simpler, but in the meantime – go the next step and verify, verify, verify.
CMA (Comparable Market Analysis).
These are the presentation tools often used by real estate agents to guide homeowners in selecting a listing price. Realtors looking for listings will often prepare these out for free. Investors can also piece together their own by comparing recent sold properties, pending listings, and expired listings, and comparing their prices and features. This is essentially the way that appraisers evaluate residential homes. However, it is an art, not a science, and it’s always best to verify.
Automated Valuation Models are the next step up. These are often used in place of appraisals, or as appraisal reviews in real estate, but can be widely inaccurate. Of course they are normally far cheaper and faster to obtain than full appraisals. Obtaining two of these AVMs to average out the findings can help, and empower investors to move quickly and decisively.
Full appraisals are not cheap. You can’t afford to order full appraisals on every prospective opportunity – A BPO is a great alternative. Otherwise, you’ll go broke before you do a deal. Your lenders will order their own appraisals and charge you for them – so a better alternative is utilizing the BPO or developing relationships with local real estate agents. In any case, investors can move the loan process along, and get better upfront answers by providing copies of previous valuations that give lenders all the specifics of a property along with photos.
Verifying the Rent.
Verifying rents is a critical part of due diligence and accurately valuing rental real estate. If you get your rent estimates wrong, the true value of the property, how much your returns are, and how much you can borrow may be very different than initial expectations.
Never take figures offered by real estate agents and sellers at face value. Instead; ask for copies of rent rolls, do your own market research, and even test it out by running ads. Don’t confuse asking rents with real rents, and make sure to understand different types of rental rates i.e. weekly, annual, and Airbnb-type rentals.
It’s critical to do preliminary walk throughs and to obtain quotes from contractors. Once there is a contract in place, real property inspections should be ordered and completed immediately. This is when you find out just how ugly your baby really is. Way too many deals have been derailed by lax inspections that could have uncovered costly repairs, liens and restrictions on the property.
The Final Step – Use a Hole Poker.
Investors can get caught up in the excitement of a new deal – regardless of level of experience or record of success. And when they do, it can lead to some pretty disastrous house flipping mistakes and funding blunders. In our blog post, Avoid House Flipping Mistakes – Using a Hole Poker, we help you recognize the value of a devil’s advocate, what to ask of them and how to find a good one.
For more information or lending questions call 800-805-3391 | Insource Funding