What Is Due Diligence?
Due Diligence in Real Estate
Due diligence in real estate is a procedure that a potential buyer, investor, or real estate agent undertakes on a property before deciding to buy or invest in it.
Note that for this article, due diligence refers to real estate in particular.
Due diligence aims to gather information and verify the condition, value, and potential risks associated with a property. Due diligence includes reviewing documents such as title reports, environmental assessments, building inspections, and financial statements. It may also include physical inspections of the property, including its location and adjacent properties.
In some cases or jurisdictions, real estate due diligence is also a legal requirement before a transaction can proceed.
The entire process is a time-consuming and in-depth investigation. For instance, home buyers undertaking due diligence have to focus not only on the residential property they are buying; they also have to look into the homeowners’ association (HOA) in the community where they plan to purchase—whether the HOA is financially sound, or if they are comfortable dealing with an HOA.
In a commercial property, due diligence can even be more thorough. Investors must assess whether their planned purchase suits their needs and can deliver profits.
Additionally, they need to be extra careful because they have few safeguards under consumer protection laws, unlike home buyers.
Starting a Due Diligence Process
The due diligence period begins in one of two ways:
- Before the buyer makes a purchase offer to the seller.
- After the buyer and the seller sign a purchase contract. Here, the due diligence period is specified between the preliminary contract signing and closing of a binding purchase agreement.
In commercial real estate, many investors think it is best to start due diligence before signing a purchase offer contract. This way, the buyers can adjust their offer accordingly and make a more informed decision.
This pre-contract investigative period is subject to a Due Diligence Access Agreement. It permits a buyer or its agent to enter a seller’s property to perform due diligence concerning the possible purchase.
This real estate contract spells out the buyer and seller’s rights and liabilities during the study period before signing a purchase and sales agreement. It typically includes a confidentiality or non-disclosure clause (primarily for the buyer).
Due diligence begins with preparing a comprehensive checklist. The to-do items in this early stage essentially revolve around these elements: title search and other document retrievals, property inspection, and zoning rules.
How Long Does Due Diligence Take?
In the U.S., the laws governing real estate due diligence differ per state. Therefore, the due diligence period specified under a purchase contract offer can vary depending on the property’s location.
Also, the investigative period’s length depends on the property type. For example, residential real estate due diligence typically lasts 10 business days or 14 calendar days in most parts of the U.S.
Meanwhile, for commercial property, the inspection and disclosure statement can take 30 to 60 days. This time frame is longer because commercial real estate deals are more complicated and revolve around complex financial due diligence.
Who Initiates the Due Diligence Process?
Property buyers engaging in due diligence typically consult a real estate attorney and/or a real estate agent to start the process. This consultation is critical if the buyers’ purchase is out of state.
Each state defines real estate due diligence based on its environmental factors, which typically differ from other states. Buyers need to consult local professionals for an effective due diligence process.
What Does Due Diligence Look For?
Due diligence looks for different things depending on whether the property is commercial or residential.
Commercial Real Estate
In the typical due diligence period for commercial real estate, the property documents that have to be reviewed before the inspection include the following:
- Deed and title.
- Actual property uses.
- Information on current lessees (if any).
- Covenants, encumbrances, and zoning.
- Notices on pending or past governmental and legal actions.
- Tax and environmental audits.
- Property and land improvement records.
- Service contracts and seller’s property inspections.
- Title insurance and any other insurance policy.
Residential Real Estate
Home buyers, particularly those getting a mortgage, need a property appraisal as part of their due diligence. They can do this by hiring a professional home appraiser to determine the property’s fair market value, which follows (more or less) the same criteria as that of a commercial property.
A home appraisal allows the lender to gauge if the mortgage amount a home buyer has applied for is appropriate.
Next is a home inspection. A home inspection determines the condition of the residence, such as that of its electrical and plumbing installations.
Home buyers also need to research the property’s neighborhood. They need to look into the accessibility and security of the neighborhood. As mentioned earlier, it is also necessary to check the homeowners’ association that a residence may be a part of.
Investors in residential properties particularly need to note the following:
- Property taxes.
- Current tenants.
- Residential utilities.
- Local ordinance on rentals.
- Expected return on investment.
Adjusting an Offer After Due Diligence
After a due diligence period, buyers can revise their offer and negotiate with the seller on new terms, including the purchase price. The negotiation can continue until the seller accepts the revised offer.
Note that a buyer cannot back out when the due diligence has been completed and a contract has been signed. However, they can back out from their offer during the due diligence period. In this case, they stand to forfeit the earnest money they conveyed to the seller when they made an offer.
There are a few ways to recover the earnest money deposit, though. One example is if the buyer backs out because they can prove that the seller has concealed a title issue or a major defect.
- Due diligence in real estate is a thorough process by which property buyers examine if they are getting their money’s worth in a purchase.
- Due diligence allows a buyer or investor to mitigate risk and verify the property’s details, condition, and known facts.
- Buyers are responsible for undertaking due diligence on a property they are interested in or have submitted a purchase offer for.
- Due diligence should be mostly completed before a buyer enters a binding contract.
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