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[UPDATED] The Importance of Adhering to a Proper “Due Diligence” Checklist When Purchasing Property

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  • [UPDATED] The Importance of Adhering to a Proper “Due Diligence” Checklist When Purchasing Property
Founding Member of Moshes Law, P.C.
During his years of practice, Yuriy has concentrated in litigation and real estate transactions as his areas of expertise.

If you’ve previously dealt with property transactions, you should have seen the term “due diligence.” First-time home buyer? Trying your hand at commercial properties? Have no fear! Rarely do buyers truly understand the responsibilities that due diligence implies. 

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    Buying a home is a monumental responsibility, but you’re accomplishing a major milestone! This milestone costs some serious money, and there are some steps you should take before fully committing to the property. At the end of the day, being a first-time buyer is no excuse — especially not in court.

    What Does Due Diligence Mean in Real Estate?

    “Due diligence” describes your responsibility, as a reasonable buyer, to examine and scrutinize the property before contracting. Before acquiring this giant liability, a reasonable buyer would research a little. The “reasonable buyer” is a standard based off the average property-buying adult that is domiciled in your state. 

    There are several things to consider before sealing the deal: the title search, the conditions of the property, the inspections, and the zoning rules. Additionally, there are numerous federal laws regulating various factors like the property survey, mortgages and other loans, insurances, and taxes. A reasonable buyer would do everything within limit to avoid buying property with a bunch of hidden problems. 

    Wouldn’t you like to know about a lien on the property before you took a mortgage out? Would the number of floods or termite infestations change your mind about the property’s warranties or buying price? Maybe your insurance policy will surprise you with short term disability coverage. Ultimately, proper preliminary due diligence will save you.

    Is Due Diligence a Legal Requirement?

    Each state may define due diligence in real estate for its own state. It makes sense — each state has different environmental factors that can cause various forms of property damage. As a reasonable buyer, it’s important to keep this in mind when you’re scheduling your inspections. 

    However, states are also hesitant about creating strict standards for the due diligence process because the expectations shift with the current circumstances. Additionally, these expectations continuously change with technology and regulations. New York specifies to investigate the title, along with every deed or other document that is properly recorded. 

    The State will also assume that you did look into all of these documents, even if you didn’t. Once upon a time, this standard wasn’t this strict, but this changed, thanks to modern technology. The State will assume that if you diligently tried, you could have access to all of these documents. 

    It’s understandable if this seems overwhelming. After all, there are a lot of things that can affect a title. Before buying real estate, it’s important to remember to consult with a real estate attorney and a real estate agent. It’s especially important to choose an attorney and agent that are well versed in New York’s property market. These professionals can help you navigate these expectations, in accordance with New York’s laws. 

    Due Diligence for Commercial & Residential Real Estate 

    Due diligence should start before any contracts get signed. This way, the offer can be adjusted accordingly. One of the primary reasons why preliminary due diligence is important in commercial and residential real estate transactions is so that the buyer can properly analyze the property’s value to create an offer strategically. Plus, no one wants to be surprised by the home being out of the price range. The most effective and diligent way to accomplish this is by using a due diligence checklist. 

    what does due diligence mean in real estate

    An important way to start the due diligence process is by calculating your Net Operating Income (“NOI”). This should be one of your primary factors in determining your price range and how much you are willing to pay for the property.

    NOI =Income-Operating Expenses, not including taxes or interest

    Many documents are only available after the buyer places an offer. Determining your NOI beforehand will assist with any issues arising from this inability to explore the property’s net profitability. 

    Once the offer is placed, you can proceed towards the appropriate due diligence process that is outlined below. The following sections further detail the essential aspects of due diligence. Be sure to add these items to your due diligence checklist.

    Due Diligence for Commercial Real Estate 

    The term “commercial property” encompasses a large range of properties. If you’re thinking about buying commercial property, you have a particular purpose for the property in mind. Whatever this purpose may be, the property should fit your vision if you’re buying it. 

    Doing your due diligence will protect you as a buyer from buying a lemon. It would be disastrous if you’re stuck with a lemon that doesn’t fit your purpose or have any resale value. This can all be avoided with careful and diligent examinations of the property, including proper investigations. 

    The due diligence period should begin before signing the contract but usually won’t begin until an offer is made. Once the offer is made, the due diligence period has absolutely begun, so you can begin reviewing the relevant documents and scheduling inspections. Examples of relevant documents are:

    • the deed [pay attention to the type of deed] and the title review;
    • existing, actual uses of the property;
    • information about any current lessees;
    • encumbrances, covenants, and zoning documents;
    • any notices regarding currently pending or past legal and governmental actions;
    • environmental assessments, land and improvement surveys, and tax audits;
    • any service contracts and seller inspections of the property;
    • current title insurance, along with any other necessary insurance policy; and
    • notices or any other available documents regarding past and pending legal or governmental action against the property.

