First Time Home Buyer’s Guide: What Is Due Diligence?
Many first-time home buyers have little idea of what they need to do after they sign a contract to purchase a home. In this article, we’ll look at the “due diligence” part of buying a house, and discuss the various tasks that are vital to ensuring that your purchase becomes a positive event and not a nightmare.
A Basic Definition
First things first: due diligence refers to a buyer’s investigation of the various aspects of a property, either before making an offer or (more often) within a specific timeframe between entering into the contract and closing. If any defects in or around the property are discovered, most real estate contracts contain language that specifies what the buyer and seller will do to remedy the problems so that the transaction can continue toward closing. In some cases, you may be able to cancel the purchase and have your binder deposit returned in full.
Here are some of the basic due diligence tasks you should expect.
Get to Know the Area
Before you even make an offer, you should drive around the neighborhood and surrounding areas to assess the other homes and people who live there. Check with the local police department to see if the home is located in a low-crime area. Talk with other residents, and ask them if property values are rising or falling.
Be Prepared for Multiple Inspections
There are several types of inspections that are usually performed on a home before it’s sold.
General home inspection: This inspection looks at the overall condition of a home and covers its main structures and systems, including the roof, plumbing, heating and cooling, electrical, kitchen appliances, and water heater. A licensed contractor or 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.
In some contracts, you can ask the seller in writing to make the repairs, if they aren’t too numerous or severe. But sometimes a property has so many problems that you may decide to terminate the contract and get a full refund of your binder deposit.
Wood-destroying organisms (WDO) inspection: This inspection, which many lenders will require, looks for wood rot in the structures of the property caused by termites, other insects, or water damage. This often includes the exterior siding, garage, and even the interior walls and baseboards.
Lead-based paint inspection: This inspection tests for the presence of lead-based paint in or outside of the home. It’s legally required for homes built before 1978; federal law requires that sellers disclose certain information about the presence of lead-based paint and allow potential buyers to test for it.
Radon gas inspection: This tests for radon, a radioactive gas that has been found in homes all over the United States. The EPA and the Surgeon General estimate that long-term exposure to high levels of radon gas causes thousands of lung cancer deaths in the United States every year.
Defective drywall inspection: A relatively new test in which a property is inspected for evidence of defective Chinese drywall, which emits a strong sulfuric smell and corrodes building materials and wiring. It was used in many new homes and buildings between 2001 and 2009, particularly in Florida, and has been linked to health problems.
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 glean a lot 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.
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 just like 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
If you want the best-quality, least-expensive insurance, 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 you’re going to live in the home. It covers fire and theft, liability, natural disasters, and private property losses.
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.
Empty or vacant property insurance: Buy this 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.
Have the Property Surveyed
A survey is a geographic “map” of the property and its boundaries. It typically includes the home and land around it, as well as any right-of-way easement areas. It will also show permanent structures on a property, such as a fence or swimming pool. On occasion, a survey may show that a neighbor’s structure is actually encroaching on the property you’re purchasing. In such cases, it may be necessary for that problem to be corrected before a lender will grant you a mortgage for the property.
Get Owner’s Title Insurance
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.
Owner’s title insurance protects you 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.
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.
When you purchase a new or used condo unit, you’re usually permitted to read through the covenants and restrictions within a couple of days of signing the contract. Take advantage of that opportunity. Should the covenants and restrictions not be to your liking, you can cancel the real estate contract without any penalty or loss of binder deposit. However, no such law applies to single-family homes.
The Bottom Line
All of these due diligence tasks may seem overwhelming, but fortunately, your real estate professional knows some knowledgeable and experienced people to perform these tasks. As the buyer, you’ll be advised of the results every step along 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” and that the home you are buying will be in excellent condition and free of liens, encumbrances, or title defects.
This article from Auction.com was reprinted with permission. It originally appeared as First time home buyers’ guide: What is due diligence?
Ethan Roberts is a real estate writer, editor and investor. He’s a frequent contributor to InvestorPlace, and his work has been featured on MSN Money and Reuters. He’s also written for Seeking Alpha, Investopedia, The Fiscal Times, ForSaleByOwner and Smarty Cents, and was one of five contributing editors to The Tycoon Report. He’s been investing in real estate since 1995 and has been a Realtor since 1998. He also teaches classes on investing in residential real estate.