Due-Diligence

Due Diligence

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A real estate purchase cannot be completed when the seller accepts the offer from the buyer, because the buyer will need some time to fully investigate the property, to ensure that the seller has honestly represented it and to ensure that there are no other problems that the seller may not have known about. If the property has rental units or businesses, then the buyer will want to investigate the books and records of the property to determine the past income, current expenses, and projected future cash flows. Hence, real estate sales contracts have contingencies that allow the buyer to back out of the transaction without penalty, if the buyer is not satisfied with the property.

This detailed investigation of a property is known as due diligence, and is a major part of the real estate closing process. The formal due diligence period starts when the offer is accepted and escrow is opened and ends with the close of escrow, which completes the sale. Usually, unlimited access to the property only occurs during the due diligence period. The due diligence period is the last chance for the buyer to cancel escrow and get any deposits back. If due diligence reveals problems, then the buyer can cancel the transaction or renegotiate a lower price.

During the due diligence period, the buyer should verify financial information, especially leases, and have a licensed general contractor or property inspector examine the physical property thoroughly.

Pre-Offer Due Diligence

Pre-offer due diligence is performed before the offer, but is necessarily limited, since access to the property, books, and records is limited. However, the pre-offer due diligence allows the buyer to either eliminate properties that clearly do not meet the buyer's objectives or determine a realistic price range with which to begin negotiations.

Several methods allow the buyer to obtain information without contacting the seller. The buyer can get information from tenants, homeowners association, neighbors, and even some government agencies about the property and the neighborhood. Economic data can be collected about the local economy, such as the unemployment rate, which will be pertinent if the buyer is buying rental property. Market rates for rents can also be checked.

The buyer should also consider if property taxes are adjusted when the property is sold, based on the selling price of the property, as they are in many communities, which will provide a better estimate of recurring expenses with the new property.

Reviewing the Books and Records

Before the due diligence period, the buyer will often receive a pro-forma financial statement about the properties, which is simply the projected cash flow of the property, not actual results. Often, the pro-forma statement is based on idealistic assumptions that may be difficult to realize. Since the sale price of income-producing property is dependent on the net income of the property, the seller will be inclined to inflate income and minimize expenses. For instance, the seller may advertise vacant units at higher-than-market rents, even though it is unlikely that the units will be rented at those high prices. Therefore, the buyer should only rely on the actual inspection of the books and records, which will only occur during the due diligence period. The buyer should also receive a written list of all personal property included with the purchase.

Properties with tenants will generally take longer to close because the buyer will want to verify the rent roll, which is a list of all rental units, specifying the tenants name, current rent, security deposit, the lease start and expiration dates, and move-in date. The buyer will also want estoppel certificates from each of the tenants, especially for business tenants, to verify the information in the rent roll. Using estoppel certificates, the tenants, at a minimum, certify, under oath, the basic terms of their lease, including the lease amount, the amount of any deposits, any prepayment of the rent, and whether the landlord has fulfilled the terms of the lease. The tenants will be legally bound to the information that they provide in the estoppel certificates.

The buyer should also verify income and expenses for at least the past 12 months, which can best be done by examining a copy of Part I of Schedule E, Supplemental Income and Loss of the seller's tax return. Tax liability helps to ensure that the seller did not overstate income or understate expenses when reporting his own income to the tax authorities. The seller should also provide a written statement that no verbal concessions or agreements have been made with any of the tenants regarding rents, deposits, services, or other concessions.

The buyer should try to receive copies of the rental applications, rental agreements, correspondences with the tenants, legal notices, maintenance work orders, copies of all business licenses, and any required government certificates or permits as well as any pending legal action involving any tenants or the property. Additionally, if the landlord paid for any utilities for the tenants, then the new buyer would need to have the information regarding those accounts, so that the account can be transferred to the buyer on a specific date. The buyer should also obtain a copy of the seller's insurance policy and any claims made on that policy, since it can help to determine the type of coverage that the buyer should have on the property.