    During this period, the buyer can make a different offer and the parties can negotiate until the seller accepts an offer. After acceptance, the buyer deposits the down payment into the escrow account and will be applied towards the purchase after the closing. The due diligence period will typically last anywhere from 30 days after closing to more than 9 months after. The safest bet is to complete your due diligence duties before the closing.

    Remember, if you want to build a bar, you don’t want to buy property in a zone that forbids alcohol sales. By promptly completing your due diligence duties, you won’t waste any time with bad properties. With patience and diligence, you’ll find that perfect property for your needs. 

    Due Diligence for Residential Real Estate

    Don’t hesitate to conduct your own investigations for residential properties either. Buying property is a big deal — regardless of being for commercial or residential purposes. It’s important 

    to conduct due diligence towards investigating the property’s condition and value. With residential real estate, there are not as many objective measures of valuation of property, especially for single-family residences.

    In general, you can get the residential property appraised or research local real estate trends to help estimate the value. The due diligence period for residential properties in New York tends to end once contracted. To accomplish proper due diligence, examine:

    • the deed and title review,
    • the documents covering the various insurance policies, 
    • the surveying documents,
    • the property inspections, and
    • the environmental assessments. 

    If the residential property is a multi-family home, definitely examine: (1) the property taxes; (2) the current tenants; (3) the utilities; (4) the local ordinances; and (5) the amount of profit you want to generate.

    Though you aren’t applying for business licenses, there are covenants and zoning requirements for residential properties too. Some areas have extra fees, like for an HOA. Other ordinances may restrict items that are physically allowed to be on the property. As a buyer, you should decide if you like the strings that come attached with the property. 

    Title Review

    The title review should be the first item on your due diligence checklist. The title is the transferable legal right to the property. Note, the title review isn’t the same thing as the deed. The deed refers specifically to the document used to transfer property. 

    As a buyer, you want to be sure that the seller has the proper title for sale. Reviewing the condition of the title will inform you if you are buying a clean title or not. A title review will tell you about the previous legal owners, the property lines, and the property’s legal description. Any encumbrances, liens, and previous judgments of bankruptcy or foreclosure will also show up during the review. 

    Buyers should purchase title insurance so the title can be thoroughly reviewed. The title insurance company well-versed in title searches. Plus, the policyholder is liable for missing any claims against the property. Title insurance is one of the most responsible ways to increase your efficiency in buying real property. 

    Title Review for Commercial Real Estate

    A title insurance company will usually produce a Preliminary Title Report (“PTR”) for commercial properties. This PTR will include details like the title owner, the type of estate, the property description, and the presence of any encumbrances or claims against the property. The PTR should give a full picture of the title’s condition. Any presence of a title defect should be listed on the report. 

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      If you need help interpreting this report, contact an experienced real estate attorney. The attorney will walk you through the PTR, scrutinizing it along with you. As the buyer, it’s important for you to remain clear on the state of the property. We don’t want to see you waste your hard-earned money on a lemon. 

      Title Review for Residential Real Estate

      More than likely, the mortgage lender will mandate that you acquire title insurance. A title insurance company will conduct a similar title search for residential properties. If any claims against the property are found, the seller is informed so the claim can be quickly redressed.

      Once the title has been deemed cleared, the title insurance company will issue a title commitment. A title commitment is a statement declaring that the insurance company will insure the property. The title commitment will likely complete your lender’s requirement for approving your mortgage

      If you are purchasing a distressed property for renovation, you may have to agree to satisfy any existing liens at closing. Otherwise, you may have difficulties receiving the title commitment. Obviously, this will affect your mortgaging ability, so it’s important to plan for this beforehand. 

      Real Estate Appraisals

      One of the most critical aspects of the real estate purchasing process, real estate appraisals will be a key determinant in any assessment of the property’s value. This is what the seller will use to determine their asking price, what lenders will use to determine the amount they will lend, and what tax agencies will use to assess taxes. 

      Appraisals for Commercial Real Estate

      Commercial real estate appraisals assess the physical structure, zoning records, geo-demographic information, financial records, leases, and comps to value a property. You will want to be sure that the seller is providing current and updated financial information to the appraiser. Generally, commercial real estate appraisals will range from $2,000.00 – $3,000.00. 

      Appraisals for Residential Real Estate

      Usually, licensed residential real estate appraisers will either use: (1) the sales comparison approach — which emphasizes comps; (2) the cost approach — which looks at the replacement cost of the property; or (3) the income approach — to develop an initial opinion of value. When reviewing the appraisal, you should be clear on the chosen approach, the date of valuation, and the independence of the appraiser.

