Managing the Due Diligence Process
The due diligence process is a long one. It’s like a tape measure that shows stuff to do every inch along the way. Sometimes it can seem like it will never end, and so it requires good time management and a great deal of focus. But don’t worry, when broken down into bite-sized pieces, the process can be managed successfully. As for organizing the whole process, we recommend that you organize yourself much like a project manager would — with project task lists and project deadlines. We guide you in the following sections.
Let’s say that you have a signed contract, and you’re ready to begin due diligence. The first thing you should do is open an escrow with an escrow company or title company. (In some states, an attorney will act as the escrow holder and perform those duties as well.) The escrow company is an unbiased and neutral party to the buyer and seller. It handles all the money and relevant documents that pertain to the transferring of ownership and closing of the deal.
To open an escrow, simply go to an escrow company (or an attorney that performs escrow services) and request that it handle your escrow for a property sale. And don’t forget to bring along your signed purchase contract. When choosing a company to handle your escrow, ask a real estate broker or a fellow investor for a referral. A seasoned and hardworking escrow officer can make all the difference when things get hairy, especially during the last few days of closing.
After you’re set with your new escrow, you can expect the escrow company to do the following tasks:
* Prepare preliminary escrow instructions: The escrow instructions tell the escrow officer what to do in order to close the deal with the buyer and seller.
Mistakes on the preliminary (and even on the final) escrow instructions are common, so check the math and check for accurate figures. You’ll see many fees listed — understand each one. If you don’t understand something, stop and question it.
* Receive the earnest money deposit: An earnest money deposit, which is also called a good-faith deposit, shows your intent to purchase the property in good faith.
* Order a preliminary title report: This report tells you who the actual owner of the property is as well as what loans or liens are currently on the property.
* Order a certified survey: This survey is ordered from a surveyor who goes to the property to verify the legal street address, its block, lot number, and subdivision.
* Request payoffs from lenders or lien holders: The lenders and lien holders will request payoffs so they can see how much is owed and to whom to pay off at closing.
* Receive all reports pertaining to the closing: The type of reports that the escrow company receives includes termite reports and deferred maintenance inspection reports.
* Record the title to the buyer after closing: This is the actual transfer of legal ownership from the seller to the buyer.
* Finalize and close the escrow: To finalize the escrow, the company pays off all loans and liens, delivers all closing documents, and pays the seller his proceeds.
The title of a property is the legal evidence of rightful ownership and is given in the form of a deed. So, after you have an opened escrow, the escrow or title company officer will order you a preliminary title report. Preliminary reports are thorough evaluations of public records of the ownership chain or “chain of title” for the property. They’re based on information that has been gathered by the title company over the course of many years. You can expect to receive your report within three to five days. In this report, you find the general history of the property’s ownership as well as loans, liens, or encumbrances placed on the property by other parties.
If the title has problems, it can’t be transferred to you at closing. In other words, each title problem must be resolved by the seller and escrow company before closing can occur. So, it’s important to order and review the preliminary title report early, because the owner then has time to take care of the problems while everyone works toward closing.
Here are some red flags to watch for on your preliminary title reports:
* Improper authorization: Make sure that the person who signed on the contract is authorized to do so and has the ability to actually sell the property to you. In other words, make sure that the person who signed the contract is the owner or can verify that they represent the owner.
* Unsatisfied mortgages: An unsatisfied mortgage can occur either because the seller has an outstanding mortgage on the property or because a previous mortgage wasn’t recorded properly as paid and then removed.
* Property tax liens: If a seller is behind on paying the property real estate taxes, we suggest you arrange for the owner to pay them before closing or renegotiate the terms of the deal, especially if you end up paying for them.
* Mechanics liens: In the case of mechanics liens, the seller didn’t pay for contractor services performed on the property, so the contractor has a lien against the property for payment.
* Judgment liens: If you come across a judgment lien, you know that the seller has been a party to a lawsuit, and a judgment has been awarded against them and the property.
* Leases: Here the seller is under a lease agreement for either equipment or a service and the property is used as security for the lease.
* Easements: If the seller has easements, that means they’re granted the right to use another person’s land for a stated purpose, such as the right to travel across a property owned by another person. This becomes a red flag to new owners who thought they could use the property exclusively for themselves.
Don’t get too worried about having to be an expert at reading preliminary reports. Your escrow officer and real estate attorney can pick up on the red flags. Your main task is to follow up with the seller to get these red flags addressed within the due diligence time period.
