SMART Investor eGuide

5. Escrow, Due Diligence and Information Refinement

"The closer you get, the better the information"

Here is where you get very close to knowing all you need to know about the property before removing contingencies.

Opening Escrow

Once escrow is open, that's when the real fun begins. You will finally be able to get answers to all your questions:

What is the true condition of the property?
What are the current rents?
Are all tenants on formal lease agreement?
What are the lease terms?
What are the existing expenses?

Inspections

Due Diligence: If the property was "drive-by only" and the offer written "subject to buyer inspection", this may be the first time you have seen inside part or all of the property.

Professional physical inspections are more extensive than most single family residences.

Termite inspections also typically cost more than SFR, and remediation is often an issue, due to the problem of needing to ask tenants to move out during tenting, spraying, repair, etc. Compensation is usually provided by the rental property owner for that inconvenience, such as offering to pay for temporary housing for a few nights until the work is finished.

Estoppels/Lease Agreements

Current lease agreements may or may not be up to date, or even exist! You, as prospective buyer, are entitled to (by contract) statements by current tenants as to the existing lease terms, including amount, duration and security deposit. These are called estoppels, and a standard C.A.R. form is used. We always also ask for copies of current lease agreements and security deposit accounting.

You should be aware that if a tenant has been in a property less than a 1-year lease, for example, and no other lease agreement has been signed since the expiration of that lease, the tenant is automatically considered to be on a month-to-month lease agreement.

Expenses

Expenses are important to know for an income property. They heavily impact the bottom line cash flow. There are two general sources of expense information for a property:

We always ask for a copy of the seller's property expense records. They may or may not have them, organized or at all. However, they are required by contract (see "RIPA", above) to provide whatever accounting they do have
Sched E is especially valuable to see for an income property. The seller may or may not be willing to share that, but if asked to redact the SSN, many are willing; try to get it

Security Deposits

Security deposit accounting is required to be given to the new buyer by contract (see "RIPA") before Close of Escrow. The new buyer takes over security deposit funds at Close of Escrow.

Rental property owners should keep their security deposits in a separate bank account, called a "Trust Account". Security deposits do not belong to the rental property owner. They are basically insurance in case a tenant leaves a unit with excessive cleaning or damage, and refuses to compensate the rental property owner. Security deposits should not be used to collect unpaid rent, either during or after tenant occupancy. In practice, that's often what security deposits are actually used for.

The rental property owner has 21 days after a tenant vacates to provide an accounting of excessive cleaning and repair funds taken out of a tenant's security deposit. Actual return of unused deposits should take place soon after that. Remember: security deposits are not your funds. And, as a result, they are not dischargable in the unfortunate event of rental property owner bankruptcy.

Keep The Tenants?

When taking over an income property, you are required to honor the terms of the existing leases.

However, a tenant on month-to-month can be removed, if desired, with either a 30-day (former lease 1 year or less) or a 60-day notice (former lease over 1 year).

Property Management

As part of your Cash Flow Analysis during the Property Search phase, you should have determined whether they want to manage the property yourself, or work with a reliable professional property management company.

Typical property management fees run from about 7-10% of monthly rents. Professional property management can alleviate the headaches of investment property ownership, including tenant search and screening, along with the joy of midnight plumbing repairs, especially for the new rental property owner.

You can always try it out, and then work towards self-management over time. Or vice versa.

Repairs

It is often necessary to make repairs to an income property immediately after purchase. Long-term rental property owners may have allowed deferred maintenance to build up, or the new owner may want to leverage his or her new acquisition and maximize the rent by making it into something special.

Some repairs may be requested prior to Close of Escrow. That way, any ill feelings a tenant may have enduring the inconvenience of in-place repairs would likely be toward the exiting rental property owner. Either way, part of the process after inspections and re-analysis should be moving toward the decision about when to effect repairs.

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5. Escrow, Due Diligence and Information Refinement