Monday, March 16, 2009

Due Diligence on Residential Rental Properties

I can’t emphasize enough on the importance of due diligence. How many of you signing your mortgage documents without thoroughly reading it? Or buying stocks of a company without at least reading the financial statements?

I know this happens not only at the individual level, but at the institutional level as well. Few friends confessed to me that they didn’t read the mortgage documents before they signed them. Some well known corporations, their representatives didn’t thoroughly verify the vendor invoices before paying them. Let’s say you receive an invoice of total cost $30 millions, do you know that one of the charge of $75K, may not be a valid expense? If you are one of those people, chances are, you may not do the proper due diligence when buying investment properties.

One time, my agent, who was a seasoned REALTOR with more than 20 years experience, presented a property to me. The property was in a good neighborhood and relatively new. I started to do the due diligence. Everything looked fine, until I found out the guy who was living cross the street was a sexual offender. I immediately notified my agent, and he was surprised. He didn’t know about it. Since my intention was to purchase the property and hold it as a rental, it would be a big liability for me, let’s say if I had tenant with children. Especially I had the knowledge about the presence of sexual offender. You may guess the end of the story. I asked my agent to find me another property.

Due diligence requires a lot of work and knowledge. Novice investors don’t do proper due diligence because they don’t know how to do it. But the worst part is, people who exactly know what they are supposed to do and know how to do it, yet they choose to ignore it for whatever reason.

So, what kind of due diligence has to be done on residential rental properties? I give you few examples.

Demographics, do you know the population, density and the growth rate in that city or county? How much is the average household income? How about vacancy rate?

Business and economics, who are the major employers? Do they have plan for expansion or reduction? Any future massive layoff? What is the unemployment rate?

Natural Disasters, whether it is an earthquake, tsunami, hurricane or tornado, know your potential risk.

Zoning and Planning Department of the city, what is the zoning of the subject property? Does the city have plan to construct highway close by (potential noise)? Any public airport near by?

Title and lien, any easement, encroachment, or special tax assessment?

And much more. No matter how well you do the due diligence, it may be still few surprises down the road. The goal is to know what you are buying and minimize your risk as much as possible. If you have the proper due diligence, you will still be much better off than if you don’t.

In the future, I will write about “Due Diligence on Apartment Building”. Stay tuned and come back often.

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