The Role of Due Diligence in Real Estate Transactions

13 mins read

Introduction

A recent survey found that nearly 40% of home buyers waive inspections to make their offers more competitive in today’s cutthroat housing market. While this rush to close may win the bid, it opens buyers to serious risks that thorough due diligence is designed to avoid. Due diligence is an essential part of any real estate transaction, equipping buyers with deep knowledge of all aspects of the property and allowing informed decisions to be made. This post will examine what constitutes due diligence, why it matters so much for buyers, specific areas to focus attention on, working with due diligence experts, and key questions to pose to sellers. If you are considering real estate investments, understanding due diligence and its value in avoiding costly surprises down the road is critical.

What is Due Diligence?

Due diligence refers to the in-depth investigation and verification process undertaken by a potential buyer of a real estate property prior to finalizing the purchase. It encompasses activities that aim to uncover all relevant details and information about the physical land, structures, systems, legal rights, and title ownership status tied to the property. Due diligence is far more exhaustive than a standard home inspection, delving deeper through document reviews, interviews, historical research, consultant evaluations, and third party testing and analysis.

The basic components of a thorough due diligence process include:

  • Title Search – A title company performs a detailed title search, examining current and historical property records to verify legal ownership and identify any easements, liens, pending judgements or other entanglements impacting title.
  • Home Inspection – A general home inspection looks at the physical condition of the property, structures and systems. An inspector helps identify issues with roofing, siding, electrical, plumbing, HVAC, appliances, drainage, and more.
  • Termite Inspection – A pest control professional performs an inspection and evaluates the property for wood destroying insects like termites, powderpost beetles, or carpenter ants. Treatment and repairs are identified.
  • Flood Plain Check – The site is evaluated to determine if it falls within a FEMA designated flood zone, which would require flood insurance through the National Flood Insurance Program.
  • HOA Document Review – If part of a Homeowners Association, all governing documents, bylaws, fees, restrictions and other details are reviewed.
  • Property Disclosures – The seller discloses information about known defects, facts and issues impacting the property that might otherwise go unmentioned.

The ultimate purpose of due diligence is to eliminate surprises for buyers by digging deep and uncovering all possible information about a property – the good and the bad – before purchase. This allows the buyer to make fully informed decisions with their eyes wide open.

The Importance of Due Diligence

Conducting rigorous due diligence provides a number of advantages and protections to buyers that make it well worth the time and fees required.

Avoid Hidden Issues – One of the top reasons for due diligence is avoiding unexpected issues and problems that can quickly become money pits post-purchase. Things like faulty structure and systems, outdated utilities, environmental contamination, drainage and moisture intrusion, pest infestations, restrictive easements and more can be uncovered through due diligence before buying, saving owners significant hassle and expense down the road. Catching issues ahead of time allows them to be properly addressed via renegotiations, credits or fixing prior to purchase.

Confirm Representations – Due diligence verifies that all aspects of the property are as advertised and represented by the seller and listing broker. This protects against misrepresentations that might occur if taking listings strictly at face value. For example, due diligence could reveal that the remodeled kitchen touted as being fully updated in 2017 actually still has 20-year appliances, or that the additional “bedroom” does not meet egress requirements to legally be permitted as a bedroom.

Inform Negotiations – The information unearthed during the due diligence process arms buyers with more leverage during price negotiations, especially if repairs are needed or misrepresentations identified. Due diligence often leads to renegotiations for credits, lower price, or sellers making repairs when issues come up that impact home value and habitability. Many times issues are minor and can be rectified before closing.

Avoid Delays – Skipping due diligence can result in last minute snags right before closing when problems or red flags finally surface. This can jeopardize or delay closing. Thorough due diligence allows any major issues to be identified early on so they can be addressed in the beginning versus the 11th hour.

Obtain Financing – Mortgage lenders require appraisals and inspections to secure financing and determine loan amounts. Due diligence gets buyers this required information upfront so there are no hang ups or surprises during the financing process. Lenders may not fund loans on properties that appraise low or show unaddressed issues in inspections.

There is simply too much at stake in real estate deals to skip due diligence. It provides buyers protection against inheriting unwanted problems, ensures the property is as advertised, enables negotiations from a position of knowledge, keeps the transaction timeline on track, and facilitates financing.

