Once you have a property under contract it is time for the due diligence process and inspections. This is time to inspect all aspects of the property. You will inspect the physical condition, look for deferred maintenance, review all the financials, and do legal inspections.
THE PHYSICAL INSPECTION
The physical inspection should include all the major systems such as electrical, roofing, plumbing, HVAC, as well as structural issues. At the beginning of your investment career, I highly recommend hiring a qualified, well reputable inspector to go through the property. Be there with the inspector as he does his inspection. Watch what he looks at. Ask them a lot of questions and take it as an opportunity to learn. Eventually you may learn enough to act as your own inspector. I haven’t paid an inspector for years and act as my own inspector now.
Only act as your own inspector if, and when you are confident in your own abilities to see the major issues and accurately assess them. Missing a major item that needs to addressed could cost you years of your cash flow. A single structural issue could cost tens of thousands to address. If you aren’t planning on it, it could set you back years. Thorough physical inspections are crucial to your success as an investor.
Deferred maintenance is exactly what the name implies. It is maintenance that has been deferred. As such it is the stuff that will need to be addressed very soon. Maybe the HVAC works just fine now, but is 24 years old and could go out at any day. Perhaps all the kitchen appliances are all on their last leg. Maybe the flooring will have to be replaced before the next tenant. Or maybe the window frames are rotting, and the roof only has a couple years left, and the deck is getting old, and the bathroom needs redone. The list can go on and on. You MUST properly identify and plan for all of that. Otherwise you can say bye-bye to your capital reserves as well as your profits for years to come.
There is no formula to follow in every case when there is a lot of deferred maintenance, but let’s explore some of the possible scenarios. If the property is close to the threshold of your target for rent to purchase price, you will need re-negotiate a price that is reflective of the work that needs done.
Three methods can be used if you have to re-negotiate. You can:
- Negotiate a lower price
- Request a credit at closing to address the issues
- Request that certain things be fixed or replaced by the seller prior to closing.
Sometimes the difference will be too great and you won’t be able to come to a new agreement. Be ready to walk away. No deal is better than a bad deal.
WHAT IF THE PROPERTY IS ALREADY A STEAL?
In that case, you can still try to negotiate, but the price may already accurately reflect amount of deferred maintenance. If that is true, don’t expect much to happen with re-negotiating. This time it’s not as much about negotiating or walking away. This time it is about planning out how to pay for all of it. You need to know how much everything will cost. Then plan for everything to need to be replaced sooner than later.
If you don’t have the capital reserves to cover the work, you may have to walk away from even a fantastic deal. But don’t let that be your first option. Consider getting a line of credit somewhere that you could use for additional reserves if you need them. Also, if you do everything to the extent of it being nearly a full remodel, you could not only raise the rent considerably, but you could also refinance it afterwards at the new value and get all your cash back. This is a favorite strategy of mine. It is typically where you get the best returns, even up to infinite returns. Read about that here. This is why I typically seek out properties with significant deferred maintenance.
The financial review may be the most crucial aspect of the due diligence period. Just as accurately running numbers is the most important part of analyzing and selecting your property, it’s the most important part of the inspections. Now is your final step to verify that all of your analysis is correct and verify that all the numbers the seller provided you were true and accurate.
If you have not already, you should ask for a couple years of income and expense reports. Get the the current year to date’s income and expense report as well (also called a profit and loss statement). Some people recommend requesting tax returns to further verify that information, but those aren’t always given even if requested. It is more common for these to be asked for/given on a larger property like an apartment complex that someone is holding in a separate entity. I have never asked for tax returns for the properties I have purchased and believe it to be overkill. It is just worth mentioning that you could.
I hope that before being under contract you had already requested and received the actual rent roll. Pro-formas are notoriously inaccurate. Never trust the pro-forma given for a property. So, if you have not received the rent roll, make sure to get it now. Along with that you will want to get actual copies of all the leases to verify the accuracy of the rent roll. Yes, this means that if you are buying a 24-unit building you will want to go through each and every full lease for all 24 units. Make sure the names, rental rates, and dates match up with the rent rolls you were given.
Going over the leases is also an important part of the legal inspection. You need to know how things are structured and the agreements in place. Know what your obligations will be since you will most likely have to honor those leases until they expire before switching to your preferred lease. Most of the rest of the legal inspection will be in regards to the actual ownership and titling of the property. This is the responsibility of the title company, so make sure you are using a good one. Doing a land survey is an optional part of the legal inspection. It can be useful if you want to know exactly where the property lines are, but is not always a necessity to do.
SUMMING IT UP
The inspection period is an incredibly important part of the process. Just because you are under contract doesn’t mean you are done. Don’t get stuck with a surprise! This is the time to make sure you are buying what you think you are buying. Inspect it all and inspect it carefully!