Getting Started In Real Estate Investing – Phase 6: Property Due Diligence
If you have been following our whole series about getting started in real estate investing, HERE is where it all starts to come together. NOW you will see the benefit of creating your investment plan that we discussed in the first phase of investing. AND, now that you know what you want out of your investment, you are better equipped to find the right type of property for your anticipated returns. As we discussed in Phase 4, the due diligence process of identifying the best real estate investing locations, we can now uncover the best property that you will want to focus in on to obtain your investment objectives.
Here are a few simple guidelines to consider:
Are you looking for Capital Growth your Number 1 criteria or is it Cash Flow, or maybe something altogether different.
When Cash Flow is your Number 1 objective, you will want to give high consideration to your control over the expenses.
If Capital Growth is your objective, then it is important to invest in property that will ultimately (during your liquidation phase) sell to an end user. So you will want a product that the largest number of people will be looking for.
Either way you will want to consider the type of property that will best maximize your number 1 objective. Let’s look at what this may look like:
- 1st is the Single Family Homes: In the US, the most sought after piece of residential real estate is the 3 bedroom, 2 bath home (known as a 3/2). Even more sought after is the 3/2/2 (3 bedroom, 2 bath and 2 car garage) home. In any city USA, this 3/2/2 will be the Number 1 sought after property.
- Next will be the Town home or Villa: These properties are typically a group of homes that are attached in a row of two to 6 units per building with multiple sets of buildings to the complex. The difference of these two are subtle. The town home is typically a two story building where you own a two story home that is simply attached to the neighboring home. The villa is simply a one story building. It is the ownership style that makes this appealing to a number of people. As an owner you own the property that you live in and you (usually) are free to do what you want to the unit. In most cases you own everything within your unit including the interior walls. The exterior yard space is typically deemed to be an undivided interest in the common areas. This simply means you have equal rights to enjoy the entire outdoor space as anyone does. These are popular to many busy business professionals as the exterior maintenance to the property and the yard work is all taken care of by the association This associations are often called HOA (Home owners Association) or occasionally referred to as a (common interest community). They will have a fee that each unit owner pays monthly to cover the cost of these services.
- 3rd is the Condo: there are many similarities to the Town Home or Villa in that the condo also is a common interest community. The difference is that the building is a large apartment style complex which may have many floors and you simply own one of the units within the building. With a condo, you also pay monthly association fees. The biggest difference in ownership is within a condo you own the space within the building. It is said you own from paint to paint. This means you do not have the privilege of making changes to the property other than painting it a different color. Any interior remodeling will have to be approved by the association.
As you can see, the single family home is the most highly sought after piece of real estate since the largest number of people wish to own them, because they provide the largest amount of freedom. When you own a single family home, you have the most amount of control, and as a landlord, you also have even more control. Because you do not have any HOA to contend with, you do not have the uncertainty to changes in policy or HOA fees either. Typically, an investor who owns a single family residence will have tenant pay for all utilities, lawn care, etc., the only expense an owner has is the mortgage(if there is one), insurance and the property management.
When buying a property within an H.O.A. or a common interest community, you will want to do large amounts of due diligence in understanding what the rules and regulations are for the property. You will want to carefully look over the budget of the Association to make sure the complex is financially sound. The big thing to watch out for in the HOA Budget is insuring they have proper amount of reserves on hand. As an example, every 20 years or so a new roof will need to be put onto the buildings. Let’s say it has been 10 years since the last roof was installed. Each month the HOA should be depositing a certain amount of money to put into their roof fund. This should be itemized out and is information made available to a prospective buyer.
Here is where many people make mistakes in their due diligence; they tend to buy similar properties with much lower HOA fees. Lower HOA fees may mean that the association is underfunded. When an HOA is underfunded and it comes time to do a repair such as a roof, then the Funds will not be available to purchase a new roof. The HOA will then be forced to put an assessment onto each unit to pay for the roof repair. These assessments will cut into your cash flow and often times can be much more expensive than your cash flow will support. As you can see, due diligence on any property that has a Common Interest Community will be paramount to the success of the property's financial returns. With all that being said, there are many investors who like these types of properties because they offer more services such as exterior lawn care and exterior routine repair and replacement. These services offer a piece of mind to the owners as they do not have to worry about budgeting for them. The tradeoff is they do not have control over the expenses either.
Now for the financial
Yes, we finally made it to the part where most people start. Crunching the numbers on the financials!
I always say that real Estate is an I.D.E.A.L. Investment. Ideal because it can produce all 5 of the Wealth Building Principals:
I = Income / Monthly cash flow D = Deductions / tax benefits such as deductions and appreciation E = Equity / The debt reduced on the mortgage that is paid for by the tenant A = Appreciation / Value growth from year to year (national average is 6% past 50 years) L = Leverage / the ability to have 100% of these above benefits while borrowing 80% of the money used to make the purchase
With your investment objectives in hand and your type of property picked out such as single family homes, town home, etc. you will want to see which of these 5 Wealth Building Principals you will want. I always say, if your investment cannot produce at least 3 of the wealth building principals then you should not be investing. There are cases where people do not want to own real estate because they prefer a more passive investment, but love the idea of investments secured by real estate. These people may opt for an investment like the purchase of a cash flowing note, and even this investment may not produce tax deductions but will typically generate the other 4 wealth building principals.
Properties, as cheap as they are today, still represents a pretty big investment. I always recommend a third party inspection. These inspections should focus on the structural, electrical and mechanical integrity of the property. There are many inspections that a person may have. Many of these inspections can be identified by the primary inspection. For example there are MOLD inspectors or lead based paint inspectors. Your primary all-purpose inspector should have enough bask knowledge to identify if a property has a concern that may require a deeper in depth look over a PARTICULAR CONCERN that he may identify. Inspections are extremely important but you may want to make sure you are not being sold additional inspection services that many not be needed. The two I always recommend are the Basic Home Inspection and if you are purchasing in a warm climate that does not freeze in the winters, you will also want a Termite Inspection, also know as a wood destroying organism inspection. The combined total of these two typically will not exceed $500 and will offer a good 3rd party reporting of the overall CONDITION OF THE PROPERTY.
Simultaneously, you will want to make sure you have secured the best property manager available. Any seasoned investor will tell you that the investment is made or broken through the property management so do your proper diligence review. We have a great resource for that, our Due Diligence Property Management Questionnaire.
All right, with this diligence complete you are ready to make an offer so next we will discuss Acquisition and how to duplicate the process!