How to Do “Due Diligence” on a Rental Property, in 3 Easy Steps
“Do your due diligence!” If you have heard it once, you have heard it a million times — often from someone who has never done “due diligence” in their lives.
It sounds good, but no one ever stops to think about how unhelpful that platitude is. Okay … I should do my due diligence. Granted. But what does that mean?
Honestly, there is no need to be cryptic. When it comes to real estate, “due diligence” means three things … and none of them are rocket science. In many cases you will have professional help.
Here are the three critical stages of due diligence.
1. Financial Due Diligence
Financial due diligence is the process of “crunching the numbers” on your investment. This is how you determine whether or not it is a “good investment.”
Here’s how to do it …
Analyze the current conditions of the local real estate market and determine whether or not you are getting the property at a good price. A real estate agent may be able to help, or you can do it yourself using online tools like Redfin or Zillow.
Cash Flow Analysis
Determine the gross potential rent the property can produce (based on prevailing market rents for similar properties) and subtract the total expenses. We break down the major expenses a landlord should account for in this article.
Check online to see what market rents are for similar properties. Look at utility bills and maintenance contracts. Examine any current leases and property tax bills. Try to corroborate everything with documentation.
If you are conservative in your estimates and come out with a positive number, you have a reasonable chance that your rental will produce positive cash flow, not negative cash flow.
Tax Savings Analysis
Figure out how much you will be able to save on your taxes every year as a result of owning this property. If you have a CPA or tax prep specialist, they may be able to help. Details to look at include which expenses in the cash flow analysis can be deducted, and how much depreciation you can take. We explain depreciation in this article.
Decide how many years you expect to hold the property. Three years? Five years? Ten years? It’s up to you. You can always change it later; this is just for the purposes of due diligence.
Determine how much you expect your property to appreciate in value each year. Also, set a number for how much you expect your rent and expenses to increase each year, and project those numbers for however many years you decide to hold the investment.
Now take the total appreciation, cash flow, and tax savings over the time horizon you identified and add it all together. Throw in the mortgage principal paydown you expect over that period while you’re at it. How much bigger is that number than your down payment, closing costs, and initial repair budget? Use that number to determine your total projected return on the investment.
2. Physical Due Diligence
Physical due diligence means inspecting the property itself to determine its condition. Our lenders do not require a professional property inspection but you are able to coordinate one if you choose to do so.
Issues relayed in the inspection may affect the calculations that go into financial due diligence, including your budget for future repairs and maintenance.
3. Legal Due Diligence
Legal due diligence determines whether the property can legally be transferred to you. Determinations from legal due diligence include verifying that the seller is the legal owner and has the right to sell you the property. Legal due diligence also reveals whether the property is subject to any easements, liens, covenants, or other encumbrances that might affect the sale or the value of the property.
Legal due diligence is actually the easiest part — the title company handles this for you, during escrow.
As you can see, there’s no great mystery to due diligence. It has defined stages, and you can rely on professional help at most of those stages, especially if you are new to the landlord game. MartelTurnkey makes it even easier. With our portfolio of available turnkey rentals, we have done much of the due diligence for you. Contact us today — we’re happy to show our work and explain everything to you until you are ready to buy with confidence, satisfied that you have “done your due diligence.”