      Property Inspections

      To be truly certain that the property is structurally sound and up to code, all building inspections should be done by a certified third-party. Inspections for commercial real estate will typically cover roofs, HVAC, electrical, heating, plumbing, and structure. These inspections will cover the same areas as commercial real estate inspections. Additional residential inspections include: pest-infestation inspections, septic inspections, chimney inspections, water quality, exteriors and interiors, and other areas.

      define due diligence in real estate

      Inspectors will look at the lifespans of these systems. All other things held constant, the typical lifespans are: 10 – 15 years for a roof, 40 – 60 years for plumbing, 50 years for electrical systems, 15 – 17 years for HVAC systems, and 70 – 100 years for the underlying structure. Commercial inspections will also typically include parking areas, among other areas of a commercial property. 

      These inspections generally start at $325.00 and should take at least 2 – 3 hours to ensure thoroughness. It’s highly advisable that you attend the inspection with the inspector to ask questions and learn to spot issues with other properties you may purchase in the future.

      Surveying

      Proper surveys should be the second item on your due diligence checklist. Surveying allows you to evaluate the boundaries and legal description of the property compared to the actual land. Completing a survey will show if there is an encroachment on the property. It will also inform you if the nearby property has an easement on your property. 

      An encroachment describes when a portion of someone else’s property is intruding onto yours. An easement is a granted right to pass through your property. A survey will also uncover any unrecorded rights, which wouldn’t show up in a title search There might be other covenants — conditions and restrictions that are tied to the land.

      Once the contract is executed, the due diligence process will continue with property surveys, bank appraisals, title searches, loan commitments, and more repair negotiations. It’s essential to know all of these details before making a purchase. Both the title insurance and the lender will likely require proper surveys.

      Surveying Commercial Real Estate

      If you’re planning to renovate or expand the property, surveying is critically importance. You’ll want to look for a survey from the American Land Title Association (“ALTA”). ALTA surveys are prepared by a licensed surveyor and in accordance with the Association’s standards.

      Oftentimes, title insurers want to see the results of an ALTA survey before issuing a commitment. The survey will include information on encroachments on to the property you intend to purchase; encroachments the property you intend to purchase has on neighboring properties; and easements that affect the intended property.

      Residential Real Estate Surveying

      For residential real estate, the surveys should be as recent as possible. Many lenders won’t honor a survey that’s more than 6 months old. Most residential real estate purchasers will use the less expensive option, house location surveys. 

      However, title insurance companies won’t consider these surveys in coverage of encroachments and boundary line disputes. To get title insurance that covers these issues, you should also consider getting an ALTA survey when buying residential real estate as a potential investment.

      Real Estate Leases

      Evaluating the real estate leases should be the third item on your due diligence checklist. As mentioned previously, you should evaluate the income generated by the existing leases to evaluate the property. You should also look at the tenants’ files and their creditworthiness. It would be wise to personally assess the condition of the leased spaces to corroborate the seller’s assessment of the property’s condition.

      Other documents to evaluate in tandem with any existing leases should include: (1) existing loan documents; (2) insurance documents, which may provide further information and a risk assessment from the insurer; (3) utility expenses; and (4) property taxes, that you’re responsible to pay when the property is vacant.

      Evaluating Commercial Real Estate Leases

      Some experts recommend that you review the previous period’s actual operating performance instead of the pro forma statements. These pro forma statements may give you a misleading portrait of how well the property is actually doing. 

      You should also thoroughly review the lease terms and the tenant files. If possible, interview the tenants directly, as they will be yours to manage shortly. During the due diligence process, ask the seller to keep you abreast of any tenant problems that occur during the process so you can be informed of the current issues.

      Evaluating Residential Real Estate Leases

      Beyond reviewing leases for income projections, you’ll want to review them for any clauses related to access of the leased space, renovations, and selling the property — in case you’re interested in flipping it. Also, make sure that the seller informs you of any amendments they make to the lease during the due diligence period. At the closing, don’t forget to ask the seller to credit you for the tenants’ security deposit.

      Zoning

      Understanding the local zoning requirements should be the fourth item on your due diligence checklist. Zoning certifications are obtainable from planning offices of the jurisdiction that the property is located. The buyer should verify that the building is currently complying with zoning regulations. Furthermore, the buyer should learn about any planned zoning changes that may undermine their intended use of the property. Start talking to the representatives from the local zoning office so you remain up to date.

      Commercial Real Estate Zoning

      Commercial real estate property owners should confirm that the property is in present compliance with existing zoning regulations. This is especially important if they’re planning renovations, development, or further expansion. Zoning can also address assessments, exactions, and impact fees — all which can directly influence net income. After you purchase the property, it is very important to stay informed of the developments in the city’s zoning plans.

