This is another crucial part of the due diligence process. The third party reports that I am talking about are primarily the Environmental, Property Conditions, Appraisal, and Market Study. You may or may not need them based on the type of property you are buying, but in most cases they are good to get and even may be required by your lender. Let's start at the top of the list.
I would highly recommend that you hire a company to provide you with an environmental study on the property. This report looks at soil composition, hazardous materials, and the like. Typically you contract for a Phase 1 report, which is affordable, approximately in the $2,000 to $3,000 range. This report is well worth the expense if the company turns something up like toxicity in the soil or some other hazardous materials.
TIP The downside risk is way too large not to spend the money on a Phase 1 environmental report. Do one, no matter what.
If you are using a conventional financing source, your lender will require a Phase 1 report. They often have an approved list of vendors, so I recommend that you check with your lender before you hire a provider to do this work. If you do not have a lender yet, you should hire a national company that has affiliates in your region, then ask them for a list of lenders they have done business with.
A property conditions report does just as the name states. It will call out issues with the property's condition that the inspections reveal. This would include structural issues, roofs, asphalt, sewer, and other building systems. The report also will give you an estimated useful life for those items. This is very important when you are capitalizing your budget.
TIP The property conditions report gives you a second opinion on the condition of the property and can either affirm/dispute the inspection findings that you and your property management firm did earlier. Or it can find something you both have overlooked. That's important to know.
When it comes to costs, property conditions reports can be all over the board, but this is no place to skimp. Not only do you want a firm that is experienced and knowledgeable, you want to hire a firm that has a national presence and is acceptable to your lender if you know who that is. As I mentioned earlier, if you have not yet chosen a lender, your inspection company may be able to help with a recommendation.
The other benefit of having a property conditions report is that it is a third party report and completely unbiased, in contrast to the report compiled by your property management company. If you go back to the seller with your property management report, asking the seller to pay for something that is wrong with the property, he or she may feel that the report is biased in your favor. That's hard to do when you are also holding a third party property condition report that reflects the exact same issue. This report gives you much more credibility and negotiating power.
Depending on how sophisticated a real estate investor you are, you may not think you need an appraisal. My advice is almost always to get one. If you are financing your project, you will need one anyway, and why not be sure that the property is valued where you believe it to be? It validates your own assessments, or in some cases refutes them. Either way, the knowledge is good to have.
As the borrower, it can get a little dicey if you hire the appraiser. Federally chartered banks have guidelines that they must adhere to. One of those guidelines is that the borrower cannot order the appraisal. Most banks and nonbank lenders are more comfortable making the decision on whom to hire. What I do in those instances is let the mortgage broker hire the appraiser or go to the lender with an appraiser in mind and let him hire that person. I generally want some say in the appraiser.
The mistake I see the most is when appraisers are hired and they are inexperienced in the type of property the buyer is purchasing. I run into this quite a bit with banks. They just send out a bid sheet to three appraisers and hire one not necessarily based on his expertise but on his time availability and price. A bad appraisal can bring the entire transaction to a standstill in a second.
To avoid this I always suggest having one or two appraisers that are good at what they do and qualified in your type of property that you can recommend to the bank. I also recommend that you take the time, or let your mortgage broker take the time, to share your vision of the property with the appraiser. If the appraiser does not see the value that you currently see or are going to create, you are toast. Finally, be proactive with him and provide him with as much information as you can.
TIP Remember an appraisal is an opinion of value. You may have, and are entitled to have, your own opinion, but you'd better be ready to back it up.
Usually the appraisal will contain a good discussion of the market for your type of property. However if you are planning to do something a little more on the edge or something that is complex like a condo conversion, hotel, golf course, or some kind of unique single family project, for example, you may need an additional market study not only for your own knowledge but to help move your ideas forward with the people around you.
There are companies, both regional and national, that can do market studies geared directly toward your kind of project and just about any other kind of project including ones I mentioned in the previous paragraph. Consider engaging them to do the report and show it to everyone who you think needs to see it. What I mean by that is show your market study to clarify and support your vision and to defend your position.
TIP Show your market study to clarify and support your vision and to defend your position.
Warning—these market reports can be expensive. It is common to see them run in the $10,000 to $30,000 range. But at times, they are worth their weight in gold. I have successfully used these types of reports to argue the assumptions used in an appraisal that came in low. Again, it is much easier to argue your points on absorption, price points, rents, etc., when you have a credible third-party report supporting you.
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