Areas to Focus Due Diligence

Not all aspects hold equal importance when it comes to due diligence. Savvy buyers and investors should focus extra attention on these key areas:

Titles and Ownership – A title search dives into property records to confirm legal ownership rights. Look for liens, loans, judgements and easements impacting title. Watch for red flags like unfamiliar individuals listed on the deed, odd property boundary lines, or lack of permitting records for additions.

Physical Condition – Have a qualified home inspector conduct a top to bottom physical inspection looking at all structures, systems, appliances, etc. Pay particular attention to the roof, siding, foundation, electrical, plumbing, HVAC and structural integrity. Get repair estimates for issues found.

Pests – Termites and wood boring insects can severely undermine and damage wood structural components. A termite inspection is crucial for identifying and addressing infestations before they get out of hand. Any evidence of pests warrants added inspection by a pest control professional.

Environmental – Homes built prior to 1978 must be checked for lead-based paint. Have radon testing done and inquire about prior uses of the property or activities that could have led to onsite environmental contamination. Order soil tests if concerned.

Flood Zone – Being in a designated FEMA flood zone increases risk of flooding and mandates expensive flood insurance premiums through the National Flood Insurance Program. Secure a flood zone determination to see where the property sits.

Zoning and Permits – Verify with the local municipality that the property’s current use and structures comply with zoning regulations. Check that any past additions or renovations received proper permits. Unpermitted work can jeopardize future renovations and create issues at resale.

HOA Status – If part of a homeowners association, the HOA governing documents, bylaws, rules around leasing, fees, dues, upcoming special assessments, and restrictions should all be reviewed. Interview HOA board members on pending issues.

Taxes – Make sure property taxes are current without any tax liens present on the property. Check amounts due and confirm the exemptions applied match the property use. Verify property description and acreage match tax rolls.

How In-Depth to Go

How deep and exhaustive buyers get with due diligence depends on several factors:

Budget and Risk Tolerance – Those with sizable due diligence budgets and an abundance of caution are smart to almost leave no stone unturned during the verification process. More risk-oriented buyers may opt for just the bare essential inspections to keep costs down. Real estate is unpredictable, so comprehensive due diligence always adds an extra layer of protection.

Property Age and Type – A newer suburban spec home will likely require less intensive due diligence than a 100-year old Victorian era house located in a rural area atop a hillside. The older and more unique the property, the more poking around and testing should occur since problems are more prone to going unnoticed. Income producing properties also warrant added financial diligence.

Inspection Results – If the initial inspections and title search uncover an array of issues and red flags, it signals that deeper due diligence is required across the board before proceeding, even in areas that may initially seem lower risk. Follow the clues.

Local Market Conditions – Frenzied real estate markets can create pressure on buyers to waive some elements of due diligence in order to place competitive bids. This is extremely risky. Savvy buyers are cautious with waived due diligence, using thorough contingencies and only limiting inspections on lower worry items.

Amount at Stake – On big ticket properties draining the entire savings account, buyers should match the intensity of due diligence to the total dollar amount at stake. When seven figures are on the line, due diligence should be exhaustive leaving no uncertainty prior to closing.

Working With Due Diligence Experts

Conducting thorough due diligence often involves assembling a team of specialists across different focus areas. Relying on the knowledge and technical skills of professionals pays dividends during the due diligence period. Experts to consider include:

Real Estate Attorneys – Real estate attorneys help examine title history, confirm ownership rights, identify title issues, analyze contracts and HOA docs, and surface any red flags. They also negotiate resolutions to any issues found.

Home Inspectors – Licensed home inspectors utilize high tech tools like infrared cameras, moisture detectors, and carbon monoxide testers to evaluate all aspects of the property and identify issues not visible to buyers. They provide detailed reports outlining findings and cost estimates for repairs.

Appraisers – Appraisers are hired by lenders to assign a fair market value to the property. This informs the loan amount and LTV ratio. Their valuation considers comparable sales and sometimes identifies issues impacting value.

Environmental Consultants – Environmental consultants help assess properties for environmental hazards like lead-based paint, asbestos, radon, mold and more. Particularly valuable for older homes where more risks exist. They take samples for laboratory testing when needed.

Structural Engineers – Professional structural engineers are experts at identifying structural deficiencies and concerns with the building envelope including the foundation, framing, drainage, and roofing systems. They diagnose root causes of settlement and leakage issues.

Cycle Inspectors – Cycle inspectors focus on evaluating mechanical cycles including HVAC, electrical, plumbing, elevators, fire and safety systems, pools, parking structures and more. They help diagnose issues and determine remaining useful life.

