Why You Need to Perform Your OWN Due Diligence!
A case study from of John P.
In 2022, John purchased a home from an acquisition company. His intent was to fix and flip. John failed to perform even the most basic elements of due diligence.
So, here's what happened!
- John found that the home was built without a building permit
- John states that the home was built on the ground and did not have a foundation.
- Possibly the home was built on a concrete slab?
- Seemingly, the builders of the home went rogue and just built the structure without obtaining any building permits or lot surveys.
- The lack of a survey resulted in the driveway and carport being built on the neighbor's lot.
- In addition, another part of the home was built on the neighbor's land.
- John relied on the estimated value placed on the home by the seller. Because of this, John wound up paying $72K more than he possibly should have.
- Then, in addition, John relied on the seller's estimate of rehab cost. The estimate fell short by $19K. John had to eat that expense.
- With that, we can start to see that John P. Is almost $91K in the hole on this one and he hasn't even dealt with attempting to remediate the unpermitted construction of the home, nor the encroachments onto the neighbor's property.
- BUT WAIT! THERE'S MORE!
- John P. learned about the encroachments and lack of a building permit we talked about supra, when he went to obtain a building permit to start to rehab. At that time, John P. also learned that:
- His request to obtain a building permit would not be approved due to the encroachments onto the neighbor’s land and the extensive renovation required.
- According to the city, his only recourse would be to demolish the existing structure and go through the process of building and entirely new structure.
- Now, John P. purchased the home for $140K. $125K of that was hard money. He also spent $70K in cash to close and perform other rehab to the property.
- Now, John P. states that according to the City, he cannot do anything with the home except to tear it down.
Just a quick note: I have some concerns about this case study where it seems that either some of the facts are questionable, or the buyer was simply too eager and unknowing.
However, here's what should have been done prior to closing on the sale:
1. John P. should have consulted with a licensed real estate broker to determine the estimated value of the property in its as-is state.
2. Then John P. should have accurately estimated the rehab costs by having a licensed general contractor walk through the property with him. If the walk through discovered issues with the foundation, John should have consulted with a licensed foundation repair specialist or engineer.
- Additionally, with this walkthrough, an experienced contractor would have noticed the red flags and would have been able to explain what types of peril John P. might be facing.
3. Instead of relying on the seller's ARV statement. John P. should have obtained the ARV from a licensed real estate broker (obviously since John P. seemingly had no clue as to be able to perform this area of due diligence himself).
4. Some will say that John P. should have requested the most recent survey of the property. I say "never trust what someone has done before you arrived on the scene. Have your OWN survey performed." Remember, the seller of the home should be bound by the contract to deliver marketable title. If the structure encroached on the neighbor's property, then the title is NOT marketable UNTIL a remedy has been employed.
- Secondly, where is the title insurance policy? Had John P. sought title insurance, the encroachment would have been discovered and the sale would not have been able to close until the defect had been cured.
5. John P. should have checked with the city to see if there were any code violations, open permits or any other adverse conditions on file with the city. By doing this, the city would have said Whoa! We didn't know there was a house out there!
6. Lastly, as an investor (This is for new investors. Seasoned investors already understand this.), be especially weary when the seller wants to move at a lightning speed pace where the prospective buyer is simply unable to put forth an effective due diligence effort. Remember, while title insurance is an additional cost to be absorbed, title insurance is your best friend and should NEVER be declined.
7. If the seller is not flexible in allowing you to perform your due diligence, it might be wise to move on to the next project. Remember, the relationship should be mutually beneficial. The consideration for the seller is the promise to pay the agreed upon sales price. The consideration for the buyer is to obtain marketable fee simple title to the property where the buyer has been made aware of (and has remediated or resolved) any conditions or defects which might detract from the value of the property.
8. In essence, the buyer should know as much about the property as a reasonable person would expect the buyer to know. Obviously, it would not be reasonable for the buyer to know that a huge sinkhole is ready to pop up on the property. However, it is reasonable to state that the buyer knew or should have known about that huge sink hole that had been sitting in the back yard for the past year.