Due diligence is important in order to verify the value and uncover potential problems with a business transaction. This article focuses on real estate, but the general ideas apply to any business transaction.
- In real estate, laws require some aspects of due diligence, such as a seller’s disclosure.
- Good due diligence involves careful and thorough inspection of the property, the neighborhood, and your financial situation.
- For most residential real estate contracts, the period takes 10 – 15 days.
In real estate, laws require sellers to disclose any problems they know with the property. However, they are not liable for issues they do not know about. That is why home inspections, appraisals, and title searches are important. It is also important for you to do your due diligence by having your finances in order before you begin looking for a new home.
Is Due Diligence a Legal Requirement?
Due diligence is a legal requirement for most large transactions, including real estate. Having said that, it is a purposely ambiguous legal term for a couple of reasons. One is that the seller may present all the facts they know about the investment and not know about a potentially damaging issue. The other reason is that the buyer must engage in the process. In simple terms, the seller is obliged to answer honestly, but the buyer is obliged to ask the right questions.
What is the Most Important Aspect of Due Diligence?
It is impossible to pinpoint just one most important aspect of due diligence. Further, what is most important depends on the type of contract. For real estate, there are three paramount issues:
- Inspection of the land improvements (buildings)
- Appraisal of the property value
- Title Search
- Financial inspection of the buyer (ability to get a mortgage, usually)
Different professionals (a home inspector, appraiser, title agency, an underwriter) inspect each of these during the due diligence period. For most residential real estate contracts, this period lasts 10 – 15 days. After that, the buyer must voice any negotiable issues. Then, the contract becomes binding for the buyer and seller.1
What Happens if Due Diligence is not Done?
In real estate, certain aspects of due diligence must be done, or else the deal will not go forward. The buyer’s mortgage company will inspect the buyer’s financial situation in detail. If they find that the buyer cannot afford the house, then they will not underwrite the loan. Likewise, the lender will demand an appraisal of the property. They will not underwrite the loan if they feel like the sale price is greater than the value.
A home inspection is not required for the deal to close. However, the buyer should always get a licensed inspector to thoroughly examine the house. If the inspector finds a problem, the buyer may:
- Renegotiate the contract
- Ask the seller to make repairs
- Back out of the contract without any repercussions
If the buyer does not get a home inspection, they cannot ask for any remuneration after the contract is binding. However, there is one aspect that the buyer may sue the seller for at any time. The law requires sellers to disclose any problems that they know about the property. If the seller hides a problem, they are liable even if the home inspection does not find it.
What Does Good Due Diligence Involve?
Good due diligence involves careful, a thorough examination of all aspects of a transaction. The process should take time because it is detailed in nature and necessarily precise. In real estate, like in any other business transaction, it begins even before you begin looking for a home. It includes:
- Making a checklist of the important features you want in your home
- Assessing your financial situation and getting a preapproval from a mortgage company
- Researching neighborhoods to find the best area that fits your needs
You should do all of these before you begin to look for a home. The more precise you can be about what is most important to you the better a real estate agent can work for you. Speaking of agents, that is another important aspect of due diligence.
Interview all professionals you work with. You should thoroughly vet your Mortgage representative, realtor, attorney (and/or title company), and home inspector. Research the team of professionals you will work with carefully because a good team will make the process go smoothly and protect your interests.
How Long does Due Diligence Take?
For most residential real estate deals, due diligence lasts 10 – 15 days depending on where the house is. In fact, generic contracts have this time period built into the document. However, anything is negotiable. If you feel that you need more time, then you can always negotiate.
The seller usually wants to leave this period short because they want to close the deal as quickly as possible. Indeed, most of the time this period is sufficient to accomplish the home inspection and appraisal.2
Who Pays for Due Diligence?
In real estate, the buyer pays any fees associated with due diligence. The mortgage company usually rolls the appraisal and underwriting fees into the closing costs for the loan. However, home inspection fees are out of pocket. The inspector almost always wants compensation at the time of the inspection.
In most areas, the contract is not binding for the seller or buyer during the due diligence period. That is not the case everywhere, though. In some places, like North Carolina, the buyer pays a non-refundable fee to the seller for the due diligence period. In this case, the contract binds the seller but not the buyer.
Can I Back Out?
Due diligence is a time-consuming process, even for residential real estate. During this period, the buyer may back out without consequence. During this time, the buyer should look for any potential problems. If the buyer finds any problems, then they renegotiate the contract. It is important to know that you will not be bound to the initial terms when new information arises that significantly changes the value of the property.
What is the Next Step?
In real estate, the next step after the due diligence period is the finalization of underwriting for the mortgage company. Because it takes longer to underwrite the loan than this window allows, the contract always has a clause to allow the lender to complete this process.
After underwriting, the lawyers (or title company) prepare the final documents. Then the deal closes. It usually only takes a couple of days to prepare the documents after underwriting concludes.
Final Thoughts on Why is Due diligence Important
Due diligence is important to protect yourself from unforeseen problems. With any complex transaction, like a home purchase, there is a potential for these issues to arise. That is why it is important to take it seriously and hire experienced professionals to help you navigate the process. These professionals, for real estate, include an attorney, mortgage representative, real estate agent, and home inspector.
You do not want to buy a money pit. They even make funny movies about it. Doing your homework will make sure that you do not fall victim to such a situation.