Geotechnical Engineers – Geotechnical engineers specialize in soil conditions testing load bearing capacity, stability, drainage, and grading for new or existing structures. They identify risks like landslides, erosion, and slope failures.

Questions for Seller

In addition to visual inspections, due diligence involves asking the seller direct questions to surface information they may not proactively disclose. Smart buyers inquire about:

  • Why are you selling the property? Look for responses that raise red flags about issues prompting the sale.
  • Have there been any major repair or remodeling projects done in the past 5 years? Ask for details on scope of work, contractors used, permits pulled, and outcomes.
  • Has there ever been any water intrusion, flooding, drainage backup, or moisture issues in the home or on the property? Look for evidence of mold or water damage.
  • Have there been any pest control issues or termite infestations? Were these fully resolved? Ask for documentation.
  • Are you aware of any foundation, structural, roofing, or envelope issues? Search for signs of settlement or damage.
  • Have there been any hazardous materials identified on site like asbestos, lead paint, buried fuel tanks, ground contamination? Request inspection documentation.
  • Is the property zoned for its current use? Have you made any additions or improvements that lacked permitting? Unpermitted work can compromise safety.
  • Are HOA dues fully paid? Have you received any violations or fines? Request documentation showing compliance.
  • Are there neighbor disputes, claims or encroachments impacting the property? These could surface post-purchase to become buyer’s problem.
  • Are property taxes fully paid and current? Are you party to any lawsuit that could create a judgment lien? Liens transfer with ownership.

Conclusion

Due diligence serves an incredibly valuable purpose in real estate transactions by equipping buyers with a deep and thorough understanding of all facets of the property prior to purchase. Attempting to shortcut due diligence only introduces risk and uncertainty down the road after the purchase is complete and recourse limited. While due diligence does require an investment of time and money upfront, it is always less expensive and disruptive to address issues before rather than after closing. Something as minor as a water leak can quickly spiral into mold remediation and structural repairs if left unaddressed.

Despite competitive pressures in today’s housing market, smart buyers and investors proceed with abundant caution, obtaining professional inspections, thoroughly researching title history, and verifying seller representations prior to closing. Although waiving certain elements of due diligence might help win a bidding war, savvy buyers utilize contingencies allowing an out if issues do arise during limited due diligence. For high dollar luxury home purchases or commercial acquisitions, limiting due diligence is particularly risky and ill-advised.

The best approach is to work closely with knowledgeable real estate attorneys during the due diligence period who can review findings, advocate on your behalf in negotiations, and prevent legal pitfalls. While due diligence does take some time, it places buyers in a far better decision-making position, delivers peace of mind, and prevents unpleasant and costly surprises down the road. For most people, buying a home or property is the largest investment they will ever make. Do not make that investment blindly without thorough due diligence beforehand.

FAQ

How long does the due diligence period typically last?

The typical due diligence period ranges from 30 to 90 days, with 45-60 days being common. The exact length is negotiable and specified in the real estate purchase agreement. This time period needs to be sufficient to allow the buyer to thoroughly assess the property, obtain multiple contractor estimates, review findings with professionals, and negotiate resolutions if needed. Rushing through due diligence in under 30 days is risky and ill-advised. Anything over 90 days can be problematic for sellers who want to minimize time their home is off the market. Consider 60 days a reasonable compromise to accommodate a wide range of inspections, from minor to very detailed.

What happens if problems are discovered during due diligence?

If issues or defects are uncovered during the due diligence process, the buyer has several options to address them. Most commonly, the buyer will present repair requests along with contractor estimates to the seller, and request they make fixes prior to closing. For minor issues under a certain dollar threshold, they may ask for a credit towards closing costs equal to the repair estimate instead. Ultimately if major issues impacting property value or habitability surface, such as foundation problems or extensive roof damage, and the seller refuses to make repairs, the buyer can exercise their right to terminate the purchase contract contingent on due diligence findings. This allows them to back out and recover earnest money deposits. However, termination is a last resort option. Most sellers are willing to correct minor issues or provide closing credits if negotiated reasonably.

Can I rely on the seller’s disclosures alone?

It is unwise for buyers to rely solely on seller disclosures when evaluating a property prior to purchase. Seller disclosures do provide helpful information that sellers are legally required to provide upfront. However, sellers may unintentionally fail to disclose issues they were unaware of themselves. Homeowners are not professional inspectors. The entire purpose of due diligence is for buyers to independently verify all aspects of the property through their own inspections and research, rather than taking the seller’s representations at face value. Seller disclosures should be viewed as supplemental to, not a replacement for, the buyer’s due diligence.