In most states, the seller either has to refund the security deposits to the tenants or the deposits can be transferred to the new owner. Generally, the buyer should try to have the deposits transferred, since collecting deposits from tenants who are already living in the units may be problematic.

If the seller has an ongoing relationship with contractors or service providers, then naturally the buyer will want to contact those people either to continue their service or to terminate it so that the buyer can choose his own providers.

Disclosure Requirements

For residential real estate consisting of 4 or fewer units, most states have disclosure requirements, revealed in what is sometimes called a transfer disclosure statement, or TES form, listing all structural or mechanical deficiencies with the property that are known to the seller. Even if the state does not have a disclosure requirement, there will still be a legal duty for the seller to disclose material facts: known defects with the property that would have a significant impact on the property value.

The TES forms of most states list common disclosures, such as:

environmental hazards, including buried fuel storage tanks

past or present problems with mold or mildew, or wood destroying insects

leaks in the roof or foundation

the age of the roof

problems with sewer lines or septic systems

upcoming assessments, such as for neighborhood improvements, like sidewalks

planned changes in the neighborhood that may devalue the property

Most TES forms allow the seller to simply indicate yes or no for the most common disclosure items. They can also indicate no representation or unknown, if they do not know or are uncertain about the potential problem. Additionally, specific disclosure may be required for such things as whether the location is under an airline flight path, over faultlines, in a floodplain, or other local conditions that may devalue the property.

Statutory disclosure requirements are less strict or non-existent for commercial real estate, which includes residential real estate consisting of 5 or more units because buyers of such property are considered more sophisticated and more savvy in real estate transactions. Nonetheless, sellers of commercial property will have a legal duty to reveal information that will impact the value of the real estate, such as zoning, environmental hazards, encroachments, disability issues, and other items.

Some sellers will attempt to sell their property as is, especially if there are known defects with the property. However, in most cases, the disclaimer offers no legal protection to the seller, since they still have a duty to disclose all known defects that may significantly lower the property value. Indeed, a buyer should always be aware of any seller selling property as is, since it usually indicates a serious problem with the property.

Property Inspection

The buyer of the property has a right to a complete inspection of the property. Sellers who try to limit inspections with restrictive times or access should be avoided. Rental property will generally have some tenants, so the seller should set up a time that is agreeable with the tenants to allow the buyer and his agents to inspect the property thoroughly. The buyer hires the inspector to inspect the property. For larger residential units and commercial properties, a lender may also require that its own inspector be used to inspect the property. Generally, the inspection includes the structural integrity and overall condition of the property, including:

the foundation, crawlspaces, basements, subflooring, floors, walls, ceilings, attics, roofs;

plumbing systems;

heating and air-conditioning;

electrical systems, including ground fault circuit interrupters;

safety systems, such as smoke and carbon monoxide detectors and fire alarms;

moisture problems and drainage;

any evidence of subsidence and flood risk;

landscaping;

any modifications or additions to the property that violate local zoning laws.

There are generally 2 types of defects: patent defects and latent defects. Patent defects can easily be observed, such as broken windows or dry rot. Latent defects cannot easily be observed, because the defects are hidden within the structure of the unit, such as termite damage.

Any evidence of environmental toxins or moisture problems should be examined thoroughly because they can be expensive to remedy. Moisture problems, for instance, can lead to mold, which many insurance companies will no longer cover and may lead to lawsuits against the owner. Another expensive problem to fix is damage caused by wood-destroying insects, such as termites, carpenter ants, carpenter bees, and powder post beetles. Termites, in particular, can cause the most damage and will more likely be a problem if wood is close to the soil. All wood destroying insects require moisture, and so are more likely to thrive if there is a moisture problem. Dry rot, caused by a fungus, is another potential problem that requires moisture.

Property inspectors may not be qualified to inspect all systems or there may be special fees for inspecting septic systems, private wells, radon, and mold. To purchase a home that does not use public utilities with FHA or VA financing, the home inspection will have to include reports on the septic system and water tests. If these are necessary, then it would make sense to hire a property inspector who can perform this test and would do it as part of the inspection.