      Residential Real Estate Zoning

      Staying informed of your residential zoning laws is very important. For example, if your tenant decides to operate their business in their apartment, it may cost you a hefty fine. Similarly, it’s pivotal to remain knowledgeable about local zoning plans. For example, if your city re-zones, allowing commercial property development, it could increase your property’s development potential.

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      Environmental Inspections

      Completing proper environmental inspections should be the fifth item on your due diligence checklist. Environmental inspections are also imperative, especially for commercial properties with occupants that might purchase large quantities of environmentally harmful products. It’s possible that the property sustained previous environmental damage, and this may affect your intended usage. 

      Environmental Inspections for Commercial Real Estate

      For commercial properties, environmental appraisals begin with a Phase I Environmental Report. The reports will indicate if there are serious problems that need remediation and will include appraisals from licensed third parties. These reports also include any reviews of state and federal compliance agencies of the property in question. If there are such reviews, a Phase II investigation will typically proceed. A Phase II investigation will usually involve additional testing.

      Environmental Inspections for Residential Real Estate

      Residential property purchases also include environmental assessments. These assessments are completed by licensed assessors, selected by title insurance firms. While Phase I and Phase II assessments are not required, it’s in your best interest to secure the most thorough environmental assessment available. It would be diligent to ensure that you have full use of the property.

      Nonobvious Tips for Real Estate Due Diligence

      • Google the address of the property

      You’ll be surprised with how much you’ll find out by just doing this crimes, fires, accidents, bankruptcies, etc.  

      • Have a talk with the building department

      It’s good rule of thumb to be familiar with people you know you’re going to have to speak to regularly. You don’t want to be sideswept by the department’s decisions over your property. Plus, you might learn some information about the building that you wouldn’t have found otherwise. 

      • Talk to the neighbors

      Lending a helping hand and building relationships with the community will allow you to have people to rely on. Neighbors will speak honestly about previous owners and conditions, which is crucial information about the property.  

      • Shop around for your mortgages 

      Just like you shop around for new cars and houses, you should shop around for mortgages. This way, you’ll ensure finding the best interest rate and other benefits.

      • Speak with the police department

      The police department will supply you with any public records concerning the property, plus any other information that may be shared.

      The Importance of Owner’s Title Insurance for Buyer

      Owner’s title is a legal document that asserts that the property is free and clear of any defects in ownership, liens, or title claims, and that any and all liens have been paid in full prior to the closing date. For example, if a previous owner had a new roof installed, but never paid the contractor, the contractor could attach a lien on the property that would have to be paid in full before the property could be sold.

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        Owner’s title insurance protects buyers from hidden title problems that weren’t discovered during the initial title search, such as errors or omissions in deeds, mistakes in examining records, forgery, or undisclosed heirs. If you discover any liens after the closing, the company that prepared the title insurance would have to pay for them. If there’s a mortgage, lender’s title insurance protects the lender if there’s a problem with the title. 

        Frequently Asked Questions

        How long does due diligence take when buying a house?

        Typically, it will take somewhere from 1-2 months.

        Does due diligence include weekends?

        It is counting business days — Monday through Friday, 8:00 A.M. – 4:00 P.M.

        What is the due diligence process in real estate?

        The due diligence process is the thorough and proper examination of the property of interest. The process should be mostly completed before entering a binding contract.

        Who gets due diligence money?

        The seller gets to keep the money in almost all circumstances, except if the seller is in breach.

        Who holds due diligence?

        Buyers give it to sellers to hold.

        Can a buyer back out during due diligence?

        Yes, the buyer can back out during this time. But the buyer loses the ability once the due diligence period is completed, and the contract is signed.

        Who has the most responsibility to perform due diligence in a real estate purchase?

        Buyers have the ultimate responsibility for proper due diligence towards the property they are possibly acquiring.

        How to Get Help with Fulfilling Your Due Diligence

        Although proper due diligence is a lot of work, it is worth it and in the long run will help you determine if the property is what you actually want or whether you should purchase the property. Essentially, this is one of the most important stages of the real estate property buying process.

        If you feel yourself overwhelmed with variety of tasks on the checklist, you need to consult a real estate lawyer who will take the time to explain the steps, take care of the paperwork and the title research, and go through the proper due diligence checklist. 

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        At the Law Office of Yuriy Moshes, we assist clients who buy or sell property in the greater New York City area including all its boroughs (Manhattan, Brooklyn, Queens, the Bronx, and Staten Island) as well as Northern New Jersey, Long Island, and Upstate New York.

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