The preliminary title report then becomes the final title report, on which title insurance is based. Title insurance is an insurance policy that covers the title of a property if for any reason problems appear on your title after closing.
The buyer has the right to approve or disapprove the preliminary title report and back out of the deal unless the seller can provide a clean title by eliminating certain exceptions to the title before closing. But the buyer will only have a short period of time, as stated in the purchase contract, during which to act on the preliminary title report. It’s extremely important for a buyer (that’s you) to carefully review a preliminary title report immediately and to take appropriate action if any red flags appear.
A key component to your purchase contract’s due diligence process and to protecting yourself while under contract is the contingency clause. This clause is also sometimes called a “subject to” or “escape” clause. Basically, these clauses make your purchase of the property contingent upon something happening.
For example, most purchases are contingent upon the buyer inspecting the property and approving of its condition prior to closing. Another example may be that the purchase is contingent upon the buyer getting approved for a loan for the property. In both cases, if the buyer doesn’t like the condition of the property or can’t get approved for a loan, they may back out of the deal.
That’s the good side of contingencies — the side that protects you, the buyer. Here’s the flip side, however: Purchase contracts state how much time you have to perform due diligence duties. The amount of time usually ranges between 30 to 45 days. If you fail to perform those duties or don’t reply to the seller concerning those items within the time period, you automatically waive your rights to those contingencies and they’re considered “removed” from the purchase contract. After the contingencies are removed, the earnest money you put into the escrow becomes nonrefundable and belongs to the seller if you back out of the deal. So be sure that you pay strict attention to every contingency clause and its time periods during due diligence. Negligence can cost you thousands of dollars and a mean headache.
Check out these commonly used contingencies:
* Financing contingency: This contingency makes your purchase contingent upon getting financing for the property. Usually the contract states that you have 5 to 10 days to apply for financing through a lender, and then you have a total of 30 to 45 days to get approved for a loan. If you get approved for financing within the contingency time period, you simply contact the seller in writing that you have been approved for financing and that you’re hereby removing this contingency from the contract.
After you waive this contingency, your earnest deposit becomes nonrefundable. So, if you don’t get approved or can’t find acceptable financing, make sure that you notify the seller within your contingency time period so you can get out of the deal and have your earnest money returned to you.
* Inspection contingency: Usually this contingency involves two inspections: a physical inspection of the property and a financial and business inspection of the property’s books and records. For the physical inspection, you basically hire a professional inspection company to walk the property and report to you on the overall condition of the property. During the financial and business inspection you review, among other things, income/expense statements, leases, rent rolls, and service contracts. And, typically, you have 30 days to complete this contingency. Again, if your results tell you that you should get out of the deal, do so within the contingency time period so that you get your earnest money returned.
* Title contingency: This contingency, which usually has a due diligence time period of 7 to 14 days, allows you to make sure that the title is cleaned up before closing. For example, let’s say that a seller was behind in their property tax payments and also failed to pay their contractor for some roof work that was completed. Both parties can file a lien against the property to “cloud” the title and stop the closing from happening until both parties are paid.
* Appraisal contingency: This contingency can help you get out of a bind where there are differences in appraisal and purchase price amounts. For example, if the lender says that the property is only worth or has been appraised for $750,000, but your purchase price is $1,000,000, you have a problem. You’re coming up $250,000 short. You have three choices here. Take $250,000 from your own pocket for the difference. Ouch! Ask the seller to reduce the price by $250,000. Good luck there. Or, finally, you can make the deal contingent upon the property appraising for no less than the purchase price. If the lender’s appraisal comes up short, this contingency allows you to get out of the deal.
Here are a few tips on managing and using your contingencies like a pro:
* Keeping track of contingency periods and expiration dates can be trying, so post a contingency log on your office wall. That way, all the dates are visible and trackable with a quick glance. This is especially helpful if you, like your humble authors, make several offers at once on many different properties. Also consider setting up reminders for contingency and expiration dates on your computer, email calendar, or cellphone.
* If you find yourself running out of due diligence time in one of the contingencies, it’s okay to ask the seller in writing for a time extension. Usually, the seller will grant you more time if you can show good intent toward removing the contingency. However, don’t wait for the last day of due diligence to ask for a time extension on a contingency. Doing so leaves you in a weak and vulnerable negotiating position.
* Adding too many contingencies to your contract weakens your offer in the eyes of the seller. It makes you look like you want to get out before you even get in.