Environmental Hazards

Lenders for commercial and residential rental properties consisting of 5 or more units require a Phase I environmental report, which lists prior owners and uses of the property and aerial photographs, but does not usually include testing. However, the lender will require a Phase II environmental report if the Phase I report revealed any problems, since environmental issues are generally very expensive to correct. Although most residential properties do not have any environmental hazards, certain types of commercial property will have a higher probability of problems, such as property occupied by dry cleaners, gas stations, and auto repair companies.

If the Environmental Protection Agency or a state environmental agency determines that the property was the source of hazardous materials, then the current property owner will be required to clean it up. Indeed, cleaning up properties is so expensive, that lenders will generally be unwilling to lend money to buy such property, and if it does, the loan agreement will generally include a provision, stipulating that the buyer of the property will be responsible for any cleanup costs or other costs arising from the environmental contamination, even for nonrecourse loans.

Selecting Property Inspectors

Many states require property inspectors to have a license or certificate, but the buyer should only hire property inspectors with extensive experience. The buyer should also accompany the property inspector to verify both what was inspected and the condition of the property. Home inspectors may not have specific credentials — many are licensed general contractors — but there are some trade associations that specify minimum requirements for home inspectors, such as the American Society of Home Inspectors.

A buyer should examine sample reports offered by various property inspectors, to assess the quality and detail of the reports. The buyer should also request an electronic format of the report including digital photographs, so that they can be sent to anyone, such as a lender, requesting information. Additionally, the buyer can retain a copy for future buyers. To better assess competence, a potential buyer should request a list of prior clients for those property inspectors that made the short list.

Some questions that should be asked and which any reputable home inspectors should be willing to answer include:

Where did they get their training?

How long have they been a professional inspector?

Are they an engineer or general contractor?

Have they continued their education?

Do they belong to a professional organization that has strict standards? If they do, research the organization on the Internet. Most organizations should have a website with a page specifying what their standards are.

Do they carry errors and omissions insurance?

Repairing Property Defects

Most real estate purchase contracts have contingencies allowing the buyer to cancel the contract without any penalty, including the loss of earnest money, if the property inspection yields significant problems. If there are defects in the property, then the seller can either correct the defect or give credit to the buyer in escrow. In many cases, the buyer will prefer receiving a credit so that he can make the repair that will suit him personally, such as replacing the carpet with his own style and color. The seller may prefer that also, since she will not have to deal with the problem.

However, a buyer who receives a credit in escrow should not attempt any property repairs until escrow closes, since if the sale does not finalize, the buyer would simply be improving the seller's property. However, the buyer can select companies before closing to perform the services, with the contingency that the services will not be required if the property does not transfer. And no work should start until after the property transfers to the buyer.

Never Rely on the Seller's Inspection Report and Never Hire an Inspector Recommended by Either the Seller or His Real Estate Agent

Some sellers will offer an inspection report, supposedly to save the buyer time and money. However, the seller will be prone to hire an inspector who is not critical of the property. The inspection report can be used as a 2nd opinion, but the buyer should still hire a property inspector for an independent inspection. Similarly, never hire a property inspector suggested by real estate agents who work for the seller, since they will be inclined to suggest inspectors who are not diligent in ferreting out problems.

Home Warranties

Home warranties are insurance policies that cover appliances and plumbing for a home. Some policies also cover heating and air-conditioning systems, but if they do not, then coverage can usually be purchased for an additional cost. Sellers often buy home warranties while they are selling the home to cover an older home with older components. The premium is usually paid at closing.

Home warranties usually have a duration of 1 year, so that buyers do not have to pay additional money for expensive repairs or replacements shortly after buying a home, since the purchase depletes many buyers of cash. Although home warranties can be renewed, premiums increase, since older systems or appliances are more likely to fail. A copayment of $30-$60 is typically charged for each visit, to discourage the filing of claims for small repairs, when the visit would cost more than the repair itself.

Note that home warranties do not cover structural defects or title problems. Since the coverage provided varies widely, it would behoove the buyer with limited funds to scrutinize the policy details.