What are the consequences of waiving the inspection contingency?

Waiving the inspection contingency typically means the buyer loses their right to have the property professionally inspected, receive repair requests from the seller based on inspection findings, or cancel the contract if significant issues are discovered. Without an inspection contingency, the buyer essentially purchases the property “as-is” with no recourse for undisclosed latent defects that surface later. This presents tremendous risk to the buyer, who may become liable for expensive repairs and remediation for problems that existed all along but were undiscovered because inspections did not take place. As competition heats up in real estate markets, more buyers regrettably waive inspections to make their offers attractive. This poses potentially disastrous risks if a money pit is purchased sight unseen.

Does the seller pay for correcting issues found?

The purchase agreement terms will stipulate financial responsibility for correcting issues found during the buyer’s due diligence inspections and research. Typically, the seller is on the hook for reasonably addressing issues surfaced during the due diligence period, either by making repairs and corrections themselves prior to closing, or by providing a credit towards closing costs so the buyer can remedy issues post-closing. Most sellers are willing to fix minor items like faulty electrical outlets or clogged plumbing to allow the transaction to proceed. But for larger issues impacting habitability or property value, the contract may require renegotiations or even allow the buyer to terminate without penalty if no compromise can be reached. Buyers should consult real estate attorneys to ensure purchase contracts favorably address how due diligence findings will be handled financially.

What happens after the due diligence deadline passes?

The due diligence deadline, as outlined in the purchase agreement, represents the end of the period where the buyer can freely back out of the transaction based on inspection findings or really any reason at all. Once the due diligence deadline has passed, the buyer loses their ability to cancel the contract and must proceed to closing, as long as all other terms and conditions have been met. So it is essential buyers ensure all inspections, research, reviews and negotiations related to due diligence findings are completed before this deadline. Do not let it sneak up. After the deadline passes, only specific breach of contract contingencies can allow a way out of closing. Otherwise the buyer is obligated to complete the purchase, for better or worse.

Should I hire a buyer’s agent to assist with due diligence?

Yes, it is wise for buyers to hire a knowledgeable buyer’s agent to assist with due diligence. An experienced agent will help you strategically plan inspections, provide referrals to inspectors and attorneys, attend inspections to look for red flags, compare inspection reports to seller disclosures, advise you on repairs to request, and negotiate credits or fixes on your behalf. They act as your advocate throughout the process. Buyer’s agents are paid by the seller through commission splitting upon closing.

What should I do if the seller refuses to make repairs?

If the seller refuses to make repairs requested based on due diligence findings, do not automatically walk away. Start by getting multiple contractor estimates to provide the seller and see if a compromise on credits can be reached. Presenting repair estimates strengthens your negotiating position. If major issues impacting habitability surface, consult your real estate attorney about options like contract termination clauses, and consider asking the seller to split repair costs. Communication is key to settlement. Only terminate as a last resort.

How much can I expect due diligence to cost?

Budgeting $1,000-$3,000 for due diligence inspections and testing is reasonable depending on the property type, size and location. The Title search and physical home inspection will make up the bulk of costs. Additional testing like lead paint, radon, pest, etc can run a few hundred dollars each. Also factor in your time costs for meetings and reviews. Obtain itemized cost estimates upfront so no surprises arise. The cost is well worth it.

Should I be present for inspections?

You should strive to attend all inspections if possible. Following the inspector allows you to ask questions in real time, point out concerns, learn about the property, and verify the full inspection takes place. If unable to attend, speak with the inspector after to go through findings. Review all inspection reports and seek clarification if needed. Don’t sign reports until fully understood.

Can inspections be limited in scope to save money?

Attempting to limit inspection scope or skip inspections altogether to reduce costs is false economy. The cost difference between a thorough and limited inspection is minor compared to the value of avoiding expensive issues post-purchase. Spotting just one undetected $25,000 foundation problem makes all inspections worthwhile. Prioritize due diligence. Don’t cut corners or waive. Avoid regret after closing.

Should I hire an attorney to review property documentation?

Yes, it is prudent for buyers to retain a real estate attorney to review the seller’s disclosures, title report, HOA documents, municipality zoning records, and all other documentation impacting the property. Attorneys catch issues that buyers may miss. They also negotiate resolutions to problems, represent your interests in closing, and ensure legal requirements are fulfilled. Paying reasonable legal fees upfront saves much larger expenses later.

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