So you have started your home buying journey – YAY! There are all sorts of terms being thrown around: earnest money, escrow, inspection, appraisal, closing, and due diligence. So, what the heck is due diligence in real estate and why does it matter?
What is due diligence in real estate?
In real estate, due diligence from the buyers side refers to a buyer’s investigation of the various aspects of a property. This investigation either occurs before making an offer or (more often) within a specific timeframe between entering into the contract and closing. This is known as a due diligence period.
If any defects in or around the property are discovered, refer to your contract. Most real estate contracts contain language that specifies what the buyer and seller will do to remedy the problems. This is to ensure the transaction can continue toward closing. In some cases, you may be able to cancel the purchase and have your earnest money deposit returned in full. This should all be detailed within a combination of the purchase and sale agreement, addendums, and contingencies.
Here are some of the basic due diligence home buying tasks you should expect:
DUE DILIGENCE INSPECTION – GET TO KNOW THE AREA
Before you even make an offer, you should drive around the neighborhood. Can you see yourself living in the neighborhood? Check with the local police department. They can talk crime rates with you. Talk with other residents, and ask them if property values are rising or falling. Interested in knowing how the school system is? Contact the schools nearby.
Buyer: “Okay, but why can’t I just ask my agent? Shouldn’t they know?”
Answer: “Yes and no. While they may have an opinion, their opinion is just that – subjective! Meaning it is based on their vast array of life experiences. Which is why a good agent won’t weigh in on whether they think a home is ‘in a good neighborhood’ or has a good school system. This can easily be considered discriminatory and, personally, I’m here to help you find your home, not get hit with a lawsuit. A good agent should, however, be on top of the market statistics for property values (both the rise and the fall). Don’t hesitate to ask!”
WAIT?! WHAT KIND OF INSPECTION DO I NEED?
There are several types of inspections that can be performed on a home before it’s sold. What are they?
General home inspection:
This due diligence inspection looks at the overall condition of a home and covers its main structures and systems. These main structures and systems include the roof, plumbing, heating and cooling, electrical, kitchen appliances, and water heater. A certified home inspector will give you a full report on any issues that he or she finds, and whether the problems are minor or serious. Check here for a list of local home inspectors.
In some contracts, you can ask the seller in writing to make the repairs, if they aren’t too numerous or severe. Please note, a sellers market, buyers market, or neutral market all deserve different treatment. The type of market you are in, in combination with the guidance from your real estate agent will help you evaluate the amount of requirements you put forth. It is always best to discuss this with your agent – they will be able to help give you valuable local market information.
Sometimes a property will have so many problems that you may decide to terminate the contract and get a full refund of your earnest money.
Wood-destroying organisms (WDO) inspection:
This inspection is more common in some geographical areas than others. Your lender may or may not require one, so make sure you ask your local lender. When a WDO inspection is performed, the certified inspector looks for wood rot in the structures of the property caused by termites, other insects, or water damage. This will often include the exterior siding, garage, and even the interior walls and baseboards.
READ THE SELLER’S DISCLOSURES
Seller’s disclosures, when given, are a part of the real estate contract. Disclosures are not always required, and the laws regarding them vary from state to state.
However, you can gain a great deal of useful information about the past and present condition of the home by reading these reports. In some states, the seller isn’t required to provide this form if he hasn’t lived in the property for the last six months, but if he has specific knowledge of any material facts that could affect the value of the home, he’s required to disclose them during the due diligence period.
In the state of Washington, while sellers have always been required to disclose material facts, the Form 17 has been required by law (RCW 64.06.020) since January 1, 1995.
IF YOU’RE FINANCING, EXPECT AN APPRAISAL
A home appraisal is a determination of a property’s value. If you’re financing your purchase, your lender will select an appraiser from an appraisal management company. Although still recommended, an appraisal isn’t required on a cash purchase.
The appraiser will inspect the property similarly to a home inspector, but will be more concerned with features like property size, lot size and location, general condition, and upgrades. He or she then compares this “subject property” with other comparable properties or “comps” in the neighborhood (or nearby neighborhoods, if not enough comps exist in the same neighborhood).
If the appraiser doesn’t believe the property to be worth the sales price, the appraisal will “come in low.” In most cases, the seller will be forced to reduce the sales price of the home in order for the loan to be approved.
GET THE RIGHT TYPE OF INSURANCE
Finding the right insurer is a balance between best-quality and least-expensive insurance. Just like with most things, you get what you pay for so it’s important to shop around. There are several types of insurance you may want to consider, based upon your use for the property.
Homeowner’s insurance:
Purchase this insurance if you’re going to live in the new home. It covers fire and theft, liability, natural disasters, and private property losses. In fact, with most loans, you will be required to bundle this in to your escrow account. Make sure to shop around for not just the best rate, but for the best coverage. Contact your local lender – they will be happy to answer your questions and help guide you.
Dwelling insurance:
If you’re going to be renting the home out to tenants, buy this type of insurance. It contains liability coverage and protects the landlord’s property, but not the tenant’s belongings. Therefore, it’s recommended that tenants purchase separate rental insurance. Still have questions? Make sure to contact your local insurance provider.
Empty or vacant property insurance:
Consider this insurance when you’re going to resell, or “flip,” the home within a short period of time. You may or may not be doing work on the home during the weeks or months after you buy it, but nobody is actually “living” in it. This type of insurance is more expensive than the others because there’s more risk of fire, theft or vandalism with an empty house. As always, consult your local insurance provider. They will help you make an informed decision.
Flood Insurance
Gain peace of mind and make sure to look up any home you are considering making an offer on through FEMA’s Flood Map Service Center. The average cost of NFIP flood insurance is $700, but the amount you pay will depend on your home’s location and build, among other factors.
GET OWNER’S TITLE INSURANCE
Owner’s title is a legal document that asserts that the property is free and clear of any defects. These could be defects in ownership, liens, or title claims. This legal document also attests that any and all liens have been paid in full prior to the closing date. For example, let’s say the previous owner had a new roof installed, but never paid the contractor. Well, the contractor could attach a lien on the property that would have to be paid in full before the property could be sold.
Owner’s title insurance protects buyers from hidden title problems that weren’t discovered during the initial title search. These discoveries could be 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.
*note: lending requirements vary by state. For example, WA lenders will secure free and clear title before lending on a property.
CHECK THE HOA COVENANTS AND RESTRICTIONS
Most condominium and townhomes—and some single-family neighborhoods—have homeowners associations (HOAs) that propose and enforce rules for the subdivision in an effort to protect the appearance and values of the community. Make sure to the homes CCRs and HOAs will work with your intended use of the property before making an offer.
THE BOTTOM LINE
All of these due diligence home buying tasks may seem overwhelming. Fortunately, your real estate professional is ready to help you navigate the learning curve. As the buyer, you’ll be advised of the results every step of the way. When the day finally arrives to sign the closing documents, you’ll have peace of mind knowing that you have done your “due diligence.” The home you are buying will be in excellent condition and free of liens, encumbrances, or title defects. As one of the greats, Russel Wilson, would say, “the separation is in the preparation!”