IS YOUR BABY UGLY?

The Due Diligence Steps Every Real Estate Investor Should Take

How do you know if you are really onto a good real estate deal and should invest? What due diligence should property investors engage in before presenting the deal to potential lenders?

Everyone Thinks Their Baby Is Beautiful

Beauty is definitely in the eye of the beholder. When it comes to investing in real estate, investors need to look beyond the property and test their optimism with real, fact-based due diligence. Investors need to make sure the opportunity will be profitable and that it’s attractive to the lender. Not every deal is a good deal. You’ve got to see the property for what it is—and what it isn’t.

How to Screen for Money Makers

Here are six quick steps for making smart real estate acquisitions:

1.Make sure the deal matches your investment and acquisition criteria.

2.Optimize your processes. These processes are screening and making offers on properties, and arranging funding.

3.Follow smart principles and use formulas and common sense (don’t get caught up in the excitement of the deal). Run the numbers using the formulas in Chapter 22, check your assumptions, and run it past a partner or colleague.

4.Verify the numbers before making an offer.

5.Present the deal to the right lender(s).

6.Dig in and complete the due diligence and closing.

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 of what you are looking for. This way you spend your time on the most viable opportunities that fit your investment objectives. These criteria include:

•Location and marketability

•Square feet of living area

•Price range

•Potential profit spread or rental income

•Number of bedrooms

•Property type

•Complexity of repairing and remarketing the property

Investors need to make sure not only that the opportunity will be profitable but also that it is attractive to lenders.

If properties don’t match your criteria, your marketing and due diligence should reflect that. Any referral sources should have a good idea of your buying criteria. If you are marketing through your website, your messaging should target the kinds of houses you are looking for, so you attract good quality prospects. Serious volume investors often have acquisition assistants to screen 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

Following are some general rules of thumb used by many real estate investors. Not all of them will work for you, or in every location every time. But having your own rules of thumb is important for quickly analyzing property deals and maximizing your results.

The Rule of Financial Intelligence

Recognizing the following definitions can help in decision making:

•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 Percent Rule

The 50 percent 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 and taxes and other expenses to cost you $500 per month.

The One Percent Rule

The one percent rule calls for investors to only look at income properties that can rent for at least one percent of the purchase price per month. So, if you are buying a $100,000 property, it should rent for at least $1,000 per month. Some investors set the benchmark even higher at 2 percent.

This, like the 50 percent rule, is a quick and dirty (QAD) calculation. When it comes to rental real estate, before you make any buying decision, use net operating income (NOI) calculations (see Chapter 22) for single-family properties and capitalization (CAP) rate for commercial properties.

Debt Service Ratio

Debt service ratio (DSR or DSCR) is normally used by commercial property lenders. This ratio compares annual mortgage payments to expected net operating income. Most lenders demand at least a ratio of 1.2, meaning your NOI is 20 percent more than your mortgage payments.

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.

Zillow Is for Suckers

Even though notoriously and often wildly inaccurate, Zillow’s “Zestimates” continue to be used to guess the potential market value of properties by novice investors and sellers. The result is losses by sellers, who are led into falsely believing their properties are worth much more than they really are and then end up refusing viable offers. Online valuation tools too often rely on old data and simply can’t accurately reflect the realities of your market.

BPO: The Broker’s Price Opinion

Computer-generated valuations can’t do what a set of human eyes can. In some instances, you may want a formal valuation analysis, called a broker’s price opinion (BPO). A paid licensed professional visits the subject property, provides photographs, and prepares a full comparative market analysis. Providing your lender with accurate valuation information is critical to setting your loan in motion and securing good terms for your loan. A BPO does not replace an appraisal in most cases, but it’s a good place to start when shopping lenders.

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 percent lower than 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 make it simpler, but in the meantime, go the next step and verify, verify, verify.

Comparable Market Analyses

Comparable market analyses (CMAs) 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 CMAs for free. Investors can also piece together their own by comparing the prices and features of recently sold properties, pending listings, and expired listings. This is essentially how appraisers start the evaluation of residential homes. However, it is an art, not a science, and it is always best to verify.

Automated Valuation Models

Automated valuation models (AVMs) are the next step up. They can sometimes be used in place of appraisals, but can be 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 be helpful and empowers investors to move quickly and decisively.

Appraisals

Full appraisals are not cheap. You can’t afford to order full appraisals on every prospective opportunity. Otherwise, you’ll go broke before you do a deal. Your lenders will order their own appraisals and charge you for them, so it’s a better alternative when initially evaluating a property to use the BPO or to develop relationships with local real estate agents. In any case, investors can move the loan process along and get better up-front answers by providing copies of previous valuations that give lenders all the specifics of a property along with photos.

Rent Verification

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 from 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 (e.g., weekly, annual, and Airbnb-type rentals).

Inspections

It’s critical to do a preliminary walk-through 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 careless inspections that could have uncovered costly repairs, liens, and code restrictions on the property.

Is There a Lender for This Deal?

Before signing a contract or even making an offer, it pays to make sure there is a lender that funds your type of deal. While you aren’t able to guarantee funding, you should have identified a lender whose criteria matches your deal. For example, there is no point making an offer on a property you hope to tear down and rebuild if there are no investment lenders that offer construction financing in your area for your property type. Do your screening, find a lender match, then forge ahead.

Finding the right lender means finding the right properties and doing your homework to get the deal closed. Carefully analyze the deal and the outcomes you expect—and don’t be afraid to walk away from an ugly baby. Remember, not every deal is a good one.

TAKEAWAYS

There are a number of good ways to determine the value of a real property. Of the methods listed in this chapter, which can you employ in your business? Why are they the best choice?

What are your basic criteria when looking for properties? This knowledge allows you to spend your time on the most viable opportunities.